Why One Analyst Sees Expensive Water Utility Stocks Going Even Higher

The current bull market is over 10 years old, the strong economy has been slowing and investors are seeing and hearing “recession” so frequently some people might think a recession is already here. The U.S.-China trade war and slowing global economy are making investors nervous as well. It turns out that some defensive sectors tend to be recession-proof, and the world of negative interest rates outside the United States and super-low U.S. rates have investors looking for safety and income.

24/7 Wall St. has been touting the safety of investing in water for years now. Utilities are deemed to be defensive in their own right, but while you might be able to limit electricity and gas use there is no substitute for using water. This makes water utilities a prime destination for many types of investors, and the sector just doesn’t have that many water utilities to invest in.

A fresh research report from Janney Montgomery Scott’s Michael Gaugler has substantially raised price targets across the universe of U.S. water utilities. His view is that the price-to-earnings ratio investors will pay for these defensive leaders is going to rise, and an economy in which interest rates may be lower for longer makes the dividend yields attractive (even if they are weak versus electric utilities). Gaugler’s report said:

As we look across our water utilities, most yields are trading within a narrow band around the aforementioned U.S. 10-year Treasury-Note. Looking forward, our view is this: yield (and the ability to raise dividends consistently) is now a primary determinant affecting water utility share prices and valuation. … Our changes raised Fair Value targets to reflect what we consider to be the “new normal” in water utility valuations.

Any water investor understands that it is “expensive” to invest in water utilities. While valuations are very high, the top 10 U.S. water utility stocks do not even add up to a total of $45 billion in market cap at the current time. And to prove the premium further: only two of those 10 have a 2% or higher dividend yield.

Gaugler handily increased his price targets in this defensive but expensive sector, and the report talks about valuations being extreme.

American Water Works Co. Inc. (NYSE: AWK) was reiterated as Buy and the price target was raised to $153 from $121 at Janney. The report even shows how this utility could rise another 135% over the next decade, if the interest rates stay this low and if it continues to live up to its dividend hike trajectory. After closing at $125.78 a share on Friday, American Water Works was down 1.2% at $124.30 on Monday afternoon ahead of the close. It has continued to be a stock to own for the decade.

Aqua America Inc. (NYSE: WTR) was reiterated as Buy and the price target was raised to $70 from $50. Gaugler even noted that Aqua America’s shares could rise 177% over the next 10 years, if the interest rates stay this low and if it is able to raise payouts.

SJW Group (NYSE: SJW) was reiterated as Buy and the price target was raised to $89 from $71. The long-term upside for higher payouts and lower rates led Gaugler to opine that SJW could rise 124% over the coming 10 years, if the scenario plays out.

Middlesex Water Co. (NYSE: MSEX) and York Water Co. (NASDAQ: YORW) were both reiterated as Buy. Middlesex’s target was raised to $73 from $64 and York’s was raised to $53 from $38.

Janney maintained its Neutral rating on American States Water Co. (NYSE: AWR) and on California Water Service Group (NYSE: CWT).

The Janney report addresses whether the current multiples are sustainable if they can work higher and addresses the risks of higher interest rates or competing yields with the same defensive characteristics as water utilities.​ Gaugler said:

The consistent rise in water utility P/E multiples has been nothing short of breathtaking; we now have three coverage names trading near or above the 40 P/E level on 2019 consensus EPS estimates. Valuation has become somewhat of a black hole, with no discernable rhyme or reason as to why individual names trade at the valuation metrics that are now a reality. … Our opinion is that the relentless hunt for sustainable (and growing) dividends in a low-yield world has pushed P/E multiples to elevated levels, and that those conditions aren’t likely to change anytime soon. Using the benchmark U.S. 10-Year Treasury T-Note’s yield as a guide, should U.S. interest rates stay lower for longer (as they have in many developed economies around the world), we believe the answer is “Yes”, multiples can remain at elevated levels and share prices can continue to work higher.

Investing in water is not cheap by any means, but the sector has such few public stocks to invest in that paying a premium just seems to be the price of entry into the club at this point.

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