The Spigot Reopens at American Water Works
By JACK WILLOUGHBY
American Water Works will be a major beneficiary of a flood of new investments in water infrastructure and the push for better tap water.
SHARES OF AMERICAN WATER WORKS HAVE BARELY treaded water since the utility holding-company went public April 22. Last week, they were trading at around 20, below an already-discounted 21.50 at the offering. Weighed down by a poor IPO market and a confining rate agreement between its European controlling owner and U.S. regulators, North America's biggest public water and waste-water service provider hasn't seemed capable of making much headway.
Brad Trent
"We've come public in a very tough time," says CEO Don Correll, but "we're in the business of investing in infrastructure with a long-term horizon."
But some of the drag on American Water Works ' (ticker: AWK) performance is gradually subsiding as political and financial currents shift in its direction.
The company doesn't own water; it provides the infrastructure to clean and deliver it to homes and businesses across the U.S. The holding company derives almost 90% of its roughly $2.2 billion in revenue from regulated utility subsidiaries like Kentucky American Water, which is about to build a new water-treatment plant, pipeline and booster station to improve water delivery. Unregulated businesses, such as providing water services for the U.S. military or managing desalination plants, as the company does in Tampa, Fla., constitute about 10% of sales. In many cases American Water owns the pipes or other facilities it runs; in some it signs long-term contracts to manage them for other entities.
GERMAN UTILITY GIANT RWE (RWE.Germany) was so attracted to American Water's prospects that in 2003 it paid $8 billion, including debt, for the company, a price that now looks hugely inflated. In order to get approval for the transaction, RWE also agreed to freeze rate increases for five years in many states, effectively capping the company's ability to lift revenues. With that agreement now expired, the company can focus on growing its rate base again. (After selling $1.25 billion in the IPO, RWE has said it hopes to take its remaining 58% stake below 50% by year end, an overhang that will impede share performance.)
The pricey acquisition also left American Water Works with about $1.7 billion in goodwill on its balance sheet, along with some other charges that regional water authorities will no doubt monitor closely to make sure capital levels remain stable.
Under new CEO Don Correll, however, American Water is not only free to seek rate hikes, it is playing to a more sympathetic audience. Popular interest in good, clean tap water is growing as concerns about transportation and fuel costs, not to mention the adverse environmental effects of commercial bottled water, rise. Public utility commissions are encouraging water companies to upgrade aging pipes, management facilities, scrubbing equipment and other delivery mechanisms that outfits like American Water Works provide. Increasingly water itself is viewed as a scarce resource.
"We've come public in a very tough time, and I'm happy about the IPO and what's happened since," Correll says. "We're in the business of investing in infrastructure with a long-term horizon. We don't worry much about what happens in just three months." He is a veteran of New Hampshire's Pennichuck and New Jersey's United Water, and he joined 122-year old American Water in 2006.
The tide is turning for North America's biggest public water utility. And its stock is cheap, reports Barron's Jack Willoughby. (Aug. 11)
Investors were understandably reticent about diving into the IPO in light of lousy stock- market conditions in April and the near-moribund new-issues market. RWE originally hoped to raise $1.8 billion but had to cut the size of the deal by 25% to get it sold. Now, however, the shares trade at 16 times forward earnings, a discount to the industry average of around 22. What's more, American Water sports a 4% dividend yield, so investors are getting a decent payout while waiting for RWE's remaining issues to be worked through.
Ryan M. Connors, an analyst at Boenning & Scattergood, one of the underwriters of the IPO, has a Buy recommendation on the stock and a price target of $26, about 30% above recent levels. Other analysts put the projected 12-month price closer to 24.
The company earned $1.04 per share last year, and Connors is expecting the company to earn $1.15 this year.
There's little argument that the U.S.' infrastructure for managing its water resources is getting worse. The American Society of Civil Engineers has said that its grade for U.S. water infrastructure has fallen from B-minus to D-minus over the past 15 years; waste-water plants are in similar straits.
By necessity the investment to upgrade the facilities will come in the form of higher rates to consumers. One government study estimated that by 2020 almost $1 trillion needs to be invested to replace the failing infrastructure. Another government survey of U.S. drinking water pegs water capital expenditure needs through 2022 at $280 billion, or about $20 billion a year.
Table: Plumbing the NumbersTrying to cope with these needs are small and mostly old municipal and regional treatment facilities. The U.S. has about 53,000 water systems, 85% of which serve fewer than 3,500 people. All must contend with federal, state and local regulations about both water quality and infrastructure. In many cases, the government entities lack the manpower and expertise to handle bigger projects and systems.
AMERICAN WATER IS BY FAR THE biggest provider, serving 16 million people in 32 states via 45,000 miles of water mains. On the company's latest quarterly conference call in May, Correll noted that: "Our scale allows us to capitalize effectively on growth opportunities across our service areas while helping to insulate us from adverse conditions in any one geographic area."
And the company's long history has given it a strong base of contacts and technical know-how. Cash-strapped regional governments will have to become more innovative in partnering with financial firms and companies like American Water to find cost-saving solutions. The Buffalo Water Board, for instance, signed a contract with American Water to upgrade, operate and maintain its water system more than 10 years ago. It's estimated the change has saved the city $21 million; residents' water rates have fallen by 8%.
American Water's plans call for $900 million in annual capital expenditure -- twice the annual level it had from 2003 to 2005. All this should eventually translate into "superior earnings growth," says Boenning & Scattergood analyst Connors.
Although cost increases are politically sensitive, particularly today, water-services' bills remain small in comparison to other utilities', notes Correll. About 90% of customers pay between $1 and $1.50 per day. "The consumer doesn't even notice the water bill," he says. After all, most Americans don't think twice about paying more than that for a single bottle of water from some supposedly natural therapeutic spring.
Ron Sorenson, CEO of money manager W.H. Reaves in Jersey City, N.J., has been a big buyer of the stock. "Before being acquired, American Water Works was one of the country's prime moderate growth utilities. We expect the company to regain it premier status now that it is once again public."
It shouldn't be too long till company profits are fully flowing once more.
