American States Water: The Longest Dividend Growth Streak In America – Seeking Alpha


Companies that have consistently increased their dividends over the course of several decades are often some of the most resilient businesses in the market.

Dividend kings are especially popular with income investors because they have boosted their payouts for at least 50 consecutive years.

American States Water (NYSE:AWR) is a small cap and under-followed dividend king with 63 straight years of dividend increases under its belt, the longest payout growth streak in the U.S.

Let’s take a closer look at American States Water to better understand its competitive advantages, assess how quickly its dividend could grow in the future, and evaluate if today’s valuation makes sense for investors, especially those seeking safe high yield stocks.

Business Overview

Founded in 1929 in San Dimas, California, American States Water is a regional regulated water and electrical utility serving 75 communities in 10 counties in Northern, Coastal, and Southern California.

Source: Investor Presentation

It also serves 24,000 electrical customers in San Bernardino County.

The company has three business segments: regulated water, regulated electrical (both under the Golden State Water Company), and its utility services unit, which operates water and wastewater systems on 10 military bases around the U.S. under 50-year contracts.

In 2016, approximately 78% of its revenue came from its regulated utilities operations (primarily water), with the remaining 22% coming from American States Utility Services (ASUS).

Business Analysis

The key to most dividend investments is to buy companies with dependable sales, earnings, and cash flow, and defensible competitive advantages.

In the case of regulated utilities such as American States Water, its moat is inherently wide because the company essentially operates as a government-sanctioned monopoly (i.e. there is no direct or indirect competition in its service territories), but with regulators setting prices and maximum allowed returns on equity and base rates.

In fact, American States Water filed a request with the California Public Utilities Commission (CPUC) in April 2017 for a return of equity and return on base rate (what customers pay) of 9.43% and 8.34%, respectively.

If approved, its prices will become effective starting in January of 2018 and continue providing excellent visibility into the returns the company will get on its capital-intensive investments.

Fortunately for American States Water, management has over 100 collective years of operating in a challenging regulatory environment and getting large scale infrastructure investment projects approved and recouped quickly.

For 2017, that includes $110 million to $120 million in capital expenditures on new utility infrastructure.

However, the thing to keep in mind about American States Water and all regulated utilities is that their business models are inherently slow growing.

Source: Simply Safe Dividends

And when it comes to American States Water in particular, the company’s lack of diversification in its core business means that its revenue isn’t as stable as that of larger water utilities such as American Water Works (NYSE:AWK) or Aqua America (NYSE:WTR).

This helps explain why the company’s revenue declined in recent years, because California’s five-year drought resulted in water rationing and thus lower demand for AWR’s most important service and region.

Fortunately, the company’s margins and returns on shareholder capital held up well due to the regulated nature of its business.

In addition, the end of the California drought, thanks to the past winter’s intense rain and snowfall (and an end to water restrictions), has resulted in sales, earnings, and margins bouncing back very strongly in recent quarters.

However, it’s important for investors to realize that, because of its relatively small size, American States Water lacks the kinds of economies of scale that its larger peers enjoy. As a result, its margins are slightly below that of its industry average.

Trailing 12-Month Profitability

Sources: Morningstar, GuruFocus

The good news is that the company’s conservative and disciplined management team continues to generate relatively good returns on shareholder capital, meaning investors can rest easy that their hard-earned money is being well utilized to build long-term value.

Going forward, American States Water’s growth plans call for a three-pronged strategy.

First, in its core water business, management hopes to increase its customer base through organic growth and opportunistic acquisitions (i.e. industry consolidation).

This should help the utility boost its overall margins as fixed costs are amortized over a larger base of revenue, earnings, and cash flow.

Second, American States Water hopes to convince regulators to allow it to more aggressively upgrade its share of the state’s aging water infrastructure, most of which was built in the 50s, 60s, and 70s.

This would help boost earnings substantially because the regulated nature of this business means that profits are derived from a cost plus model of investment, guaranteeing a healthy return on AWR’s capital outlays.

In fact, the EPA ranks California the state with the largest new water infrastructure needs, with $70.7 billion in new water delivery and treatment investment necessary over the next two decades to meet the needs of its large and growing population.

With Governor Jerry Brown saying that such infrastructure spending, especially on water, is a top priority, American States Water will likely receive the authorization it needs to continue growing both its top and bottom lines for years to come.

The other major potential growth catalyst is American States Utility Services, which management hopes to grow substantially in future years by winning more military utility service contracts.

For a small and slow growing company such as AWR, the growth potential from this business unit could prove substantial. For example, its most recent contract, for Eglin Air Force base, is for $510 million over its 50-year length, or about $10.2 million a year.

To put that in perspective, that single contract will boost American States Water’s annual revenue by 2.3%, which is considered a decent growth rate for a water utility.

