Revisiting American Water Works as a Stock to Own for the Next Decade

July 16, 2019 by Jon C. Ogg

American Water Works Co. Inc. (NYSE: AWK) has been an incredible performer over the years. It fits right in on the defensive utility sector trade for investors who want predictability safety, and being the top water utility in the United States has given the company that status of perhaps the perfect secular bullish investment of the past decade.

24/7 Wall St. named American Water Works as a stock to own for the decade way back in late 2010. While some of the stocks on that list have risen exponentially, and some were duds, there are some aspects that make the case that this stock could be owned for another decade.

That said, what has changed into 2019 from prior years is that this stock’s valuation metrics have simply reached a level that new investors probably cannot and should not try to justify for creating a new position in the shares.

Wall Street analysts have been tempering their formal ratings on American Water Works because of the valuation profile. Still, the utility sector has grown in importance and in size over the past decade. With roughly 28 utilities being included in the S&P 500 Index, its utilities sector now has a combined market cap that is nearing $900 billion. Even though American Water Works is the largest of the water utilities, it still doesn’t even have a $21 billion market cap itself, and it would rank in 18th place of the 28 S&P 500 utilities by market cap.

A fresh analyst downgrade has hardly bitten into the value of American Water Works. The question is whether it should be given a closer look.

Merrill Lynch downgraded the shares to Underperform from Neutral on Monday, but what makes matters difficult to interpret is that the firm raised its price objective to $121 from $110 in this call. Despite a Neutral rating being reiterated in February of this year, Merrill raised its price objective to $103 from $92 then (when shares were at $98.66) and its downgrade to Neutral from Buy came when American Water Works closed at $83.13 back on January 10, 2018.

As far as that most recent Underperform (“Sell”) rating is concerned, Merrill now perceives a less clear-cut upside case for this premium utility story. Despite being the single highest quality earnings growth and de-risked equities, its 36% premium to electric utilities has become hard to justify.

Back on May 2, 2019, Janney Montgomery Scott reiterated its Buy rating on American Water Works, and the firm raised its price target to $121 from $102 (versus a $107.10 prior close). The firm noted at the time that earnings beat its estimate but were a tad under consensus, at the same time that it announced an August retirement for the firm’s chief financial officer.

On March 27, 2019, Wells Fargo downgraded the stock to Market Perform from Outperform with a $111 price target. The valuation call came after the stock closed up 0.5% at $107.20, and it was above the then-consensus $103.46 target price.

When 24/7 Wall St. first named this as a stock to own for the decade in late 2010, the shares came with a 3.6% dividend yield and were trading at just $24.55. Since the start of 2012, American Water Works has more than doubled its nominal dividend per share, and the price of the stock (without backing out dividends) is up close to 350%.

After its next dividend payment is made later this summer, American Water Works will have paid out more than $12 per share in dividends since the start of 2011. Still, the current dividend yield, even after having been raised over time, is barely 1.7% for a new investor wondering if this should still be bought as a new position.

The water utilities current dividend per share is running at $2.00 on an annualized basis. Refinitiv has a consensus earnings estimate of $3.59 per share in 2019 and $3.90 per share in 2021. Even if tax reform is challenged in the years ahead, its dividend actually appears to be safe with room to be raised. American Water Works has a stated strategy to increase its dividend per share by linking its dividend increases to earnings per share growth with a target a payout ratio of between 50% and 60% of its net income.

Where things get difficult to justify for future earnings valuation is that American Water Works now is valued at 32.2 times expected 2019 earnings per share and 29.75 times expected 2020 earnings per share. The earnings multiple, for expected earnings share, is about 19 or 20 times the median consensus earnings estimates for the S&P 500’s utilities sector as a whole.

With shares currently at $116.00 and a 52-week range of $85.88 to $119.30, it would be very difficult to justify calling American Water Works a new stock to buy for the next decade. Then again, it’s just as equally hard to justify calling it a strong sell at the same time, when other public water utility stocks are also valued at a large premium to the electric utilities.

Short sellers also have decided not to stick their necks out too far when it comes to American Water Works and many other defensive water utilities. Less than 2.5% of the company’s float was counted as being short in the latest short interest report.

This group of water utilities has become one of those sectors that money flows into when there is uncertainty and when investors want to become defensive. With an entire market capitalization of only about $44 billion for the entire U.S. public water utilities stocks as a whole, coupled with a lack of active sellers, it’s easy to see how and why these shares are able to keep generating upside at a time that the traditional valuation metrics may be harder to justify.

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