Water consumption is totally uncorrelated to the underlying market conditions. Even during the deepest recession, people won’t limit their water consumption patterns. Two companies that can benefit from this are American Water Works Company (NYSE: AWK) & California Water Service Group (NYSE: CWT). Being the highest-valued water utility in the United States, with a market cap of $27.7 billion, AWK offers an exceptional moat. Likewise, CWT is the dominant player in California, also distinguishing itself from its industry peers.
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The industry offers another advantageous characteristic. Due to it being highly regulated and capital intensive, there is essentially no competition for the existing players in the market. It’s a secured oligopoly. Combined with the fact that regulators allow for regular rate hikes to ensure that water utilities make a fair return on their investment, water utilities enjoy incredibly predictable and stable cash flows.
Still, due to their overextended valuations, I am neutral on both stocks.
Cash-Flow Visibility to Drive Predictable Growth
AWK and CWT have performed resiliently during the harshest economic environments for the reasons mentioned above. While the ongoing macroeconomic setup and geopolitical concerns are disturbing the economy, the two companies are hardly being impacted. Due to their incredible cash-flow visibility, the two companies offer a predictable pathway toward growing earnings and dividends. Investors are used to these prolonged earnings and dividend growth patterns.
Take American Water Works, for example. The company features a 10-year earnings-per-share and dividend-per-share CAGR of 13.5% and 10.4%, respectively. It may go unnoticed, but these growth rates are remarkable, considering that the water provision industry is particularly mature.
Another positive element that comes with high cash-flow visibility is that companies can expand their distribution network and operations with fairly undersized risk. During the first half of 2022, American Water Works invested $1.25 billion in its infrastructure, adding around 59,200 customer connections through closed acquisitions and organic growth.
As I mentioned, rate hikes also contribute to growth. The company now featured general rate cases in progress in six jurisdictions and has also applied for infrastructure surcharges in three jurisdictions for a total annualized revenue request of roughly $598 million.
By blending predictable water consumption patterns, rate hike requests, and expansion through acquisitions, as well as organically, management has the luxury of delivering a very thorough earnings growth outlook.
Specifically, the company anticipates EPS to grow by a CAGR (compound annual growth rate) of 7% to 9% through 2026. Around 5% to 7% of this growth is to be specifically driven by regulated investment capital expenditures, another 1.5% to 2.5% from regulated acquisitions, and finally, around 1% of this growth is to be powered by military services.
Following such high cash flow and earnings-per-share growth visibility, the company is able to also provide a rather narrow dividend outlook, which it targets to grow between a rate of 7% and 10% in the long run. For context, last April, American Water hiked its quarterly dividend once more by 8.7% to a quarterly rate of $0.655, now counting 14 years of consecutive annual dividend increases.
California Water Services features a similar growth trajectory and forward-looking assurance traits. The company’s 10-year earnings-per-share and dividend-per-share CAGRs stand at 6.3% and 4.4%, respectively. Sure, these numbers are notably inferior to American Water Works due to the latter’s geographical diversification, but they are again respectable considering how late-stage this industry is.
To provide some perspective regarding the industry’s maturity, which at the same time highlights California Water Services’ ability to grow stably for decades, the company has increased its dividend annually with no exception for 54 consecutive years. Thus, sustainable growth in the mid-single digits is not as poor as initially perceived.
Predictability Comes at a Price, Unfortunately
As we have established, water utilities offer fantastic cash flow and growth visibility prospects. Unfortunately, this comes at a steep price. Even though both American Water Works and California Water Service shares have declined modestly over the past year, their forward P/Es stand at 34.8x and 33.6x. These are ultra-expensive multiples even if the former keeps growing in the low-double digits and the latter in the mid-single digits.
However, there is a powerful rationale that keeps sustaining such high multiples for both stocks. Basically, both stocks are receiving a bond-like treatment from investors. Due to their dividends being incredibly safe for the reasons already mentioned and their business models being almost “risk-free,” investors rash to these stocks to capture their yield surplus.
In other words, even if investors end up making a low return on their investment over the long run due to overpaying today, it still makes sense from a risk-reward point of view.
What are the Price Targets for AWK and CWT Shares?
Turning to Wall Street, AWK stock has a Hold rating based on two Buys, four Holds, and one Sell rating assigned in the past three months. The average AWK stock price target of $167 implies 9.8% upside potential.
As CWT stock is relatively unknown, it only had one analyst cover it in the past three months. The stock has a Moderate Buy rating based on one Buy rating, with CWT’s price target of $61 implying just 2.7% upside potential.
Conclusion: Fantastic Attributes at a Hefty Price
American Water Works and California Water Services display fantastic attributes and forward-looking earnings growth visibility prospects. While both companies are likely to keep delivering stable returns ahead, however, that would only be sustainable if their shares sustain their current elevated valuation multiples.
A substantial valuation compression, in either case, is to result in notable capital losses, notwithstanding both companies’ unique qualities.
