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A Thirst for Dividend Growth

Few industries are more beloved by income investors than water utilities. After all, these firms provide the most essential of the essential services, and that translates into rising dividends and stocks that do a superior job of holding their value in just about any environment.

Of course, those coveted qualities also mean that water utilities tend to command a premium relative to their utility peers. The average price-to-earnings ratio (P/E) among the three biggest publicly traded water utilities is 21.3, which is significantly higher than the S&P 500, at 17.3, not to mention the Dow Jones Utilities Average, at 14.8.

As value-oriented investors, we don’t like paying up for our favorite stocks. But water utilities seldom hit the bargain bin. Even California Water Service Group (NYSE: CWT), whose stock has been punished because the company operates in a state suffering a historic drought, still trades at 17.1 times earnings, despite declining 16.1% year to date.

However, patient investors may have an opportunity to pick up our recommended water utilities at a lower price if dividend stocks sell off again when the Federal Reserve finally raises rates. While a number of economists believe that could happen as soon as the Federal Open Market Committee meets next week, a majority of traders are betting on a December liftoff, at the earliest.

To be sure, even another mini-correction among dividend stocks is unlikely to erase water utilities’ premium relative to their utility peers, or even the market as a whole. But it’s still worth waiting for a lower price to lock in a higher yield.

In fact, most yield-focused investors probably wouldn’t be all that impressed with the current yields of the top water utilities. That’s in part a function of their premium prices.

We certainly like a higher-than-average yield, and a number of utilities in other areas offer that. But all too often, income investors make a snap judgment based on yield without looking at dividend growth.

American Water Works Co. Inc. (NYSE: AWK) is by far one of the largest publicly traded water utilities, with a $9.2 billion market cap that’s more than double that of its next-largest peer. It also happens to be one of our favorite water utilities, but yield chasers would probably sneer at its current yield of “just” 2.5%.

What that superficial assessment overlooks is a strong record of dividend growth. American Water’s payout has grown 8.9% annually over the past five years and 11.4% annually over the past three years.

If you depend on your portfolio to generate current income, then those are pretty nice raises in what’s been an otherwise underwhelming economy.

And it doesn’t take long for a steadily climbing dividend to seriously boost your income. American Water’s quarterly payout is now 62% higher than it was just five years ago. And analysts forecast further dividend growth of 8% to 9% annually through 2018. Yes, please!

Underpinning that rising payout is the largest and most geographically diverse water utility in the country, with 48,000 miles of pipeline serving 15 million people across 47 states and Canada. At the same time, it should be noted that operations in New Jersey and Pennsylvania account for nearly half of the firm’s regulated revenue.

One of the major themes in the water utility space is the need to upgrade and expand the country’s aging pipes. To that end, American Water plans to spend $6 billion through 2019, with about $5.2 billion allocated toward renewing infrastructure and much of that amount covered by regulatory mechanisms.

Clearly, American Water has the scale and financial strength to help modernize the country’s water infrastructure. But the water utility space is still highly fragmented, and many smaller utilities simply don’t have the ability to undertake such spending.

And that brings us to the other major theme of the water utility space: consolidation. Unlike many of its ultra-tiny peers, American Water can afford to spend, and it’s been a serial acquirer, pursuing small tuck-in acquisitions to help drive earnings growth. In fact, management has allocated $300 million toward strategic acquisitions through 2019.

In a recent interview with Bloomberg, American Water CEO Susan Story says the company’s M&A “sweet spot” is municipal systems with 25,000 to 30,000 customers.

While private-equity investors, pension funds and foreign investors are also starting to snap up some of these water-utility assets, they generally don’t want to deal with smaller municipalities. And that lack of competition helps American Water avoid overpaying for acquisitions.

The company expects to see earnings growth of 7% to 10% annually over the long term, and its policy is to pass much of that along to investors by targeting a consistent payout ratio of between 50% and 60% of earnings.

That earnings outlook comports with analyst projections, which forecast average earnings growth of 7.2% annually over the next five years.

American Water enjoys strongly bullish sentiment on Wall Street, at 13 “buys,” five “holds,” and one “sell.” The consensus 12-month target price is $58.00, which suggests potential appreciation of 11.6% above the current share price.

Though we like the stock at current prices, it’s still trading with the water utility space’s customary premium. With the potential for more broad-market volatility in the months ahead, in addition to a possible Fed rate hike, value-oriented investors may want to set a stingy limit with their brokers to see whether they can pick up shares on the cheap.

As a reference point, the stock’s year-to-date low was $48.36 at the end of June. Happy hunting!

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