Aqua America: Slow and Steady

Watch for a $27 entry price

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Oct 27, 2016
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For most investors, water utilities are as boring as it gets. Modest growth, modest yields. Don’t expect much more. You certainly won’t be able to buy a new house or car investing in water utilities and, the monopoly strength garnered by owning them doesn’t typically result in as much share price appreciation as other monopoly-type firms. So it is understandable that you pass these companies up.

That being said, times do change. The strategic importance of water, improved operating efficiencies, scale advantages and broad geographic diversification is making some of these companies far more attractive, not to mention the dividend and price stability they offer as investments.

Aqua America (WTR, Financial) is one of the best water utility companies in North America. It is a U.S.-based publicly traded company serving more than 3 million customers located in eight states –Â Pennsylvania, Ohio, North Carolina, Illinois, Texas, New Jersey, Indiana and Virginia –Â and operates 1,447 public water and 187 wastewater treatment plants. Like most modern utility companies, Aqua America operates an unregulated industrial water and services subsidiary.

Recently, the company aggressively pursued growth through an acquisition strategy, pursuing more than 200 acquisitions and joint ventures in the last 10 years. Many of these companies were small utility service businesses, consulting companies and inspection companies that clean and align sewer and storm drain systems. We don’t normally encourage growth through acquisitions but in Aqua America’s case, it has proven time and time again its ability to profitably deploy capital and generate positive returns on reinvested capital. Growth through acquisitions will likely continue in the future as a lot of smaller local operators are putting their companies up for sale knowing they can’t compete with the larger firms.

Purchase considerations and reasons for caution

With indexes as high as they are, Aqua America is most valuable as a defensive position against a market pullback –Â Aqua America is largely insensitive to broad market volatility and all investors require some defensive positions in their portfolios. We also like seeing Aqua America’s steadily growing returns on invested capital. This we think has fueled a lot of investor’s interest in Aqua America.

The company is still relatively small and has lots of potential to grow. Of course we also like how simple the business is and how easy it is to understand compared to a lot of other companies – which is one of Warren Buffett’s primary considerations. It occupies a strategic position in a key utility area and is poised to continue to expand as more public water utility companies become available for sale.

The company is earning the maximum return on equity allowed by most regulators, confirming top industry performance and tight cost controls. It is also starting to develop a well recognized brand. Whether brand power will increase consumer “willingness to pay” is another story – only time will tell. The stock has a low beta, a stable stock price, and steadily growing earnings and dividends. The dividend payout rate has averaged 55% and is growing by about 9% per year.

From an operating perspective, it is important to note that water utility companies require an enormous amount of capital investment, and a lot of companies' existing capital-base is old and out of date. On one hand, this will work in Aqua America’s favor when trying to acquire other companies. On the other hand, this will represent a sizeable drain on cash flows for many years to come. Shifting the percentage of operations to warmer climate states could help to offset capital replacement needs and support earnings in the long term. In addition, we know the company is managing free cash flow well as it has managed to keep debt growth under control.

Aqua America plans to deliver water to shale operators may not be as profitable as previously expected given the decline in energy prices and slowdown in shale demand.

Estimating sales growth

When assessing the competitive strength and investment merit of any firm, the first thing we like to do is to look at what’s going on with sales. Ideally, we are looking to invest in companies whose sales are strong, consistent, and are generally growing faster than nominal GDP growth (that is, real GDP growth and inflation combined). Based on Aqua America’s historical sales data, you can see that things look pretty steady. The 10-year sales growth has been 5% per year. This compares to nominal GDP growth of 3% per year over the same period, which is perfectly acceptable for a regulated utility company. Starting in 2011, Aqua America's sales pulled back a bit due to lower approved rate hikes.

That being said, the company remains on solid ground with new rates hikes being approved gradually as the economy continues to recover from the 2009 recession. You can invest in this company if you're looking for steady growth. Aqua America’s sales growth has been 4% per year over the last five years and 3% per year over the last three years. Aqua America's three-year revenue growth is actually ranked higher than 52% of the 576 companies in the Global Utilities-Regulated Water Industry.

