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American Water Works - Nice Steady Upward

Gordon Pape

Gordon Pape

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Contributing editor Glenn Rogers is with us this week, writing from his home in southern California. That's significant in the context of his topic today because large parts of the state have been experiencing severe drought in recent years, including some of the richest agricultural areas. Glenn is a successful businessman, entrepreneur, and investor who has worked in both Canada and the U.S. Here is his report.

Glenn Rogers writes:

"Water, water, every where, nor any drop to drink." - Samuel Taylor Coleridge, The Rime of the Ancient Mariner

Truer words were never spoken, particularly here in California where we are in the middle of a five-year drought, which is threatening agriculture and recreational activities throughout the state and has led to some of the worst wildfires we've ever seen. If this continues there will be profound effects on virtually every aspect of our lives here and elsewhere in the Southwest. This got me thinking about what companies will benefit and could play a part in helping to solve what is a global problem and a significant threat to our national well being.

The idea of water being the new oil is not new. Water related investments, broadly speaking, have mostly just tracked the S&P 500 for the past few years but going forward this looks like a mega trend that's not going away.

The U.S. water utility business is a $130 billion industry that is growing at 4% per year. The capital demands are high so there are relatively few players that can afford to be in this sector on a large-scale basis. There has been massive consolidation in the industry over the last number of years, further reducing the number of companies who can serve this important segment.

We have recommended Flowserve in the past (FLS) and did very well with it. I still like it although it seems fully priced for now. Another way to get exposure to this sector is by using the PowerShares Water Resources Portfolio ETF (PHO) that contains Flowserve and American Water Works (AWK), which I am recommending in this column.

AWK is also a significant component of the Canadian-based iShares Global Water Index ETF (TSX: CWW), which was recommended by my colleague Gavin Graham in our companion Income Investor newsletter in July 2013 at $19.65. It was trading at $24.71 at the time of writing.

So let's take a closer look at AWK. The company was founded in 1886, is based in New Jersey and has 6,600 employees. It is essentially a U.S.-based utility, which serves 14 million people in 40 American states and parts of Canada. In 16 states, the company is a regulated business similar to an electric or gas utility. This status subjects the company to oversight that includes how much it can charge for water and wastewater services. The regulated part of the business is asset based and offers water and wastewater services to approximately 1,500 communities in 16 states. It operates approximately 80 surface water treatment plants, 500 groundwater treatment plants, 1,000 groundwater wells, 100 wastewater treatment facilities, 1,200 treated water storage facilities, 1,300 pumping stations, 87 dams, and 47,000 miles of mains and collection pipes.

However, the company also has a significant market-based business that can charge whatever the traffic will bear. The non-regulated part of the business is essentially service based, with the company operating and providing maintenance, financing, and waste disposal services to municipalities, armed services, and private homeowners.

In total, American Water Works serves approximately 14 million people with drinking water, wastewater, and other water-related services

Recently the company announced first-quarter earnings that grew by 25% with net operating cash flow increasing by 63.65%, driven by revenue increases of 7.2%. This resulted in an increase in earnings to $68.1 million ($0.38 per share, fully diluted, figures in U.S. dollars). That compared to $57.6 million ($0.32 per share) for an increase of about 19% over the prior year on a per share basis. The company also recently announced an 11% increase in its dividend to $0.31 per quarter ($1.24 annually) and is now yielding 2.57% based on its Friday closing price of $48.16. It marked the seventh straight year since 2008 that the company has increased its payout.

I like the fact that this a relatively unexciting company with solid earnings, a decent dividend, and a customer base of Canadians and Americans, which reduces the risk of global craziness such as we are seeing now in Ukraine, Iraq, etc. When rates begin to rise we will have to have another look but for now AWK offers growth and stability.

If you want more reassurance, take a look at the stock's five-year chart. No scary peaks and valleys here - just a nice steady upward climb.

Action now: Buy with a target of $55. The shares closed on Friday at $48.16.

Covidien Ltd. (COV)

Originally recommended on April 19/10 (#20115) at $51.09. Closed Friday at $90.11. (All figures in U.S. dollars.)

In a surprise move that is having repercussions all the way to the U.S. Congress, Minneapolis-based Medtronic Inc. has made a $42.9 billion bid to buy Dublin-based Covidien in a cash and stock transaction that values COV at $93.22 per share. That's a premium of 29.4% to Covidien's closing price on June 13, the day before the announcement.

Both companies are in the medical technology business and once the transaction is complete - if it isn't blocked - Medtronic will have a comprehensive product portfolio, a diversified growth profile, and broad geographic reach, with 87,000 employees in more than 150 countries.

