Positive Pipelines

The U.S. water and wastewater sector is characterized by three major features: (1) it is municipally-dominated, (2) extremely fragmented and (3) its infrastructure is in need of repair or improvement.

Nearly every major city in the United States is owned and operated by the local government. Investor-owned water and wastewater systems account for the remainder and are generally economically regulated by the state public utility commissions (PUCs) in the states in which they operate. The federal government and the states also regulate environmental, health and safety and water quality matters for both investor-owned and government-owned water and wastewater utilities.

The majority of the approximately 53,000 community water systems are very small, serving a population of 500 or less. As mentioned, American Water Works is the largest and most geographically diverse water utility in the United States.

The aging water and wastewater infrastructure in the United States is in constant need of modernization and facilities replacement. Increased regulations to improve water quality and the management of wastewater discharges, which began with passage of the Clean Water Act in 1972 and the Safe Drinking Water Act in 1974, have been among the primary drivers.

The EPA estimates that approximately $277 billion of capital spending will be necessary between 2003 and 2022 to replace aging infrastructure and to comply with quality standards to ensure quality water systems across the United States. In addition, the EPA estimates that approximately $388 billion of capital spending will be necessary between 2000 and 2019 to replace aging infrastructure and ensure quality wastewater systems across the United States.

American Water Works (AWK): We regard AWK as a high quality conservative utility with unique growth opportunities. Shares offer investors a competitive 4.1 percent return with earnings growth potential through rate increases necessary to boost under-earning returns, rate base additions and consolidation/privatization opportunities.

AWK benefits from public and regulatory support of investment in water and wastewater infrastructure. In addition, the company’s national presence, diverse geographic footprint, technical expertise, operating reputation and financial resources favorably position it to consolidate and privatize the extremely fragmented and municipally dominated water and wastewater industry.

Our 2009, 2010 and 2011 earnings estimates are $1.30, $1.45, and $1.60, respectively, per share, which results in a 2008-2011 CAGR of 13.3 percent. The primary driver of near-term growth is rate recognition of past investments necessary to achieve returns near those authorized.

Over the past few years, AWK has diligently focused efforts on improving its regulated returns via an active regulatory program. AWK subsidiaries were awarded annual revenue increases totaling $206.3 million in 2008 and $159 million in 2007, which compares to $41 million in 2006 and $35 million in 2005.

During the first-half of 2009, AWK subsidiaries received rate increases totaling $18 million and during the second quarter filed for revenue increases totaling $183 million. As a result, AWK is currently awaiting orders on requests for $258 million in annual revenue increases.

We consider AWK shares to be relatively inexpensive compared to the other publicly-traded water utilities. Shares trade at 15.7X and 14.1X our 2009 and 2010 earnings estimates of $1.30 and $1.45, respectively, well below current and historic group multiples. On a price-to-book value basis, AWK shares trade at 129 percent of tangible book value (assumes the write-off of all goodwill) versus group average multiples of 195 percent.