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>>> Aqua America / Essential Utilities - Post-Merger

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gfp927z   Monday, 04/20/20 12:54:56 AM
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>>> Aqua America / Essential Utilities - Post-Merger Aqua America: Great Company, High Price


by Roger Conrad



I’ve personally owned Aqua America (WTR)—which on February 3 will rename itself Essential Utilities (WTRG)—since it was Philadelphia Suburban. And thanks to the wealth-compounding power of dividend reinvestment, my Aqua shares are worth almost 14 times what I initially put in.

I’ve also consistently recommended Aqua in my advisories. And I’ve had the privilege of meeting with current CEO Chris Franklin, as well as several times with the architect of the company’s three-decades-old growth through acquisitions strategy, Nicholas DeBenedictis.

Nick was one of the first employees of the Environmental Protection Agency in 1972, and later served in the cabinet of former Pennsylvania Governor Richard Thornburg. From those experiences, he perceived the opportunity for water utilities like Philadelphia Suburban to profitably consolidate their wildly fragmented sector.

I interviewed Nick for my 2002 book "Power Hungry: Strategic Investing in Telecommunications, Utilities & Other Essential Services." His comments then have proven prescient, both for Aqua and the US water sector overall. In fact, his insights are very much at the root of the success I’ve had investing in water utilities the past two decades.

The focus of my March 10, 2016 article "Water World: An Interview with Chris Franklin, CEO of Aqua America" was the latest phase of the company’s M&A strategy: Acquiring municipally owned water and wastewater distribution systems.

Franklin’s comments then have since proven equally on the mark, though developments have likely taken longer to unfold than he anticipated. The company’s proposed DELCORA acquisition would be the largest water and wastewater deal in state history, if the Pennsylvania Public Utility Commission approves as expected.

Today, Aqua serves roughly 3 million water customers in Pennsylvania, Ohio, North Carolina, Illinois, Texas, New Jersey, Indiana and Virginia. In the next few days, however, it will complete its most transforming deal yet: The all-cash $4.28 billion purchase of natural gas distribution utility Peoples Gas, which serves roughly 740,000 homes and businesses in western Pennsylvania, West Virginia and Kentucky.

I first discussed the Peoples acquisition when I recommended Aqua as a Conservative focus stock in the November 2018 issue of Conrad’s Utility Investor. Since then, shares have appreciated by more than 50 percent. And I’m convinced as ever that my initial bullish observations will prove accurate.

The purchase will be immediately accretive to Aqua’s earnings, adding a gas distribution franchise with annual rate base growth of 8 to 10 percent for the next few years. The merger did take somewhat longer to close than management’s initial projection of "mid-2019." But at the end of the day, the deal closed without significant new conditions and after Peoples secured an amicable rate deal.

Aqua also attracted a $750 million equity investment from the Canada Pension Plan Investment Board. That reduced prospective deal financing costs.

So has the sharp reduction in Aqua’s cost of debt capital over the past year. That point is best demonstrated by the drop in yield to maturity for its bonds of May 2049, from roughly 4.3 percent when they were issued in late April 2019 to just 3.5 percent this past week.

Adding Peoples should also open up a new range of acquisition targets for Aqua as it adds new geography. And the combined company will also benefit from the synergies of operating gas distribution and water utilities in the same area. As Essential Utilities, it will start out with nearly 80 percent of rate base in Pennsylvania, where management has built one of the most constructive regulatory relationships of any utility in the country.

The history of M&A is packed with examples of acquiring companies losing their way after entering a new business. And that includes plenty of utilities and essential service companies.

Regulated natural gas and water utility convergence, however, has a successful track record. In fact, it’s likely that buying Peoples will accelerate Aqua’s already upper single digit underlying earnings growth rate, possibly by a couple percentage points. And the merger increases the combined company’s appeal as a potential takeover target as well.

I’ve mentioned Exelon Corp (EXC) before as a likely eventual suitor for Aqua. Early in the previous decade, that company shifted its strategy to focusing on growing its regulated electricity transmission and distribution rate base rather than adding nuclear generating capacity, acquiring the former Pepco Holdings in March 2016.

Buying Aqua, which has less than one-quarter its market capitalization, would greatly accelerate that goal. And there’s even a potential human link, as former CEO DeBenedictis was once an employee and board member of Exelon.

So what’s not to like about a company that just accelerated its long-term growth rate and reduced business risk at a low cost, and is a perpetual takeover candidate? Two words: Extreme valuation.

Following regulatory approval of the Peoples merger, Aqua shares surged to a price more than 35 times expected 2020 earnings per share. That’s the highest multiple in the company’s history and compares to a likely 8 to 10 percent post-merger growth rate.

Today, there are a third fewer publicly traded water utilities than when Mr. DeBenedictis compared his sector to collector cars in my book Power Hungry. And Aqua’s current valuation is very much in line with the rest of the group, including American Water Works (NYSE: AWK) at 34.2 times expected 2020 earnings. In fact, it’s cheap compared to neighboring York Water (NSDQ: YORW) selling at 40 times.

Scarcity plus little real operating risk is why I plan to continue reinvesting my Aqua/Essential dividends, rather than selling. But it’s very difficult to see shares making real headway any time soon from these levels. Neither is the stock attractive for income now yielding just 1.85 percent.

That’s why my advice for anyone wanting to buy into this otherwise great company is to be patient for a better price. Note changing the name from Aqua to Essential Utilities is a not a taxable event and won’t change either ownership or dividends paid.


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