Riding the Wave of Success: How AWK Turns Water into Liquid Gold

Summary

• Essential Service and Market Demand: American Water Works Company, Inc. (AWK) is positioned for growth, leveraging the constant demand for water and wastewater services. The U.S. faces a projected increase in water demand, exacerbated by climate change, highlighting the essential nature of AWK’s services.
• Industry Fragmentation and Consolidation Opportunity: The U.S. water/wastewater industry’s fragmentation, with tens of thousands of small community systems, presents a significant opportunity for AWK to grow through consolidation. Legislation in states like Pennsylvania, California, and Illinois supports such strategies by facilitating fair market value acquisitions.
• Stable Revenue and Earnings Model: AWK enjoys stable revenue and earnings growth within a regulated framework, allowing for regular rate adjustments. Despite challenges from the elevated interest rate environment, the company’s essential service nature and potential for regulatory easing suggest resilience.
• Dividend Reliability and Growth: The company has a strong record of dividend reliability and growth, supported by a sustainable payout ratio. This financial stability, combined with strategic opportunities for consolidation and infrastructure investment, underscores AWK’s investment appeal despite medium risks related to rate cases, environmental compliance, and borrowing costs.

Investment Thesis

#1: American Water Works Company, Inc. (AWK) stands as a pivotal investment opportunity, leveraging its dominant position in the indispensable water and wastewater sector to ensure steady growth and stability in a market where demand perpetually outstrips supply

• An assessment recently conducted by the US Forest Service found that nearly half of the 204 freshwater basins in the US may not be able to meet monthly water demand by 2071
• Water is an indispensable part of our daily lives. The average US family uses more than 300 gallons of water per day at home. About 70% of that water is used inside the home for things like flushing the toilet, showering, and washing dishes
• The graphs below from the US Global Change Research Program compare the expected percent change in water demand in the US from 2005 to 2060 with and without climate change. With Climate Change indicates a scenario where current greenhouse gas emission trends continue, and Without Climate Change indicates a scenario where greenhouse gas emissions are reduced

• American Water Works Co., Inc. (AWK) operates a business model centered around providing water and wastewater services to residential, commercial, industrial, and institutional customers across multiple states in the U.S. The company manages a comprehensive network for its water sourcing, including 53,500 miles of pipes, 1,700 water and wastewater pumping stations, 1,100 treated water storage facilities, and 73 dams
• American Water Works Co., Inc. showcases its diversification by offering water and wastewater services across both residential and commercial sectors in 24 states

• Furthermore, In November 2021, Biden signed the bipartisan Infrastructure Investment and Jobs Act (IIJA), a $1 trillion infrastructure spending bill that earmarked over $60 billion for water infrastructure (including $40 billion in drinking water appropriations and $20 billion in wastewater appropriations). Most of those appropriations will go toward protecting environmental resources and upgrading and repairing aging systems; at least $15 billion will be used to replace lead pipes in existing water infrastructure

#2: The U.S. Water/Wastewater Industry is highly fragmented due to the vast number of community water systems and wastewater facilities, which creates opportunity for AWK to consolidate and grow it’s network

• The total addressable market for utility ownership in the U.S., given the industry’s fragmentation, has been valued at approximately $977 billion, signaling ample opportunities for companies like American Water Works to expand through strategic acquisitions and partnerships
• The U.S. water and wastewater industry is highly fragmented, with small systems serving fewer than 3,300 people making up 78% of the market
• According to the U.S. Environmental Protection Agency (EPA), there are approximately 50,000 community water systems and 16,000 wastewater treatment facilities in the United States. The vast majority of these systems serve small communities, with nearly 97% of community water systems serving fewer than 10,000 people

• Small and medium-sized systems often struggle with compliance due to the financial and technical challenges of meeting increasingly stringent regulatory standards, such as those related to PFAS and lead. These pressures can make these systems more open to acquisition by larger, more capable entities like AWK that can invest in the necessary upgrades and efficiencies

#3: American Water Works Co., Inc. (AWK) enjoys a stable revenue and earnings model due to the essential nature of its services and a regulated framework that supports regular rate adjustments

• Revenue has predictably grew 4-6% annualy for the past 10 years. EPS has increased by 4% yearly on average in the last 5 years and has been closely aligned with analyst estimates
• This stability in growth also warrants a premium on the stock which is definitely priced significantly higher to both the utilities sector and the rest of the S&P 500

• AWK alike the utilities sector has been battered by rising costs due to an elevated interest rate macro environment.
• At a macro standpoint, we believe that inflation has already peaked, and hence rate increases are highly unlikely in the foreseeable future. The current yield curve is inversed (short-term interest rates are higher than long-term rates) which has historically been a predictor of economic recessions and could indicate that investors expect interest rates to decline in the future

• American Water Works has demonstrated robust dividend reliability and growth, with 16 consecutive years of increases, a 10-year growth rate of 9.8%, and a current yield of 2.3% that’s well above its five-year average, supported by a sustainable payout ratio of 58.4%, ensuring dividend safety.

• We set a 12 month price target of $135, which is a 13% upside from the current price of $120 (March 27th). If AWK fully recovers, we believe the price can easily hit $150 / share based on management guidance for 2024 to $5.20-$5.30 per share and a forecasted P/E of 30. At the full recovery case, this represents a 30% upside from it’s current price
• Several states, including Pennsylvania, California, Illinois, New Jersey, and Indiana, have enacted legislation or adopted regulatory policies to facilitate the consolidation of water and wastewater systems, allowing utilities like American Water Works (AWK) to acquire smaller systems at fair market value, thus supporting AWK’s growth and operational efficiency strategy

Risk Assessment

• Med Risk: AWK’s eight open rate cases present a risk of regulatory uncertainty; unfavorable outcomes could limit revenue increases, impacting financial performance and potentially constraining the company’s ability to fund infrastructure projects

• Med Risk: PFAS (per- and polyfluoroalkyl substances) and environmental compliance represent a risk to AWK due to potential regulatory changes and the financial burden of treatment and mitigation efforts required to meet stringent water quality standards, impacting operational costs and necessitating significant capital investments.
• PFAS are known as “forever chemicals” because they do not break down in the environment and can accumulate over time. Their presence has been detected in water sources, soil, and in the blood serum of the general population, raising concerns about potential health impacts
• The regulatory landscape for PFAS is evolving. In the United States, the Environmental Protection Agency (EPA) has issued health advisories for specific PFAS compounds but is moving towards establishing enforceable drinking water standards. This evolution represents a shift from guidance to mandatory compliance, requiring water utilities to implement costly treatment solutions
• The need to test for, treat, and remove PFAS from drinking water presents significant financial challenges for water utilities like American Water Works (AWK). Compliance requires substantial investment in advanced water treatment technologies, ongoing monitoring, and potential infrastructure upgrades or face the risk of litigation related to PFAS contamination
• Med Risk: Elevated interest rates increase the cost of borrowing for utilities, which rely on debt financing for capital-intensive projects like infrastructure upgrades and expansions. Higher interest rates mean higher financing costs, impacting profitability and potentially slowing down capital projects
• Higher financing costs could be a consideration in rate cases, where utilities seek approval from regulators to adjust customer rates which makes risk 1 even more important to navigate