The U.S. water utility industry is highly fragmented, with an estimated 85% of the population getting water and waste water services from municipal utilities. This has traditionally given American Water Works a fairly easy growth pathway, via acquiring these community water systems. Acquisition costs then are factored into determining new rates to charge customers.
In effect, the company is reimbursed for getting bigger. Management has earmarked up to $2 billion through 2026 to acquire municipal utilities and up to $14 billion in growth spending over that period, including internal system upgrade spending, similarly recuperable through rate changes.
That relatively high growth profile clearly was attractive to investors, as evidenced by a dividend yield consistently well below 2%. A stock’s dividend yield is calculated by dividing the stock’s annual dividend by the market price.
While the company determines the amount paid in dividends, the market determines the stock price. All things equal, a rising stock price will decrease the dividend yield. Put another way, for a given level of dividend, higher investor demand for the stock lowers the yield.
However, once the market started to price in high inflation and aggressive Fed tightening, the relatively low yield likely hurt AWK relative to its utility peers. Moreover, the P/E was in the 40s, which after the shares’ early-2022 decline became more in line with peers, in the 20s.
In other words, it appears that the market simply revalued AWK in light of changing expectations of inflation and interest rates. Since taking an abnormally large dip at the beginning of the year, AWK has been just fine. In fact, in the past six months, it has solidly outperformed the S&P 500, just like its utility peers.
For any income stock, a key question is whether its dividend is safe. We think that for AWK the answer is a definite yes. The company has publicly stated that it aims to pay out 55% to 60% of its earnings as dividend.
American Water Works has confirmed that it sees 7%-to-9% EPS growth through 2026, so high-single-digit dividend growth for the next four years looks very doable, especially considering that AWK has already achieved annualized dividend growth rates of 9.4% and 9.6% over the past three- and five-year periods, respectively. That kind of dividend growth will help investors offset the erosive effects of inflation.
Looking ahead, we expect American Water Works will continue to focus its search on localities with constructive regulators likely to permit reasonable rate increases in return for capital spending to improve service. Despite the early 2022 valuation reset that resulted in its shares underperforming, American Water Works still looks like a strong bet to deliver attractive earnings and dividend growth.