Most investors consider utilities to be low-risk investments that offer stability and decent yields. However, this is not always the case. Often, the aura of low-risk causes investors to buy too heavily, causing valuations to become extreme and creating potentially significant downside risk. This view was detailed in a bearish article regarding American States Water (AWR) called “American States Water’s Valuation Likely To Fall As Rates Bottom“. The article was written in early April 2020 and the stock has declined just over 12% since.
See its long-term performance below:
As you can see, the stock has had stellar performance over the past decade despite its moderate correction this year. For now, it seems my bearish case may be playing out. However, it seems like a good time to reassess and see if the company’s valuation has become more reasonable.
The Rise and Stagnation of AWR
American States Water has had technology-like stock performance over the past decade. This makes it a bit of an anomaly compared to most utility companies that rarely see significant bull markets and instead offer steady dividend returns. However, one key difference is that AWR is also a military-contractor and generates about 20-25% of its EPS from its military water subsidiary American States Utility Services.
This subsidiary has contributed to growth since it does not take a significant capital contribution to win new servicing and construction contracts. However, this does create some important possible off-balance sheet liabilities. Most military contracts are long-term (50-year) fixed-price contracts. If costs rise more than anticipated or unforeseen difficulties occur, AWR must have to absorb cost overruns. The U.S. government has historically agreed to pay more when this occurs, but it still makes AWR’s business model a bit more risky than that of the average utility which owns its facilities.
That said, AWR was a very rapidly growing utility from 2000 to about 2014. Its stock performance during its growth period was decent, but most of its stock-growth has come after its revenue and cash-flow growth stopped rising. See below:
This is a sign that investors began to take AWR’s growth pace for granted. The company has seen a slowdown in new base contracts over the past few years. Problematically, if they keep trying to win new contracts, they may underprice which could create losses in the future.
Despite the lack of revenue and cash-flow growth over the past six years, AWR’s earnings and dividend growth has continued. As with most utilities, it generates more cash-flow (TTM $118M) than income (TTM $84M) due to depreciation. The company has seen a slight decline in depreciation recently as well as increases in accounts receivable which partly explain the different trends between cash-flow and GAAP income.
Investors should not expect AWR to grow EPS as is currently suggested in its estimates unless it grows its revenue. The company aims to do this through new contracts stemming from government privatization efforts. As one example, it recently won a $771M 50-year contract at Joint Base Lewis-McChord. However, I believe this well of growth does not have nearly as much potential as it did in the past. As such, AWR’s valuation seems to be a bit too high.
Water Companies Are All Expensive
There is no particular company that is exactly like AWR. However, California Water Service Group (CWT), SJW Group (SJW), and Middlesex Water (MSEX) are good comparisons based on company size. As you can see below, AWR is normally priced within the group, however, they’re all historically expensive:
American States Water’s “EV/EBITDA” ratio is in the middle of the four. However, the company is slightly riskier than the others due to the possible volatility associated with its contracting business. The company also has a dividend yield that is very low by historical standards.
Speaking of which, AWR’s yield (and that of its peers) is generally very close to that of a 20-year Treasury bond. These have been declining for decades due to the drop in inflation, however, it has risen over the past few months and high gold prices imply inflation could cause yields to go into a secular increase. See below:
Overall, AWR is no longer overvalued compared to its peers. However, the entire water utility industry is a bit too expensive. Long-term bond yields have been pushed lower through immense quantitative easing from the Federal Reserve which has inadvertently boosted the fair-value of low-business-risk companies like AWR. In my opinion, with yields below 1%, water companies are just not what they used to be.
The Bottom Line
American States Water missed revenue by a bit last quarter and announced that it will release Q3 earnings on Tuesday, November 3rd. The current consensus estimate is an EPS of $0.75 and $152M in revenue. This is roughly the same EPS and revenue that is 14% above Q3 2019’s levels. I agree with the consensus estimates.
On a similar note, I no longer believe AWR is the selling/short opportunity it used to be. While there are potential long-run risks to consider, AWR’s business model is strong and lower-risk than that of virtually all companies. This is attractive during times of high economic uncertainty like today. Like other water utilities, it is an extremely expensive stock that pays a very low yield, however, its yield is reasonable considering today’s abysmally low bond yields.
All said, I still would not buy AWR due to its low yield. “Risk-off” assets as a whole seem to be a bit too expensive from a long-term standpoint. Better yields (at lower overall risk) can be found by allocating most assets into cash with 20-30% in a high-yield higher risk investment. That said, I would no longer bet against AWR.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.