American Water Works Company, Inc (AWK) has been my favorite company to analyze. It is one of the few companies that I have covered that I feel is ran by disciplined and focused executives. Besides this, the company’s guidance usually is correct, and the profit margins are pretty stable. I will present my revenue estimates from my last AWK article and my updated DDM Valuation in this article.
Important Information And Key Assumptions From Original Article
In part one of this series, I mentioned how I was shocked that AWK lost $21 million (after-tax loss of $15 mn or $ 0.09 in EPS) due to the adverse effects of the coronavirus. I expected that the company would lose a couple of million because of the increase in delinquent accounts. Yet, I didn’t take into account that commercial/industrial loss in revenue would outweigh the growth in residential revenue.
Figure 1 – Impact of COVID 19 On H1 2020 EPS
Source: Q2 2020 Results Presentation
As seen in figure 1, the growth in residential revenue increased the company’s EPS by only $ 0.05. The decrease in commercial and industrial revenues decreased the company’s EPS by $ 0.09. In my original estimates I felt that residential revenue growth would balance out the decline commercial revenue.
In my last article, I estimated that the company’s revenue would grow at a CAGR of 4.2%. This growth rate is based on the company’s guidance and historical revenue growth of each business segment as I will further detail below.
- The water industry has been experiencing a decline in water usage. Most recent estimates show that water usage decreased by 2.3% (CAGR), while the U.S. population increased by 4%. AWK’s gallons of water sold only declined at a CAGR of 0.8% (2014 – 2019), significantly less than that of the industry. I believe that acquisitions are the main reasons that the company’s gallons of water sold decreased less than that of the market.
- Even while the company’s volume has decreased, its revenue was able to increase due to consecutive increases in prices. According to CBS News, water costs are rising due to the need to invest in the infrastructure, which is considered precarious by the experts of this field.
- I estimate that volume sold will decrease at a CAGR of 0.6% while the price will increase by 3.9% during the period from 2019 to 2024.
Wastewater and Other Business:
- My estimates for the wastewater segment were purely based on historical data but crosschecked with global wastewater forecasts. I estimate that this segment will grow at a CAGR of 7.1% during the forecasted period.
- From 2014 until 2019, this segment’s revenue grew at a CAGR of 8%, and revenue in 1H20 was 8.7% better than 1H19.
- From 2014 until 2019, the market-based business was AWK’s fastest-growing segment, with a CAGR of 8.7%. This segment grew due to the increase in prices of the services it officers homeowners and the U.S. military. I estimated that this segment should grow at a CAGR of 7.6% during the forecasted period.
Valuation Using DDM
Figure 2 – DDM
Source: Company financials and analyst’s estimates (gray cells)
Operation and maintenance (Ops & Maint) calculations are based upon two assumptions. The first assumption is based on historical data. From 2015 to 2019, the company’s revenue grew at a CAGR of 3.4% while its Ops & Maint cost grew at 2.4%. When a company’s expenses grow at a rate slower than revenue grows, that demonstrates that the company is experiencing economies of scale. The second assumption is based on company guidance and my interpretation of the weight that the regulated business has on the total Ops & Maint Expenses.
The other operational expenses, like general taxes and depreciation, are based on historical data. Depreciation, of course, takes into account my assumption on capital expenditures, but even then, these assumptions are based on company guidance ($ 1.9 billion in 2020) and my belief that the company will continue to spend around $ 2 billion a year over the next few years.
Based on the above information, I believe net income will grow at a CAGR of 7.4% during the forecasted period. Dividends, on the other hand, will grow at a rate of 7.8% during the same period, growing slightly faster than EPS as I believe the company is trying to reduce its retention rate. Over the past five years, the company’s average retention rate has been 41.8%. In 2019, the retention rates fell from 42.4% to 41.9%.
According to the company’s guidance, they expect to grow their EPS and dividends at a CAGR between 7% to 10% (2019 to 2024). My estimates fall within that range but on the low end. I believe that I am on the low end of the range because my ops and maint estimates are bearish.
I am bullish on American Water Works because the company is experiencing economies of scale and has a disciplined approach to running the organization. My target price for AWK is $165, giving investors a possible upside of almost 16% in the next one to two years.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AWK over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.