Description

Executive Summary:

ARTNA is a small cap water & wastewater utility company in Delaware servicing New Castle and Sussex counties. It is one of the lowest risk 9% IRR’s with a reasonable probability of 20%+ IRR over the next two years that I am aware of. Since 2014, ARTNA has maintained a conservative balance sheet, increased corporate ROE from 7.7% to 9.5%, increased TBV/share at a 4% CAGR, and grown EPS at an 8% CAGR while paying a dividend equal to ~60% of earnings. Despite these accomplishments, ARTNA remains reasonably priced given the stability and growth of the business (~20x LTM P/E; 3% dividend yield; ~2.0x TBV) and trades at a historically wide discount to its closest peers (MSEX and YORW). Furthermore, ARTNA’s corporate returns are poised to increase to >10% as an uneconomic water supply contract rolls off at YE2021 which could serve as a catalyst to rerate its valuation closer to its historical relationship to its peer group. Even without a multiple rerate, ARTNA is set up to deliver shareholders a high single digit to low double digit IRR over the next two years with minimal fundamental downside. If ARTNA closes the valuation gap to its peers, the two year IRR would exceed 20%. Liquidity is ~$900k/day.

Business Overview:

The vast majority of ARTNA’s assets are in the state of Delaware and are regulated by the DEPSC. Its largest service area is in northern New Castle county, which is essentially a suburb of Philadelphia. ARTNA also has a large presence in Sussex county and small presences in PA and MD.

95% of Corporate EBITDA is generated by the regulated side of the business. Regulated revenue is ~93% water sales and ~7% wastewater treatment and disposal. The regulated business has an allowed ROE of ~9.75%, which the company historically has just slightly underearned.

5% of Corporate EBITDA is generated by unregulated, complementary businesses. The largest of the unregulated businesses is providing SLP plans for the utility customers. These are essentially insurance plans for clogged sewer or internal plumbing lines. In addition, Artesian serves as contract operator for water and wastewater systems for a few municipalities. These businesses do not require much capital and at their current size would theoretically allow ARTNA to over-earn its regulated ROE by ~125-150bps at the corporate level (i.e. ~11% ROE ceiling at current allowed utility ROE of 9.75%). As the unregulated business grows, there will be more upside to corporate returns.

Water sales revenue is driven by volume and pricing. Average water consumption per residential connection is flattish to slightly declining (-0.8% 5 yr CAGR) so volume growth must be driven by new connections. ARTNA only provides operating stats on residential connections (60% of water sales revenue), which have grown at a 1.8% CAGR over the past 5 years but recently accelerated to >2%. Residential pricing has increased at a 1.5% CAGR over the past 5 years, which includes their last rate case in 2015 as well as a one time step down of ~4.4% due to the TCJA corporate tax cut flowing through the regulatory return calculation (worth highlighting that this mechanism protects ARTNA from any potential future corporate tax increase as well).

ARTNA’s last rate case was resolved in 2015 and resulted in a one time 7.5% y/y increase in prices. Price increases since then have come from temporary DSIC charges which are implemented by water utilities between general rate cases as they are far simpler and allow ARTNA to earn a return on non revenue generating capital expenditures. My guess is that ARTNA will file a general rate case at some point in the next few years, and they have shown that they are able to achieve good outcomes from that process. It is worth noting that the average residential water bill remains very reasonable at ~$45/month and are in line with the rates charged by the other private water utility operating in Delaware (Tidewater Utilities, owned by MSEX).

ARTNA’s largest growth area is Sussex county (southern Delaware), which has become an attractive area for retirees due to its lower cost of living and development sites near the water. Population growth in New Castle County has averaged ~0.5%/year for the past 10 years while Sussex has averaged ~2.0%/year but has recently accelerated to ~2.2%. Historical population growth is laid out below.

The favorable fundamentals outlined above will provide ample opportunities for ARTNA to grow their rate base and earn a low risk, regulated ~10-11% ROE without leaning on punitive levels of price increases. From 2015-2019, ARTNA deployed ~$130mm of capital net of advances and contributions from developers while increasing corporate returns and maintaining a solid balance sheet without issuing equity. This represents ~42% of YE 2019 invested capital. Over the next five years, management believes the capital project opportunity set is similar if not larger, which will translate into mid single digit EPS growth.

Increasing Returns

Since 2014, ARTNA’s corporate ROE has increased from 7.7% to average >9.5% for the past four years straight. As discussed above, this increase in returns has been driven by connection growth and modest price increases. There are two catalysts that will serve to increase corporate ROE further over the next two years.

The first and smaller factor is the Allen Harim wastewater project. From 2017-2019 ARTNA spent $20mm to build a wastewater project for an Allen Harim poultry facility. The in service date was delayed multiple times, but as of March 2020, ARTNA received the required permit and started earning revenue on this facility under a take or pay contract. This increase in revenue has been masked by a reduction in service and finance charges due to temporary Covid 19 related federal prohibitions on late fees and service disconnections.