In a joint statement, the companies said the deal is expected to result in at least $850 million of annual pre-tax cost synergies by the end of fiscal 2018. "These synergies include the benefits of optimizing global back-office, manufacturing and supply-chain infrastructure, as well as the elimination of redundant public company costs," the statement said.

But here's the kicker. In what is known as an inversion arrangement, Medtronic plans to move its head office to Ireland, where it will operate under the name Medtronic plc. The reason: tax avoidance. By taking over Covidien and shifting its executive offices to Ireland, Medtronic will be able to take advantage of low Irish tax rates. That prompted U.S. Deputy Treasury Secretary Sarah Bloom Raskin to comment that the deal should put pressure on Congress and the administration to overhaul tax laws.

This is a signal that some kind of business tax reform should be taken quite seriously," Reuters quoted her as telling a business forum. "Something is probably wrong with our tax system."

There have been several inversion transactions recently, prompted in part by U.S. laws that heavily tax offshore profits once they are repatriated to the country. With billions of dollars at stake, major international corporations have been exploiting tax loopholes, enraging some lawmakers in the process.

There are two schools of thought on how to proceed. One is to introduce lower tax rates for foreign earnings brought back to the U.S., thereby encouraging companies to bring home their overseas earnings. The other is to take a tough line and ban deals such as this one.

Given the controversy, there is no guarantee this plan will go forward. It is subject to regulatory approval not only in the U.S. but also in the European Union, China, and some other countries.

My advice at this point is not to wait around until the smoke clears. Let's take the money and run.

Action now: Sell. Including dividends of $3.58, we have a total return of 83.4%.

Realogy Holdings Corp. (RLGY)

Originally recommended on March 18/13 (#21311) at $47.70. Closed Friday at $35.20. (All figures in U.S. dollars.)

I recommended this stock in March 2013 when it was trading at $47.70. Initially it did well but in the last few months it has been hammered.

As a reminder, Realogy Holdings is brokerage firm for domestic and foreign real estate, principally residential. The company was involved in nearly 30% of all the real estate transactions in America last year and showed signs of recovery when the real estate business was finally picking up after being in the doldrums for several years. It differs from other businesses in the sector in that it simply makes a fee per transaction and doesn't have to worry about inventory or risk tying up capital by actually constructing homes like the homebuilders who hire the firm.

Individual agents taking a larger share of the commissions than was historically the case have challenged the model in recent years but it's still a compelling business when times are good.

First-quarter results were so-so with revenue up 5% year-over-year but profits were negatively impacted by a reduction in mortgage refinancing. However, Realogy did reduce its corporate debt by nearly $400 million and refinanced its own notes to take advantage of lower interest rates.

Compared to where we were three or four years ago, times are good indeed even given the terrible winter weather we had and factoring in that the market got ahead of itself last year. Overall, we still are in a relatively good real estate market, one that is likely to get better over the next couple years.

I think this recent pullback is a buying opportunity and I will be establishing a new position this week.

Action now: Buy with a target of $45.

Nutrisystem Inc. (NTRI)

Originally recommended on Aug. 26/13 (#21331) at $12.80. Closed Friday at $17.05. (All figures in U.S. dollars.)

I recommended this stock last August when it was trading at $12.80 and we've done really well with it. The shares closed this Friday at $17.05 for a gain of 33% and that's down 17% from its high of $20.54, which we touched last November.

Even with all the new smart phone apps and wearable technologies counting steps and calories, Nutrisystem still helps its clients lose weight and that remains a national problem that is not going away anytime soon.

There is a large short interest in the stock, which could propel a covering rally. Earnings for the first quarter of 2014 were strong with revenue increasing 16% year-over-year and gross profits up by 13%. The company has no outstanding debt. The company also raised its revenue guidance for the full year.

The stock pays a quarterly dividend of $0.175 per share ($0.70 a year) to yield 4.1% at the current price. The bad news is that the dividend has not been increased since 2008.

I still like this one.

Action now: Hold.

Broadcom Corp. (BRCM)

Originally recommended on Aug. 23/08 (#2820) at $27.42. Closed Friday at $38.28. (All figures in U.S. dollars.)

It has been more than two years since I last updated Broadcom, at which time it was trading at $34.77, up more than $7 from the original recommended price of $27.42. Since then the stock mostly traded sideways until very recently when it spiked up 25% in the past month giving us a profit of almost 40%, not including dividends.

Recently, the company announced it was selling its cellular baseband business and some analysts have downgraded the stock because of that. Recent financial results have been decent but uninspiring with revenue growing at only 3.9% over the previous quarter but flat compared to the first quarter of last year. Net income was also flat.

I don't expect to see much more progress on this one so let's take profits on the recent jump and move on. Including dividends of $1.76 per share, we have a total return of 46%.

Action now: Sell.

About the author:

Gordon Pape
GuruFocus - Stock Picks and Market Insight of Gurus

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