Timothy Winter, CFA
Gabelli & Company
Aqua America (WTR; Bryn Mawr, Penn.) is the second-largest publicly traded water utility in the U.S., serving about 3 million people in Pennsylvania (55% of earnings), Ohio, North Carolina, Illinois, Texas, New Jersey, Indiana and Virginia.
On Feb. 23, WTR reported 2015 adjusted earnings of $1.26 per share, in-line with guidance of $1.25-$1.27 per share and compared to $1.20 per share in 2014. Higher results were due to customer growth, higher rates and surcharges, and higher usage.
In 2015, the operating efficiency ratio (operations and maintenance, or O&M, as a percent of operating revenues) rose to 36.3% from 34.7% in 2014, partially due to four municipal acquisitions adding 7,900 customers and 12 investor-owned utilities (IOUs) [with] 2,700 customers. Additionally, WTR subsidiaries implemented rate awards totaling $8.6 million.
Earnings growth will continue to be driven by rate base investments, acquisitions, cost controls, infrastructure surcharges and the pipeline-rehabilitation business.
Year to date, WTR has completed four acquisitions for a total of 4,500 customers, and management has renewed its focus on municipal water and wastewater systems serving 2,500-25,000 customers; recent legislation in Illinois, New Jersey and Indiana has encouraged consolidation by allowing the purchase price in rate base or applying uniform rates statewide.
We continue to believe WTR is well positioned to continue its successful acquisition strategy given U.S. water (53,000 systems) and wastewater (16,000 systems) industries are extremely fragmented and municipally dominated (water is 85% municipally owned; wastewater 97%).
Year to date, WTR subsidiaries have implemented rate rewards totaling $4.3 million, including $600,000 in Illinois, $604,000 in North Carolina, $1.4 million in Ohio, $225,000 in Texas, and $1.5 million in Virginia. In New Jersey, WTR has a general rate case pending requesting an annualized revenue increase of $2.5 million.
Given the use of repair tax deductions, Aqua-Pennsylvania has not filed a general rate case or Distribution System Improvement Charges (DSIC), since 2011 and does not expect to need to until 2017 or 2018. WTR expects a roughly 15% rate increase, which includes the DSIC in the 2017-18 request. The use of repairs tax deduction allowed for the seven year stay-out and roughly $10 per month customer benefit.
The 2016-2018 capital investment program totals $1.1 billion, including $350 million in 2016. Roughly 63% of the investment is allocated toward pipe replacement or upgrades in jurisdictions with surcharge eligible infrastructure programs (PA, IL, IN, OH, NJ and NC). The PA PUC which regulates $2.4 billion of WTR’s $3.5 billion rate base allows for a quarterly DSIC.
Given strong cash flow, infrastructure surcharges and cash from asset sales, WTR has minimal external funding needs. As of Dec. 15, 2015, the common equity ratio was 49%, and S&P maintained its A+ credit rating for Aqua Pennsylvania.
WTR is a well-managed, low-risk, high-quality conservative utility with unique growth opportunities. Shares offer a 2.3% current return on the $0.71 per share annual dividend.
We consider WTR to be the premier water utility in the nation with a warranted premium, given the company’s national presence, strong financial condition, successful track record, and earnings and dividend outlook.
Neil Kalton, CFA, Senior Analyst
We are attracted to WTR’s low-risk, regulated-centric model, above-average dividend growth potential and considerable financial flexibility. Our Market Perform rating reflects valuation considerations — shares trade at 3-5% premiums to water peers on our ‘16-‘18 estimated EPS.
We believe an expansion of the premium could be warranted if WTR is able to consistently move the customer and rate base growth needle from accretive mergers and acquisitions, leading to a sustainable, above-industry average EPS growth rate.
Management’s new strategic M&A cultivation process and recent enabling legislation could lead to an uptick in deal activity. Management reiterated (1) 2016 guidance of $1.30-$1.35, (2) a 2016-18 capital expenditure (or capex) budget of more than $1.1 billion that is expected to result in 6-7% rate base growth and (3) that all M&A activity would be incremental to the aforementioned capex and rate base projections.
While management has not offered a long-term EPS growth rate, we got the sense at the Jan. 14 analyst day that something in the 7-8% might be internally targeted. We consider it essential that WTR remains steadfast with its proven regulated strategy, including exercising discipline when considering M&A, and does not stray too far from core competencies when pursuing unregulated growth. Positively, this was precisely the message that management communicated to investors at the analyst day.
Our 2016-19E EPS remain $1.33, $1.44, $1.53 and $1.62. We believe a five-year EPS CAGR of 6% is achievable driven by timely rate recognition of infrastructure investments, continued cost controls, modest customer growth and cash flow redeployment. We assume WTR files the much anticipated Aqua-Pennsylvania rate case in late 2017 with new rates effective mid-2018.
Our outlook is predicated on a total of $1.2 billion of regulated investments over the 2016-‘18 period, including $75 million of M&A activity. WTR has considerable financial flexibility to pursue additional M&A and, barring a very sizeable deal; we do not foresee the need for new equity.
In fact, management indicated at the recent analyst day that roughly $750 million of additional debt capacity exists. As such, we believe share buybacks and/or additional dividend increases may be considered to achieve a consolidated equity ratio closer to 45%.
We are attracted to WTR’s strong fundamentals — a proven EPS growth strategy, a growing rate base, constructive regulation, efficient operations and financial flexibility.