Description

American Water Works (AWK) trades at a material discount to its peers and is likely to exceed street expectations over the next two years. The stock was written up last year at a similar price, but has only traded up slightly due to the pressure caused by its former owner continually selling down a 60% position in three separate secondary offerings. As of last month, this holder has exited in full, eliminating this overhang. One year from now, the stock should trade to a peer multiple of 19x 2011 EPS or $30 a share.

INDUSTRY

If you do not pay your taxes the fire department will still come to your house if it is burning, the police will still try to help you if you are robbed, and your kids can still attend public school. But if you do not pay your water bill, your water gets shut off. The same is true for every police headquarters, fire department, and school. They all have to pay their water bill too. So water tends to be fairly secure within the governmental capital structure. Water also has one more major benefit over most other government services. People who have more fires, burglaries, and children do not necessarily pay more in taxes. But since a water company meters out usage individually, when a water utility's costs go up, they just hike your monthly rate. If you don't pay your fair share, in a month or two you will not be able to shower, flush, water your lawn, clean your dishes, wash your laundry, etc.

It is precisely because water companies have so much power that the industry is heavily regulated. Water companies make money by investing capital in monopolistic water assets and then requesting state permission to raise prices in order to generate an approved level of return. The companies have an obligation to provide a minimal level of acceptable service, but generally when they invest new capital they do so with the expectation that state public utility commissions (PUCs) will agree to include those investments in their regulatory rate base which will allow them to raise prices accordingly. This process happens about every year or two, and when it does the PUC acts as a mediator and appoints a consumer advocate to debate pricing with the company. The consumer advocate wants safe and reliable drinking water as well as economic expansion while the company wants a fair return. If pipes are leaky and water quality is low, the public will generally be furious that some water company executive is getting rich off of their misfortune. On the other hand, if communication is transparent and the PUC feels that the utility has delivered on its promises, it will be far more likely to agree that any capital expenditure made was both prudent and necessary. In the end, the PUC must determine two main variables, ROE and debt/capital. ROE tends to be a function of heard mentality among regulators and historically 10% has been the magic number. Debt/capital is heavily influenced by the rating agencies given that state regulators tend to want to keep their water utility above investment grade.

The biggest risk to water companies is that a lag occurs between when capital is invested and when the regulators allow them to generate a return on that investment. In theory, almost all costs should be included a water company's rate base and ultimately passed through to the end-consumer, but in practice, there is always a risk that a regulatory lag occurs between incurring these costs and being able to pass them through. Each state appoints regulators differently but a weak consumer environment combined with political pressure can pose risks in getting regulators to approve charging consumers a few bucks more per month for their water as opposed to pushing off the inevitable price increase for a few more years.

COMPANY

AWK's has been in operation since 1886 and is now the largest investor-owned water utility representing 5% of the entire water infrastructure in the US (only 15% total is public of which AWK is a third). Nearly 90% of sales and more than 95% of earnings come from regulated businesses with the remainder coming from unregulated activities, generally consisting of long-term contracts to manage non-owned water infrastructure for municipal governments or military bases. In the regulated business, the company operates a monopoly business, owning both the treatment plants as well as the pipes in the ground. Regulated revenues are concentrated in the northeast with 25% coming from NJ, 22% PA, 9% MI, 9% IL, 8% IN, 6% CA, 6% WV. About 60% of these sales are to residential customers, 20% commercial, 12% public, 4% industrial, and 4% waste and other.

It is a fairly simple model, AWK sells a little over 400B gallons of water a year for a little under $6.00 for every 1,000 gallons. With EBITDA margins approaching 40%, this yields roughly $960MM in EBITDA (400B x $0.006 x 40%). Actual results for the last two decades are below.

Source: Capital IQ & Bloomberg

BACKGROUND

In 1999, Suez (SEV FP) announced an acquisition of United Water Resources (UWR), the second largest water utility. UWR's CEO at the time is now the current CEO of AWK, Don Correll. Under his seven-year term as CEO prior to its sale, UWR's shares had increased its quarterly dividend from $0.23 to $0.30 and shares traded up from $13 to $23. The deal was completed in 2000 at $35 a share.

Then, less than a week after September 11^th, a German conglomerate called RWE (RWE GY) bought the largest water utility, AWK, at a 37% premium for an effective price of 12x EV/EBITDA. The deal was approved in early 2002 and completed at the start of 2003. One of the reasons why it took so long was because in order to receive approval, RWE had to agree to freeze AWK's rates for five years. You can see the net effect below as the increase in water price per gallon stalled at a little over 1.5% per year between 2002 and 2005.

Source: Derived from SEC Filings

While the risk was that continued investment without corresponding rate hikes would temporarily pressure what had historically been a very stable 40%+ EBITDA margins, RWE planned on generating a return on all of these investments quickly when the freeze ended in 2007 by pushing through massive rate hikes. Unfortunately, RWE had not counted on the negative sentiment that emerged when American consumers found out that a German conglomerate now controlled their water.