Overall, we can see that Aqua America has an attractive revenue profile and has done a reasonably good job of generating modest, stable and growing revenues. Sales growth is projected to grow steadily in the coming years and we continue to expect good things from this company in the future.

Figure 1: Revenues ($ Millions) and Revenue Growth (%)

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The second thing we like to do when assessing sales is to look at consensus market estimates. As reported in Yahoo Finance, the market is projecting 3% annual growth for this year and 6% for next year. These estimates are drawn from the projections of eight analysts. The sales estimate is $817 million for 2016, compared to the year-ago estimate of $814 million. Note that the company is targeting 2% growth for next year, which would imply total sales of $830 million.

A third thing we like to do when assessing sales is to compute the firm's sustainable growth rate. The sustainable growth rate reflects the rate of growth in sales that a firm can support given its existing earnings power, capital resources and dividend payout policy. In any given year, a firm's sustainable growth rate is calculated by multiplying its return on equity (ROE) by its retention rate. Rather than rely on data from only one year, however, we calculate sustainable growth by using the firm's three-year average ROE and three-year average retention rate. Aqua America's ROE averaged 14% over the last three years while its retention rate averaged 45%, giving the firm a sustainable growth rate of 6% per year.

Let's recap briefly what the sales data is showing us. From what we can tell, it is not unreasonable to estimate that sales over the next five years could grow at a rate of somewhere between 2% and 6%.

Table 1: Choices for possible growth rates

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We're going to select a rate of 4%. With $814 million in sales generated last year, this means sales will continue to grow in the future and will reach about $996 million in five years. This estimate reflects our understanding of the firm's historical results, market demand, population growth and the regulatory environment.

Estimating earnings per share

Now that we have generated our sales estimates, we’re going to estimate growth in earnings per share. This method applied below takes the sales growth projection – in this case, 4% per year – and subtracts the expenses and taxes. What we're left with are the earnings. Then we divide by the projected number of diluted shares outstanding to determine the earnings per share (see table below).

A projected growth rate of 4% will result in almost $996 million in sales five years out. Now we need to take a look at the firm's pretax profit margin (what’s left over after expenses but before taxes are subtracted). In Figure 2 below, we can see that Aqua America has been doing a decent job maintaining its profit margin – 33% in 2012, 29% in 2013, 31% in 2014 and 27% in 2015. The average for the last five years has been 30%, and the average for the last 10 years has been 28%. Aqua America's margins will revert to its five-year mean of 30%. At this rate, projected pretax profits on $996 million in sales would be just over $299 million. This means expenses would amount to $697 million.

Figure 2: Pretax profit margins (%)

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The next step in our estimation process is to establish the tax rate that will be paid on the company's profits. The most recent year’s rate was 7%. Normally we wouldn't play with that number too significantly because in general, it shouldn't change much from year to year. The only time we would make major changes to this number would be in instances where maybe the current rate differed significantly from that of the past or if we had some knowledge about what rate was likely going to persist in the future, perhaps because the company is going to get some preferential tax treatment on operations abroad.

For Aqua America over the last 10 years, the company's tax rate has been as low as 7% and as high as 40%. Tax rates for most U.S. companies will fluctuate between 35% and 40%. We're going to select a rate of 25%, representing the average rate of the last 10 years, excluding the influence of nonrepresentative years. This would result in a tax expense of $75 million from pretax profits of $299 million in five years. This would leave us with $224 million in projected earnings five years from now.

Our next main consideration is a matter of determining the number of diluted shares that will be outstanding in five years. Aqua America has increased the number of shares outstanding over the last decade. There were 165 million shares outstanding in 2006, then the number of shares went up to 172 million in 2010 and then increased to 178 million in 2015. Currently there are 178 million shares outstanding. These data suggest the company has been issuing about 1 million shares per year. We're going to rely on the company's historical share issuance activities to guide our estimation process but will be more conservative as the company is finding fewer high-valued uses of its cash to stimulate growth.