The second factor is the termination of ARTNA’s water supply agreement with the Chester Water Authority in December 2021. Under this take or pay agreement, ARTNA has been forced to pay $4mm/year to Chester Water Authority. This is an onerous agreement and ARTNA sued Chester for increasing the water price in 2011 (a lawsuit ARTNA ultimately lost in 2014). ARTNA now has sufficient water sources to self supply 100% of their water requirements and will not renew this contract when it terminates in December 2021. Not all of this $4mm decrease in costs will flow through to Net Income, but a large portion will. 2019 Net Income was $15mm. This is meaningful.

With reasonable connection growth and pricing assumptions, ARTNA will achieve >10% ROE in 2022, grow EPS at a >6% CAGR from 2019 to 2022 (8% CAGR from ’14-’19), and grow TBV/share at a 4% CAGR from 2019 to 2022 (4% CAGR from ’14-’19).

Covid -19

Part of the appeal of ARTNA is that the water utility business is not dramatically affected by Covid-19 and appears to even be benefiting from increased water sales volume (although for obvious reasons management does not highlight this fact in their filings). YTD 2020 Water Sales revenue is up 5% y/y versus a 5 yr CAGR of ~2.5%. By extension, YTD 2020 EPS is up 17% y/y versus a 5 year CAGR of 8%. There is upside to my forecast if this trend continues.

Valuation

ARTNA’s two closest peers are YORW and MSEX. Since 2008, ARTNA has typically traded at somewhat of a discount to these two due to slightly lower corporate returns as well as potential corporate governance concerns (to be discussed below). However, over the past couple of years, ARTNA’s discount has inexplicably widened dramatically. ARTNA currently trades at ~20x TTM P/E, while YORW and MSEX trade at 35x and 29x respectively.

Two Year IRR

With a modest increase in corporate returns and without any benefit from multiple rerate, ARTNA can deliver a high single digit to low double digit IRR including dividends. If ARTNA’s forecasted increase in corporate ROE serves to shrink the discount to its peer group, the 2 year IRR would be >20%.

I do not put very much weight on the chart below, but it is interesting to note that over the past twelve years there has never been a two year period (calculated quarterly) where ARTNA has delivered a negative total shareholder return when priced at or below its current P/E multiple.

Governance

Here is the rub. ARTNA has two classes of common shares, ARTNA and ARTNB, which are identical except with respect to voting rights. ARTNA is the Class A share which does not have any voting rights and accounts for 90% of shares outstanding. ARTNB is the Class B share and has the right to vote. The Taylor family controls ARTNA by owning >50% of the Class B’s. Dian Taylor is the current CEO, and Nicki Taylor, her niece, is the COO. The rest of the senior management team is from outside the family. There are six board members, three of whom are from the Taylor family (including Nicki and Dian). Dian and Nicki each own ~$11mm worth of stock providing >$300k/year of dividends. Dian’s 2019 cash comp was $800k. Nicki’s was $400k.

The governance situation means that ARTNA will likely always trade at a discount to its peers. That said, the size of the current discount is unwarranted by governance concerns given management’s track record. I have gotten comfortable with the set up for a couple reasons. The current value of the Taylor’s equity holdings is a solid multiple (>10x) of their compensation as officers. More importantly, Dian and Nicki have run the company for the past couple decades and have demonstrated their ability to execute the business plan and treat minority shareholders well. Furthermore, the Taylor family is a pillar of the Delaware community and their relationships with politicians and regulators are invaluable.

Risks

1.       Governance

a.       If the Taylor family goes off the reservation, there is no recourse. This risk is mitigated by the multi-decade track record of the Taylor family as well as by the already depressed valuation. However, the probability of a sale at a material premium by a strategic with a stronger currency is simply lower than it would be if standard corporate governance rules applied. The lower probability of such an outcome decreases the number of good things that can happen.

2.       Inflation

a.       ARTNA’s ability to increase prices is limited by the regulatory process and political reality. In the event of a rapid, sustained increase in inflation, real returns will likely suffer.

3.       Capital Allocation

a.       This is a capital intensive business and over the next several years ARTNA will deploy capital equal to a large % of current invested capital. Price increases alone would be insufficient to protect against a significant deterioration in return on invested capital. This risk is mitigated by the multi-decade track record of the Taylor family as well as the near term tailwinds to corporate returns.

Catalysts

1.       Increased corporate returns due to Allen Harim project coming online in 2020 and the termination of the uneconomic water supply contract with Chester Water Authority at the end of 2021.

2.       Continued EPS growth

Financial Model

Catalyst

1.       Increased corporate returns due to Allen Harim project coming online in 2020 and the termination of the uneconomic water supply contract with Chester Water Authority at the end of 2021.

2.       Continued EPS growth