Many Americans aren't so happy about foreigners controlling their water supply. A recent $8.6B takeover of American Water Works by German-based industrial giant RWE has led to a backlash from a handful of cities across America. The deal covers more than 800 water systems serving 15 million people in 27 states and three Canadian provinces. "As soon as people find out their water service is being bought by a German company, they are up in arms about it," said Juliette Beck, a senior organizer for Public Citizen, a Ralph Nader-backed group that has been rallying resistance to the RWE takeover. The misgivings are driving community efforts to buy out RWE and regain control of local water systems in two Northern California communities, Montara and Felton; in Peoria and Pekin, Ill.; and in Lexington, Ky. Charleston, W.Va., is considering a bid for its water system, while the Southern California city of Thousand Oaks is trying a different tactic, urging state regulators to reverse their previous approval of RWE's takeover. - U.S. Water News Online (02/03)

As the years progressed under RWE's stewardship, relationships with municipalities deteriorated and AWK's customers became accustomed to years of flat water prices. Cost inflation was much higher than expected, crimping EBITDA margins down to 35%, and since AWK was required to maintain certain book equity ratios, goodwill impairments required RWE to make substantial new investments in the company. Before the end of 2005, RWE realized that obtaining government support to push through the substantial price hikes necessary to bring returns back to historical levels would be very difficult and the company announced its intention to divest AWK. In 2006, Don Correll, who had been CEO of Pennichuck (PNNW) since 2003 where he oversaw a share increase from $18 to $24 while maintaining a healthy dividend, agreed to join AWK to help manage the transition back to a public company.

RWE has certain registration rights with respect to future issuances of our equity securities and intends to fully divest its remaining ownership of American Water as soon as reasonably practicable, subject to market condition...... As a condition of certain state regulator approvals for RWE's sale of the Company, RWE had agreed to sell 100% of its holdings of Company stock by April 2010 and previously announced its intentions to reduce its interest to below 50% prior to the end of 2008. - AWK 2008 10-K

In order get approval for the divestiture, RWE had to obtain regulatory approvals from PUCs in thirteen states. These PUCs forced RWE to agree to some fairly stiff terms. In addition to agreeing to sell 100% of its holdings by April 2010, RWE also had to agree to maintain a capital structure with a minimum of 45% common equity. In 2007, this agreement ended up forcing RWE to transfer an additional $1.1B in cash to AWK in advance of an IPO.

OVERHANG

AWK went public in April 2008 with RWE selling 63MM shares or nearly 40% of the company. The deal had been initially targeted for $24-26/share but was priced at $21.50 and traded down to $20.60 on its first day as investors showed very little interest given that RWE had publicly committed to exiting the remaining 60% by April, 2010. Since then, the overhang of RWE's additional shares continually weighed on AWK's stock price, causing it to trade at a discount to its peers.

Considering that the German utility has announced its intent to fully exit the U.S. water business as soon as practicable, we caution that the long-term structural overhang on AWK shares remains. Accordingly, we recommend that investors remain on the sidelines, although we also note that the stock offers an attractive valuation for investors with a long-term horizon. - JP Morgan (05/29/09)

Despite the company's growth prospects, however, many investors remain concerned about a perceived "overhang" issue, as majority shareholder RWE AG has signaled its intention to further reduce its stake after last year's IPO. In our view, such concerns are a major factor in AWK shares' discount valuation relative to peers. - Boenning & Scattergood (05/06/09)

Throughout 2009, AWK exited its position in the company through three separate secondary offerings.

• 06/04 - RWE sold 15MM shares at $17.25, bringing its stake down 46%, simultaneously AWK issued 15MM new shares to fund capital expenditures
• 08/14 - RWE sold 40MM shares at $19.25, bringing its stake down to 24%
• 11/17 - RWE sold 41MM shares at $21.63, bringing its stake to zero

Immediately following the final offering, there were some initial signs of Wall Street coming around.

We view this as a very positive announcement for AWK, as we believe the expectation of a large number of shares coming to the market in the near future was placing an artificial cap on AWK's share price. We anticipate that AWK's discounted valuation (13.4x our 2010E EPS) relative to the industry average (19.0x) should ease gradually after the "RWE overhang" is removed. - Longbow (11/17/09)

Now that American Water is finally out from under the shadow of former parent RWE, the focus is on the company's own performance. With the RWE overhang gone, the stock has moved up from its lows, but it is still trading at a discount to peers. Investors who are new to American Water seem to be waiting a bit cautiously for the company to prove that it can manage the business and the balance sheet to generate improved returns on its existing assets as well as future growth. - Janney Montgomery Scott (12/08/09)

EARNINGS

AWK is in the middle of catching up to years of flat rates by requesting massive rate hikes, as seen below.

