Description

Summary

American Water Works (AWK) is a water-utility trading at 25X 2017 EPS / 23X 2018 EPS. The stock is up over 40% over the last 2 years, driven by low interest rates and a low-volatility / low-risk fad. We believe AWK is a good short given its high valuation, low potential for growth and capped returns on capital.

Business

Regulated (~90% of Net Income*)

AWK is the country’s largest water utility company. AWK owns the physical water pipes, pumps, and other assets used in delivering water to homes and businesses, often including the source of fresh water. In many cases, AWK also owns the sewer and wastewater treatment facilities. AWK charges customers based on rates approved by the Public Utility Commission (PUC) in each state. Although there are variations in the regulatory structure from state to state, on average AWK is allowed to earn a 9.9% ROE on its rate base, with a capital base that is split 50/50 between debt and equity. The company is concentrated in Pennsylvania and New Jersey, which each contribute ~25% of earnings.

AWK operates a critical regulated monopoly. While minor fluctuations in the business are possible from year to year, the main determinant of company performance is the regulatory environment. AWK was purchased by the German utility RWE in 2001 (and spun off in 2008). In order to get PUC’s to approve the acquisition, RWE agreed to 5 years of rate freezes in many jurisdictions.  The company was allowed to raise rates rapidly in order to catch up: AWK’s revenue/gallon rose at an 8.3% CAGR from ’06-’11. From ’11-‘16, revenue/gallon rose at a 4.3% CAGR (from 2013-2016 growth in rev per gallon slowed even further to a 3.4% CAGR).

AWK management’s strategy is to grow earnings by deploying as much capital as possible. In order to maximize capital deployment while keeping rate increases to politically palatable levels, AWK management has sought to cut costs out of the business: cutting costs doesn’t allow AWK to earn a higher ROE, but it enables them to grow their rate base at a higher rate than customer prices. While management has cut real costs out of the business, business performance has also been flattered by changes in accounting. For example, salary expenses stayed flat between 2011 and 2016, despite having a ~50% unionized labor force. By our estimate, about ~1/3 of the savings (or rather, avoided cost increases) came from layoffs, while the rest came primarily from capitalizing more expenses into capex. Similarly, pension expense was cut in half, primarily because of changes in assumptions. Overall, we estimate that about 2/3rds of the change in reported cost over the last 5 years resulted from accounting changes. While there is likely a long runway of cost cuts possible at AWK (at least in the non-unionized portions of business), past reported improvements in AWK’s cost structure are in large part due to accounting changes, which suggests that future gains are likely to be more modest. Over the very long run, it will be difficult for AWK to squeeze costs out in the face of inflation. The company believes that it can continue to generate non-rate related profit growth beyond 2020, but acknowledges that it will become more difficult, as the low-hanging fruit of cost savings will have been picked.

Utility companies have historically underperformed their allowed ROEs by up to ~2%, primarily because they deploy capital before they are allowed to earn a return on it. AWK and others have been successful in nudging the regulatory framework to reduce “regulatory lag.” About 75% of AWK’s rate base is in states that have implemented automatic surcharges which can be billed to consumers as soon as infrastructure is deployed. Rates in these states are also based on pro-forma forward year financials as opposed to the previous year’s financials. About ~40% of the rate base allows AWK to earn a return on construction in progress, as opposed to waiting until construction is finished. AWK management thinks that it has closed ~1.5% points of ROE gap since 2011, with only ~30bps left (with another ~40bps due to parent company debt). If AWK cuts costs, the company could potentially exceed its allowed ROE, at least temporarily. However, declining water consumption is likely to cap realized ROEs below allowed ROEs: rates are generally set per gallon, so a decline in water volumes causes AWK to earn less than is allowed. Water usage is declining ~2%+ p.a. in AWK’s service areas.

Regulatory changes have also made M&A more feasible. Several states have laws which allow acquired municipal systems to be included in a company’s rate base at fair market value, rather than at depreciated cost. As a result, AWK can earn a similar rate of return on acquisitions as it does on organic capex. AWK believes that the regulatory environment will continue to improve, a sentiment echoed by other investor-owned water utility companies.

In periods of very low rates, ROEs allowed by regulators should also decline. State PUCs generally set ROEs that are appropriate to attract investor capital, using CAPM and other formulas as tools. If current rates persist, allowed ROEs could decline 50bps or more. Rate cases during 2016 in Missouri and West Virginia lowered ROEs by 25bps and 15bps, respectively. A rate case in Pennsylvania was filed in April of 2017 and is under review. While ultra-low rates may reduce allowed ROEs, declining rates have allowed AWK to refinance its debt at a lower cost. Lower interest expense allows AWK to increase the amount of capital deployed relative to customer bill increases. If rates rise, the opposite will be true.

Non-regulated business (Market-Based Operations – 10% of Net Income*)

AWK operates non-regulated water systems for military bases and other customers, including certain municipalities and food & beverage companies. AWK’s military business has seen muted growth due to sequestration, but the company expects that headwind to be lifted starting next year. AWK also provides water-system warranties to homeowners and others. In 2015, AWK acquired Keystone, a water provider to Appalachian E&P companies.

AWK does not intend for its Market-based businesses to become more than 15% of company earnings.

Valuation

GAAP earnings represent a good approximation of AWK’s potential to increase its rate-base and future earnings. Company-defined maintenance capex is ~2.5x greater than depreciation. Due to bonus depreciation in tax accounting currently in place, the company pays little cash tax (the company expects bonus depreciation to be phased out of the tax code in 2020). Note however that since AWK earns a regulated return based on the total capital in its rate base, it matters little that capex is spent on maintaining the existing physical footprint rather than growing it – any capex grows the rate base and therefore the earnings power of the company. Similarly, deferred taxes are subtracted from the rate base and decrease earnings power.

AWK trades at 25X earnings and a ~2% dividend yield. AWK needs to raise debt to distribute cash to shareholders while funding growth.

AWK management guides to a ~7%-10% EPS CAGR through 2021, with 2015 EPS of $2.64 as the anchor point. ~4-6% of growth will come from capital investment into its regulated assets, ~1-2% will come from regulated acquisitions, and ~2% from non-regulated businesses. This plan requires that AWK grow its rate base ~5% p.a. organically and keep operating expenses flat. A short position in AWK works well even if management can hit its targets: Management has guided to a 2017 EPS of $3.04. If AWK accomplishes this and then grows EPS at 8.5% thereafter, the stock is still trading at 21X 2019 earnings and 18X 2021 earnings.

Summary

AWK is a low-growth, stable business caught up in the market’s focus on low volatility. We believe shorting AWK is a compelling risk/reward with little risk of permanent capital loss.  

*From April 2017 Investor Presentation. Represents approximate 2016 figures. Excludes parent and other.

Catalyst

Correction in valuation to properly reflect the company's low growth and capped returns on capital.