With shares estimated at 178 million in five years, EPS is expected to grow at a compound rate of 2% over the period. This is slightly lower than our projected five-year revenue growth rate. Note that it doesn't always work out this way. Based on this EPS growth forecast, we are expecting EPS of $1.26 five years out. Results of our forecasting procedure are summarized in the table below.

Table 2: Path from projected sales to projected earnings

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Forecasting a target P/E multiple

Now we need to take a look at the price history of the company's stock. From Figure 3, we can see that the spread between the high and low stock prices has held fairly steady over the last 5 years. We have a current price of $29.86 with a high in the past 10 years of $31 and a low of about $15. We want to keep this variability in mind when establishing our upper and lower valuation range. Specifically, given the firm's historical stock price behavior, we should expect the stock to fluctuate by at least $5.18 over the course of a year.

Figure 3: Stock price history: Close, high, low

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Aqua America’s stock has traded at varying price-earnings (P/E) multiples over the last decade, averaging 24x over the last 10 years, 21x over the last five years, and 22x over the last three years. Currently the firm is trading at 26x trailing 12-month earnings per share and 21x expected future earnings.

For determining an estimated target P/E multiple, the first thing we like to do is eliminate any outliers from the historical data series. This includes abnormal P/Es that are not reflective of the normal operations of the firm, and this could be the result of abnormal growth or significant one-time nonrecurring charges/gains. In the case of Aqua America, we are going to leave the historical series intact. The next thing we like to do is to run an optimization procedure that reveals which P/E multiple yielded the best forecasting accuracy over the evaluation period. If in our judgment this multiple continues to accurately portray the earnings and cash-generating power of the company as well as the growth and risk characteristics of the firm, then we will use this multiple as our target multiple. If not, we will adjust the multiple upward or downward accordingly.

The figure below presents the historical P/E profile for Aqua America. We will utilize a target P/E multiple of 23x that reasonably characterizes the risk-return attributes of the company's stock. This multiple represents a contraction of 10% relative to the current multiple. It also represents an expansion of 16%, an expansion of 19% and an expansion of 6% relative to the three-year, five-year and 10-year average P/E multiples.

Figure 4: Historical P/E multiple and target point of reversion

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Setting a target price and valuation range

We selected a target P/E multiple of 23x. To determine a price target five years out, we then multiply this by our EPS estimate. EPS are estimated to reach $1.26 in five years giving us a target price of $29.20. Now, this price is in line with the current price. It’s also in line with where it traded in 2014 and 2015. Nonetheless, to properly judge the extent to which the stock may be undervalued or overvalued, we need to determine a fair-value range within which we expect the stock to trade. To do this we rely on the trend-adjusted average annual trading range for the stock, which from the analysis above we know is $5.18. This means that, given our target price estimate, we expect the stock to trade naturally, and fairly, between $26.61 and $31.79. The result of this is that when the stock is trading below $26.61 it is in the buy zone and when the stock trades above $31.79 it is in the sell zone. Currently the stock is in the neutral zone.

Conclusion

Overall, we like Aqua America in that water demand is highly inelastic. We also like that the company generates steady earnings and dividends and is largely insensitive to economic fluctuations. That said, Aqua America's insensitivity to economic fluctuations also means that it will likely benefit less than most other companies during periods of strong economic growth and rising equity markets.

So what return can we expect for holding Aqua America's stock? Well, we now know we can expect stock price depreciation of 2%. We can also expect to earn dividend income of about $3.43 over the evaluation period. Added to our price estimate, this means we could earn a compound annual rate of return of 2%, provided our estimates prove accurate. All in all, we are happy with this company but think that it is already fully valued and does not offer acceptable return potential to qualify for a new investment. We would recommend waiting for the stock to fall below $27 before purchasing.

Disclosure: We do not currently hold any positions in Aqua America.

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