Water Water Everywhere...How to profit from the best opportunity in a hot sector
To me, Monopoly is the greatest board game of all-time. When playing Monopoly, high-end properties that rake in huge sums of cash when opponents land on them, like Boardwalk, are the most sought after. However, there's always a place in one's Monopoly portfolio for the game's steady, lower-yielding utilities, like Water Works. The same goes for one's real-life portfolios. It's nice to have a few conservative investments mixed in with those that have more upside.
Publications have been all over water utilities lately. I have seen write-ups and recommendations on a number of different companies in the sector over the past several months. The thesis behind the sudden affinity for water companies is that many states and municipalities are having huge budget problems (that's an understatement - the pensions and free healthcare, etc... that the state workers get are nuts but that's a debate for another time that I don't want to get into now). These financial problems may increase the likelihood that state and local governments will sell their water-utility operations off to private companies. I personally would be all for my state selling off any water assets that it hasn't already. It could use the proceeds to pay down its massive wad of debt.
Currently approximately three quarters of all utilities are government-owned, so clearly there a lot potential for growth for publicly-traded companies in the sector.
I certainly can see the logic in this theory, however the privatization of public assets...particularly one as essential as water...is easier said than done. Even if states and municipalities want to sell off their water assets, the public often freaks out and attempts to prevent the transaction (see Trenton, NJ for an example of this).
Even though I believe that the acquisition of public water assets will be more challenging than many believe, I still see some merit in this thesis. Many states are in big, big financial trouble and despite the public outcry they may not have a choice to sell off a number of assets.
Seeking to capitalize on this potential trend, I looked into companies in the sector. I ultimately decided to go with American Water Works (AWK). Some of the people who are familiar with the industry may find this choice surprising.
As the old saying goes, you pay a high price for perfection (or something like that). This is why I often look for companies that are a little dinged up when investing instead of the best-run organizations. The former often have more upside.
Looking at the numbers, a number of the other companies in the sector appear to be run better than AWK. American Water Works' operating margin of 25.5% pales in comparison to Aqua America's (WTR) 35.4% (perhaps the industry's best run company). Furthermore, AWK's actually reported a loss last quarter (as a result of a wetter and cooler than normal weather).
So why did I choose AWK? I went with it because it has all three elements that I look for in stocks.
The company's relatively weak margins and the fact that it actually reported a loss last quarter have made the stock cheap. It currently trades at only 1.55 times sales, versus 1.82 times sales for California Water Service Group (CWT) and 3.75 times sales for WTR. American Water's price-to-sales ratio is a surprising 54.68% below the average of the Water Utilities industry.
It pays a dividend
AWK pays a solid 3.9% dividend that its cash flow from operations easily covers. That's higher than many companies in the sector.
It has hidden catalysts
In addition to the aforementioned potential acquisitions from financially strapped states, AWK has another hidden catalyst that should help its performance down the road. American Water Works was taken private by a German company in 2003. In order to get regulatory approval for the purchase, the German company agreed not to raise prices at all for five years despite the fact that it was spending a lot of money on projects. The end of the five-year no rate hike time period is rapidly approaching. AWK's margins are worse than many of its competitors because it has been spending money on lots of projects yet getting no rate hikes in return. The logic here is that it will be allowed to raise its rates to the point that it receives the 10% return on capital that its competitors are getting on average. I have seen this sort of situation play out with power company rate hike decisions in the past. The companies that have terrible margins are allowed to raise rates, but the ones with awesome margins are not. It's illogical to punish well-run companies and reward poorly run ones, but that's the way the government works I guess.