With its history going back to 1886, American Water Works (AWK) is the largest and most geographically diverse, publicly traded water and wastewater utility in the U.S., both in terms of operating revenues and population served.
The company provides drinking water, wastewater, and other related services to more than 14 million people in 24 states.
Water utilities, in general, are regarded among the safest investments due to their extremely secure cash flows that result in decades of robust performance.
Due to being the largest and most diversified of its peers, American Water offers an additional layer of security. Further, the company features fantastic visibility when it comes to its future growth and capital return prospects.
Thus, it wouldn’t be an exaggeration to say that its overall qualities are unparalleled to any company in the market. Precisely for this reason, however, investors have attached a substantial premium to the stock.
As a result, future shareholder returns could be rather limited. Accordingly, I am neutral on the stock.
Cash Flow Visibility To Drive Dividend Growth
American Water features a highly durable track record of net income and dividend growth. The company’s 10-year earnings per share and dividend per share CAGRs stand at 14.9% and 10.1%, which is impressive considering that the water provision space is extremely mature. In fact, a few days ago, American Water increased its quarterly dividend once more by 8.7% to a quarterly rate of $0.655.
This has been achievable due to the company enjoying an enduring business model, as water is necessary for residential and commercial use and a mission-critical asset for the military. Consequently, American Water has managed to expand its distribution network and operations with relatively little risk.
During Q1 2022, the company invested $437 million in its infrastructure, adding around 5,500 customer connections via closed acquisitions and organic growth.
Further, the company now holds general rate cases in progress in five jurisdictions, and has also filed for infrastructure surcharges in two jurisdictions. This displays a total annualized revenue request of roughly $220 million.
Amid predictable water consumption, rate increase requests, and growth through acquisitions as well as organically, management has been able to provide a very narrow and assertive EPS growth outlook.
Specifically, it expects EPS to increase by around 7% to 9% per annum through 2026. This is to be supported by growth between 5% and 7% from regulated investment capital expenditures, growth between 1.5% and 2.5% from regulated acquisitions, and growth of less than 1% from military services.
Due to fantastic EPS growth visibility ahead, management also expects to raise the dividend between a rate of 7% and 10% over the long run. Very few, if any, companies are able to provide so narrow EPS and DPS growth estimates over an extended period of time. It is admirable and should offer investors a sense of safety even during unfavorable economic periods.
Valuation
American Water does not only feature a very secure business model, but also boasts a quite predictable EPS and DPS growth pathway moving forward.
This makes the stock a very attractive pick both for conservative investors looking into a rock-solid company, and dividend growth investors looking for increasing payouts.
As a result, American Water’s valuation has significantly expanded over the past several years. This has been the case with most of its industry peers, who have also witnessed their multiples extend greatly. The stock is currently exchanging hands at a forward P/E of 34, considerably higher than between 23 and 28 from 2016 to 2019, and even higher from the high-teens multiple prior to 2016.
With investors flocking to American Water’s outstanding attributes and the valuation expanding extensively, I believe that shares have become rather overvalued.
Wall Street’s Take
Turning to Wall Street, American Water Works has a Hold consensus rating based on three Buys, three Holds, and two Sells assigned in the past three months. At $167, the average American Water Works price target implies 11.5% upside potential.
Takeaway
American Water Works has a moat like no other, while the company’s forward cash flow and capital return prospects visibility are absolutely remarkable. While investors are likely to enjoy consistent returns ahead, that would only be possible if the stock retains its current premium valuation.
If, for any reason, the stock were to undergo a substantial valuation compression towards its previous multiples, investors are likely to suffer significant losses.
Therefore, investors should be wary when it comes to American Water’s investment case, notwithstanding its unique qualities.
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