2 Stocks with a Thirst for Growth

09/21/2011 8:30 am EST


Roger Conrad

Chief Analyst/Managing Partner, Capitalist Times

The Environmental Protection Agency (EPA) estimates the US must spend at least $160 billion by 2020 to ensure safe drinking water supplies, so it makes sense to find a good water company or two, writes Roger Conrad of Utility Forecaster.

State and local governments’ busted budgets partly explain the dearth of water-system funding.

Some 80% of water in the US is still provided by these entities. All too many of them have spent decades siphoning off money for general purposes that was originally meant for long-term water maintenance.

The result is that needed investment simply hasn’t been made in many areas of the country for decades. And the bills are coming due in the form of massive system violations, the vast majority of which are in the small systems.

The most positive takeaway is that large systems (100,000 or more customers) are breaking the law fairly infrequently. That suggests scale helps attain better compliance, i.e. provide cleaner water.

For the best and biggest US water utilities, therein lies the opportunity. Increasingly needy small water and wastewater systems are willingly acquired and absorbed at low prices.

Companies combine them with their existing systems to increase scale and reduce costs for all. Investment is recovered in rate base, pushing up earnings, dividends and, ultimately, stock prices.

This is the formula behind robust growth at Aqua America (WTR) and American Water Works (AWK)—by far the two biggest water utilities in the US—over the past decade. And if second-quarter results are any guide, they’re only starting their run.

Aqua America announced the purchase of a wastewater system in Virginia, including a gravity-collection system and lagoon wastewater-treatment system.

The company will expand those assets by building a 70,000-gallon-a-day treatment plant in 2012. That will all go into rate base and, because Virginia has one of the best regulatory environments in the US, the investment will flow through to earnings as well.

Aqua reported record second-quarter earnings, with profits rising 26% on a combination of cost controls, system expansion and rate increases. That enabled management to boost the dividend by another 6.5 percent.

Still my favorite water utility, Aqua America is a buy up to $24. [WTR was trading around $22 on Tuesday afternoon—Editor.]

American Water’s numbers were also extremely robust, with earnings per share up 14%. Management now expects full-year 2011 profit to come in on the “upper end” of its beginning-year estimate of $1.65 to $1.75 per share.

American’s keys to growth were much the same as Aqua’s, as it added $392 million in new infrastructure investment in the first half of 2011 alone. The dividend has been increased 5% over the past 12 months and is on track for more of the same, with $254 million in rate increases currently filed.

American’s company development entered a new stage this year, with the decision to reduce the number of states where it operates from 20 to 16. That’s mainly to increase its concentration of resources on states where it sees an opportunity to dramatically increase scale and scope.

This summer, for example, the company exited Ohio and doubled its New York customer base via an asset swap with Aqua.

Like all water utilities, American is always at risk to rate lag, the constant temptation of regulators to delay needed rate increases to pay for investment already made. But with its unmatched diversification, reach and financial power, the risk of a one-state setback to the entire enterprise is minimal.

My buy target for American Water Works remains $30. [The stock just popped above that level yesterday, after being range-bound for weeks just beneath—Editor.]

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