Dividend growth investing produces the best results when an investor sticks to what they know. It doesn’t get much simpler than the investment thesis behind the regulated water and wastewater industry, which is that the United States will always require water and wastewater services. A growing population (i.e. customer base) and occasional rate hikes should serve as growth catalysts for the industry.
With operations that provide services to 14 million people in 24 U.S. states, American Water Works Company, Inc. (NYSE: AWK) is a dominant water utility. For the first time since I launched coverage last November, let’s take a look at the fundamentals and valuation of the stock.
Prospects for high dividend growth remain intact
What makes American Water Works a particularly attractive utility is its exceptional growth profile. The stock’s diluted diluted EPS has compounded at an annual rate of 9% over the past five years. This strong earnings growth allowed the dividend to grow by 10% per year during this period.
But can it continue to move forward? I tend to think so for several reasons.
American Water Works produced $4.25 of adjusted diluted EPS in 2021. Compared to the $2.36 of dividends per share paid last year, this is an adjusted diluted EPS payout ratio of 55, 5%.
And using American Water Works’ median adjusted diluted EPS figure of $4.44 ($4.39 to $4.49 according to American Water Works’ fourth quarter 2021 earnings press release), the Adjusted diluted EPS payout ratio is expected to be 57.8% in 2022. This assumes an 8.7% increase in the quarterly dividend from $0.6025 per share to $0.6550 per share next month.
These low payout ratios give the stock leeway to increase the dividend slightly ahead of earnings for the foreseeable future. And with analysts anticipating American Water Works’ annual earnings growth of 8.3% over the next five years, I feel comfortable reiterating my annual dividend growth rate of 8.5%.
American Water Works had a great 2021
American Water Works again delivered superb operational and financial results to its shareholders in 2021.
The company reported operating revenue of $3.93 billion in 2021, equivalent to a growth rate of 4.1% over the prior year period (details taken from press release on American Water Works’ fourth quarter 2021 results). American Water Works was able to post a strong revenue growth rate due to its continued commitment to growing its rate base through investment. Rate base is the amount of a company’s capital investment less accumulated depreciation, on which the utility providing services to its customers is allowed to earn a rate of return from regulatory fees.
American Water Works’ rate base increased 8.7% year-over-year to $16.3 billion in 2021 (figures as per Slide 18 of the Q4 2021 Earnings Presentation) American Waterworks). Factoring in the company’s sale of the unregulated homeowner services group business for $1.3 billion, its adjusted diluted EPS also rose 8.7% year-over-year for reach $4.25 in 2021 (data points according to American Water Works Q4 2021 earnings press). Release).
Beyond the median guidance of $4.44 or 4.5% year-over-year Adjusted Diluted EPS growth for 2022, American Water Works forecasts high single-digit annual rate base and long-term earnings growth (details from American Water Works fourth quarter 2021 earnings press release and fourth quarter 2021 earnings presentation).
Indeed, the company plans investments of $25 billion to $28 billion and acquisitions of $3 to $4 billion over the next decade to increase its rate base and profits (figures according to slide 10 of the results presentation of the fourth quarter of 2021 from American Water Works). ).
American Water Works’ low dividend payout ratio allows it to retain a significant portion of the capital needed to fund its growth ambitions over the next decade. And thanks to its respective A and Baa1 credit ratings from S&P and Moody’s (info on slide 8 of American Water Works’ fourth quarter 2021 results presentation), American Water Works can access the remaining capital needed to make its investments. through the issuance of debt securities. .
The company has $1.7 billion in cash available to fund future operations and investments (details taken from slide 8 of American Water Works’ Q4 2021 earnings presentation). Considering also that American Water Works has no significant debt maturities over the next few years, it’s easy to see why its credit ratings are several notches from quality.
These factors could make American Water Works a lucrative long-term investment if the stock is purchased at a reasonable valuation.
More downsides could be ahead
American Water Works is a quality stock. But the stock faces a few risks that could weigh on its short-term upside potential and even lead to a decline.
The first risk for American Water Works is that we are in an inflationary environment. Evidenced by the 7.9% year-over-year increase in the CPI in February.
This will almost certainly lead to a significant increase in operating and maintenance costs for the business this year. And if the stock is unable to recoup its costs through rate cases with utility commissions, it would affect its bottom line.
The other risk for American Water Works relates to the first risk, which is the correlation between its share price and interest rates. Thanks to the high inflation figures, the Federal Reserve is expected to raise interest rates from a range of 0% to 0.25% at the start of this year to around 2% by the end of this year.
Rising rates could send American Water Works’ stock price further down, as Treasuries become viable alternatives.
The stock seems slightly reduced
The fundamentals of American Water Works seem intact. But that doesn’t mean an investor can pay any valuation and expect their investment to do well.
That’s why I’ll be using two valuation models to value the shares of American Water Works.
The first valuation model I will use to estimate the fair value of American Water Works stock is the Dividend Discount Model, or DDM, which has three inputs.
The first entry for the DDM is the expected dividend per share, which is the stock’s annualized dividend per share. The current annualized dividend per American Water Works share is $2.41. To be on the safe side, I’ll use that rather than the new annualized dividend rate that will be announced in about four weeks.
The second entry in the DDM is the cost of equity, which is another term for the annual total rate of return required by an investor. My personal preference is 10%.
The third datum for the DDM is the annual dividend growth rate or long-term DGR.
Unlike the first two entries in the DDM which require minimal time on the part of an investor, accurately predicting the long-term DGR requires an investor to consider several things: these include the payout ratios of a stock (and whether those payout ratios will contract, expand, or remain unchanged in the future), annual earnings growth expectations, the strength of a stock’s balance sheet, and industry fundamentals.
As I noted in the section on dividends, I will assume an annual dividend growth rate of 8.5% for American Water Works stock.
Using these inputs, I arrive at a fair value of $160.67 per share. This implies that American Water Works shares are trading at a 0.7% discount to fair value and may offer a 0.7% upside from the current price of $159.60 per share ( as of March 25, 2022).
The second valuation model I will use to get a fair value output for American Water Works stock is the discounted cash flow or DCF model, which also has three inputs.
The first input to the DCF model is trailing twelve-month adjusted diluted EPS. American Water Works adjusted diluted EPS was $4.25 in 2021.
The next input for the DCF model is the growth assumptions.
Based on American Water Works’ annual earnings growth rate of 9% over the past five years and analysts’ forward estimate of 8.3%, I believe that an annual earnings growth rate of 8.25% is a reasonable assumption. I will then assume that the law of large numbers will result in a drop to 7.25% per year beyond the first five years.
The final input to the DCF model is the discount rate, i.e. the required annual total rate of return. I will use 10% again for this entry.
My assumptions lead me to a fair value production of $173.24. This suggests that American Water Works’ stock price is discounted by 7.9% from fair value and offers capital appreciation of 8.5% from the current stock price.
By averaging these two fair values together, I calculate a fair value of $166.96 per share. This signals that American Water Works shares are trading at a 4.4% discount to fair value and could offer a 4.6% upside from the current share price.
Summary: American Water Works could be a buy, but caution is warranted
American Water Works is a blue-chip dividend growth stock with an annual dividend growth rate of 10% over five years. And based on its low payout ratios and promising growth prospects, it looks set to continue. The fortress-shaped balance sheet helps American Water Works achieve its long-term growth goals.
But with six more Federal Reserve meetings this year and inflation showing no signs of abating, American Water Works stock could face further downward pressure. This is why I value the stocks as a reserve despite my estimate that they are undervalued by 4%.
Thus, investors would be better off waiting for more clarity from the Federal Reserve before considering any major stock purchases.