Source: Investor Day Presentation (Slide 135)

At the company's investor day on 12/07/09, management revealed that its LTM ROE excluding parent debt was still only 6.5% versus the 10.0-10.5% approved by regulators. While regulatory lag will always cause actual ROE to be 0.5-1.0% below approved rates, the company clearly has a substantial earnings runway for the next few years just to get back to par. There are three reasons why the company will be able to continue to get favorable approvals from state PUCs:

1. Current management is well received and executing. Conversations with PUCs suggest that they are much happier to be again working with "Americans," have seen a major improvement in communication, and realize that rate hikes are necessary and long overdue.
2. Tight supply of capital and increasing demand is driving ROE higher. Pipe may last for 80-100 years, but many municipalities have budgeted as if it would last forever. Water infrastructure in the US is now in horrific shape and continues to deteriorate. In order to replace and maintain these assets, hundreds of billions will have to be spent over the next two decades. However, given weakened state of capital markets, municipalities are starting to compete with one another for access to the limited amount of capital available to repair their aging infrastructure. There are indications of this pricing power with the company making requests for ROEs in excess of 12% for the first time.
3. Water is cheap. Water is perhaps the cheapest utility to buy and represents a relatively small percentage of most homeowners' budgets. Most rate hikes being requested will have an annualized impact that is less than one or two fill ups at the pump. For reference, in 2008 AWK's average customer paid around $52 per month.

With only a quarter left in 2009, AWK should report annual EPS pretty close to street estimates of around $1.28. For 2010, analysts are currently estimating EPS growth of 12% to $1.43, followed by 10% growth to $1.57 in 2011. These numbers are too low, partially because analysts have failed to adjust for the fact that 2009 was materially negatively impacted by weather.

We simply can't talk about the quarter without discussing the weather. 11 out of the 20 of our regulated states experienced either above average rainfall, cooler temperatures or both. The Northeast region had its eighth wettest summer on record with New Jersey experiencing its fifth wettest summer on record. July 2009 was also officially the coldest July on record in six of our states, according to the national climatic data Center, including Iowa, Illinois, Indiana, Ohio, West Virginia and Pennsylvania. That weather pattern has continued into the fall. In past calls we've spoken about how the geographic diversity of our footprint lessens the impact of the weather. And in fact, a few of our states did actually have more typical summers. But when a majority of our larger states in terms of revenue had the kind of wet or cool weather we saw during the summer, there's going to be some impact on revenues, net income and EPS. And that's what we saw this quarter. - Don Correll, Q3 Earnings Call

Management has highlighted that the company lost $0.07 per share in Q2 due to a 5.5% volume decline and $0.14 per share in Q3 due to a 7.4% volume decline. There are some additional declines expected in Q4 as well. Some of this is a function of the economy causing businesses to consume less water but the majority of it was due to the weather. More importantly, any loss of earnings related to the economy is recoverable.

The way that rates are set, if it's a historic state, they generally look at the usage in the historic test year. So whatever the usage is, and then for future test year states, it looks, again, at historic and some projection of usage into the future. Where it's weather-related, it generally bounces back the next year, assuming you have normal weather. But where it is something related to the economy or a decrease in consumption that is deemed to be more permanent and not necessarily bouncing back, we would be requesting it as part of the normal rate case increase. - Ellen Wolf, Q3 Earnings

All in, weather and economic impacts suppressed 2009 EPS by more than $0.20 per share, masking a lot of the strong fundamental recovery that management has accomplished with rate hikes. In 2009, AWK received approval for the following rate cases listed below.

Source: Investor Day Presentation (Slide 156)

As these rate hikes annualize in 2010, they will contribute and incremental $51MM in EBITDA and $0.18 in EPS. In addition, AWK has $218.3MM in currently outstanding rate cases. Since a typical rate case takes 9-11 months to be settled, the vast majority of these should be finalized over the course of 2010. If AWK's historical pattern of receiving more than half of the dollar amount that it requests continues going forward, the company will generate an incremental $110MM of EBITDA which translates into $0.38 of EPS. The full impact of these rate hikes will not be felt until 2011, but some portion should impact EPS next year.

Source: Investor Day Presentation (Slide 127)

Starting with 2009 EPS of $1.28 and adding $0.20 from weather and economic recovery, $0.18 from annualizing 2009 approved rate cases, and another $0.38 assumed rate case approvals in 2010, not to mention any accretive M&A activity or growth in the unregulated business, a more realistic EPS estimate for 2011 EPS estimate should be above $1.70.

VALUATION

Over the last decade, water companies have tended to trade between 15-25x trailing EPS. WTR is AWK's largest peer, and since 1996 WTR has almost always traded above 20x. If results come in above expectations in 2010, AWK should trade to a forward peer multiple of 19x, resulting in a $30 share price.

As an alternative, one could value a water company using a dividend discount model given the relatively large, uninterrupted, and reliable dividends that they pay. AWK currently pays $0.84 a year representing a 66% payout ratio. Even if the street's low estimates for 2011 turn out to be accurate, a 65% payout ratio on $1.57 would be $1.00/share. Using a midpoint of management's stated long term goal of 7-10% annual EPS growth and applying a discount rate of 12% would yield a valuation of almost $29 a share ($1.00 / (12% - 8.5%)).

RISKS

• Regulatory lag
• Rapid cost inflation
• Downward pressure on approved ROEs due to economic downturn
• Unfavorable weather
• Stock market collapse could impact pension
• Rapid increase in water conservation

Catalyst

• Recognition that the overhang is gone
• Earnings exceeding estimates
• Dividend increases
• Better weather in 2010