The Last Utilities Standing

Utilities are general considered the least-risky sector of the stock market.

That’s because in exchange for their status as natural monopolies, they’re authorized to earn a fair return on their infrastructure investments. These steady, regulated returns are what power utilities’ long-term dividend growth.

But electric utilities are currently contending with disruptive technologies that promise to transform how the sector does business.

In addition to the industry’s transition toward cleaner energy, electric utilities are also grappling with how to treat customers who generate their own energy with rooftop solar panels. The rise of distributed generation will upend longstanding relationships between utilities and their customers.

By contrast, water utilities deliver an even more essential service whose mode of operation is unlikely to be disrupted anytime soon.

That’s why water utilities trade at such high valuations, even compared to the already-high valuations of their utility peers.

The era of historically low interest rates is a consequence of two downturns followed by continuing economic uncertainty. That’s created a situation where investors are scrambling for both yield and safety, both of which are offered by water utilities.

During the 1990s, water companies tended to trade at valuations that were consistent with their status as slow-growing utilities. But that started to change in the early 2000s, as valuations became disconnected from fundamentals.

However, if we take the Federal Reserve’s current forecasts for the future direction of interest rates at face value, then it’s likely that utilities will continue to trade at premium valuations for the next few years, if not longer.

Of course, there will be periodic corrections as the Fed gets more serious about rate hikes. But we intend to use those as buying opportunities, even if few true bargains emerge.

Indeed, despite being down nearly 15% from their trailing-year highs, the nine publicly trade water utilities tracked by Investing Daily’s Utility Forecaster have a price-to-earnings ratio (P/E) of 25.7x, compared to 19.4x for the average electric utility and 20.1x for the market as a whole.

Unfortunately, high valuations tend to compress yields, unless dividend growth can somehow keep pace with dizzying price appreciation. Although income investors love water stocks, the average yield among this cohort is just 2.3% compared to 3.4% for the average electric utility.

Drink Up

But there is one tiny water utility that offers an attractive yield and one of the lowest relative valuations among its peers.

Delaware-based Artesian Resources Corp. (NSDQ: ARTNA) has a market capitalization of just $256 million, making it by far the smallest regulated water utility that’s listed on the market.

As such, it isn’t widely followed on Wall Street, and just 45.8% of its shares outstanding are owned by institutional investors, which is the lowest percentage among the nine water stocks.

That may be one of the reasons why the stock has fallen so hard since water utilities hit a high in early July. Shares of Artesian are down 20.6% from their trailing-year high and currently trade at a P/E of 22.0, not cheap compared to the market but a relative value compared to its peers.

When a company’s float is dominated by risk-averse retail investors, most will head to the exits at any sign of trouble. In early August, Artesian reported earnings that missed analyst estimates by 3.0% on the top line and 10.2% on the bottom line.

Management attributed the 8% year-over-year decline in earnings to lower water consumption due to cooler and wetter weather.

That brings us to Artesian’s biggest risk: its limited operating geography. Unlike diversified giants such as American Water Works Co. Inc. (NYSE: AWK), Artesian’s water and wastewater operations are concentrated in Delaware and nearby parts of Maryland and Pennsylvania.

With Delaware accounting for 90% of revenue, that means the company’s fortunes are largely tied to a single state’s regulators. Fortunately, regulatory relations appear to be largely constructive.

In addition, Artesian is permitted to increase rates temporarily while a rate case is proceeding. This eliminates the effect of regulatory lag, though it can lead to customer reimbursements if regulators decide on a lower rate than the one the firm requested.

Regulatory whims aren’t the only risk of Artesian’s small footprint. As second-quarter results showed, the company is significantly exposed to weather in just one region, which can also weigh on earnings.

Nevertheless, earnings per share are projected to grow 3% for full-year 2016 and 11% in 2017.

Artesian has raised its dividend for 20 consecutive years. Over the trailing five-year period, the company has increased its dividend by 3.3% annually, for a quarterly payout that totals $0.91 annually and a forward yield of 3.3%.

Yield chasers might scoff at Artesian’s yield, but it’s a full percentage point higher than its peers, though its payout ratio is on the higher side, at around 70%.

Subscribers to Investing Daily’s Utility Forecaster can view our proprietary Safety Rating and buy target for Artesian in each monthly issue’s How They Rate tables.

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