American Water Works Company, Inc. (AWK) is the largest and most diversified publicaly traded water and wastewater provider in the United States. Headquartered in Vorhees, NJ, the company has 6,700 employees and operates in 32 states and Canada.  Founded in 1886 as American Water Works and Guarantee in Pennsylvania, the company went though several reincarnations until being acquired by the German-based RWE Group in 2001,  which owned it until  April of 2008, when it was divested via an IPO on the New York Stock Exchange.

There are not many large investor-owned water utilities in the country. Most are utilities run by entities established by local municipalities to provide water to citizens as a public service.  These range from small towns which have only a few hundred customers, to a concern like the massive New York City Water Authority, which services over eight million people, has nearly $30 billion in debt, and is bigger than the entire Water Industry in the Value Line Investment Survey. Though American Water operates in many states, the bulk of its business is done in New Jersey (25% of total revenues), Pennsylvania (22%), Missouri (10%), Illinois (10%), Indiana (8%), and California (7%). The remaining 18% of revenues are scattered among 26 states and Canada.

Almost all of American Water’s operations are regulated. (About 89% of total revenues.) Thus, the company cannot unilaterally choose to raise prices. It must first file a rate case in the state involved (each state has its own regulatory commission). Thus, to some degree, American Water, like all utilities, operates at the mercy of the state regulatory commissions. Each state has its own “regulatory climate” when it comes to dealing with utilities. And, there is also no law that says regulators must be fair to utilities.  Indeed, until a politician is elected on the platform of “Let’s raise water rates sky high to be fair to American Water”, the utility will always be susceptible to a harsh regulatory ruling because of one simple fact:  Politicians (who select the member of the regulatory commission) know that voters don’t like paying high water bills, even when higher rates are justified.

How has American Water dealt with these regulatory issues? Actually, very well.  Instead of treating their overseers as enemies, the company has successfully fostered good relations with regulators by focusing on one main issue, which is to work hard to keep costs in check.  For example, American Water’s expense ratios have declined from 42% of revenue in 2011, to 40.7% last year, and should fall to below 40% by 2015. Cost containment like this, creates goodwill with regulators and makes it more difficult for them to hand down restrictive rulings.

The infrastructure of the water industry in the U.S. is in terrible condition. Billions of dollars will be needed to bring the system up to par.  In their quadrennial report on the status of the infrastructure in this country, the American Society of Civil Engineers (ASCE) found that the water/wastewater sector is perhaps the most underfunded part of the infrastructure system. According to the ASCE, water systems are about 70% underfunded. Agreeing with this opinion is the American Water Works Association, which believes that America will have to spend over $1 trillion over the next 25 years to repair and modernize the system.

American Water has been spending huge sums of money in the recent past to upgrade its systems. We expect this trend to continue through 2016-2018, as the company has budgeted $1 billion a year for this purpose. Indeed, this is of such importance that, in reference to the huge outlays that will be required, its chairman stated earlier this year that “we are in the infrastructure business.”

How will American Water finance these large capital outlays? Internal cash generation will only pay for about 70%-75% of the bill. The company will have to rely upon debt and/or equity offerings. Its last major stock offering was in 2009 (when the stock market was near its lows and American Water’s shares were selling for almost 50% of today’s price.) Still, the company has gone on record as stating that it believes its stock is undervalued. Therefore, we think, they are less likely to issue new shares.  As regards debt issues, the company risks being overleveraged if it takes on too much new debt. Currently, we rate the financial strength as average, but with no new equity offerings and the possibility of a lot more new debt, a downgrade could occur in the future.

Currently, American Water’s dividend yield is 2.7% based on its recent increase in the quarterly share payout from $0.25, to $0.28. This is 60 basis points higher than the average stock’s dividend yield in the Value Line universe. What’s more, the company has stated that it projects dividend growth to be in the 7%-10% range over the next three- to five-year period. This should clearly pique the interest of income-oriented investors.

Finally, American Water’s nonutility businesses offer some long-term potential. Though only representing about 11% of total revenue, the company has been making a push into nonregulated businesses where their returns are not capped by regulators.  To date, it is operating water systems for the US Army, (which is privatizing certain functions), offering insurance to homeowners for pipe and water damage, and is also in the consulting business. These ventures offer higher returns than the core utility business, and should help bump up earnings by 2016-2018.

All told, American Water has a lot going for it. Demand for water is pretty inelastic. (i.e. people use it during good times and bad), it has good regulatory relationships, and  its stock offers a high yield and good dividend growth prospects. On the negative side, financing will be needed to fund the large capital budget, which, in turn, could strain the balance sheet.  And, while the situation with regulators is good now, circumstances can change in a hurry.

Those investors interested in a more detailed analysis of American Water Company should study our full-page report in the Value Line Investment Survey. 

At the time of this article's writing, the author did not have positions in any of the companies mentioned.