In other words, the Utility Services division alone could help fuel long-term 2% to 3% sales growth if management can obtain just one or two new military contracts each year, and it also earns higher returns than the company’s regulated utility operations.

Combine that with a gradual increase in customer base, higher base rates (for expanding and upgrading infrastructure), and greater economies of scale, and management is confident that it can achieve long-term EPS and dividend growth of 5% per year.

Key Risks

There are two main risks to keep in mind about before investing in American States Water.

First, the lack of geographic diversity means that the vast majority of the company’s revenue is tied to the hydrology of California. In other words, should the future of the state bring more extreme droughts, the company’s ability to grow its top and bottom lines could be severely constrained.

Next, we can’t forget regulatory risk because California is a notoriously challenging state for utilities to do business in, especially when it comes to building new water infrastructure.

For example, in order to build new water systems, such as dams to increase the state’s water storage capacity, a utility needs to do several environmental impact studies as well as obtain approval from a large number of overlapping regulatory agencies such as the California Department of Conservation, Integrated Waste Management Board, the California EPA, Department of Water Resources, and the California Public Utilities Commission.

In addition, there are numerous local regulatory agencies that dot the state and operate in the numerous jurisdictions the company serves.

Finally, there is always the risk of local populist uprisings, such as the recent settlement with the Casitas Municipal Water District to buy the company’s Ojai water system under eminent domain for $34.5 million.

This occurred because a group that was opposed to private water utility ownership called the Ojai Friends of Locally Owned Water, convinced the town of Casitas Springs, where AWR operated the 2,900 connection water system since 1929, to take control of the water system and force the company to sell this asset.

While management expects to ultimately earn a pre-tax profit of $8 million on the settlement, it will still be losing an income-producing asset, and it could face similar challenges from local communities across the state in the future.

American State Water’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio.

American States Water has a Dividend Safety Score of 70, indicating a safe and dependable payout. That’s what one would expect from a company that has been paying an uninterrupted dividend since 1931 and raising its payout for 63 straight years.

The key to this kind of highly secure payout, as well as America’s longest dividend growth streak, is twofold.

First, management has remained highly disciplined in maintaining a relatively low EPS payout ratio below 60% most years, ensuring that the dividend is well covered, even during trying times, such as the recent drought.

The second protective factor is the utility’s strong balance sheet.

Now AWR’s absolute debt levels are high relative to its small size ($1.9 billion market cap). However, it’s important to remember that the regulated water industry is highly capital intensive, as well as marked by recession resistant (i.e. stable) cash flows. This means that we need to put its debt in perspective.

When we do, we find that American States Water has a much lower than average leverage ratio (Debt/EBITDA), a very high current ratio (short-term assets/short-term liabilities), and a very safe interest coverage ratio (EBITDA/Interest).

In fact, most regulated utilities have interest coverage ratios of three to five, which shows just how financially sound AWR is. As a result, the company has earned a solid investment-grade credit rating from S&P.

Sources: Morningstar, Fast Graphs

In addition, AWR has been slowly but steadily deleveraging over the past decade, avoiding the temptation to borrow at historically low interest rates just because it can. With interest rates now rising, this means the utility could have a competitive advantage over many peers because it has less risk of needing to refinance at higher rates in the future.

All told, American States Water’s balance sheet is one of the strongest in its industry with an excellent credit rating.

That should ensure it has excellent access to cheap debt going forward, should management receive regulatory permission to more aggressively expand and upgrade its infrastructure in the coming years.

American States Water Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?”. It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher are very good, and 25 or lower are considered weak.

American States Water’s Dividend Growth Score of 47 indicates that investors can likely expect about average payout growth in the future. That’s not surprising given that AWR is a slow-growing utility more famous for its incredibly consistent dividend growth than for the speed of its payout increases.

Since its current payout ratio supports an ideal mix of dividend security and moderate growth potential, investors should expect American States Water’s dividend to increase at about the same rate as its earnings per share.

Given the drivers behind management’s forecast for the utility to maintain long-term EPS growth of 5%, American States Water’s guidance of 5% dividend growth going forward seems reasonable.

Valuation

Over the past year, American States Water has outperformed the S&P 500 by about 5%, which has unfortunately caused this slow but steady dividend grower to appear overvalued.

For example, AWR’s forward P/E is 28.9, far above the S&P 500’s 17.4 or the industry median of 17.6. It’s also significantly greater than the utilities historical P/E of 22.7.

That results in a relatively low dividend yield of 2.0%. While that is in line with the S&P 500’s 1.9%, it’s far less than the 3.1% average yield its peers are offering, as well as the 3.4% average yield AWR shareholders have enjoyed over the last 22 years.

That translates into a relatively low long-term annual total return potential of just 7% (2% yield + 5% annual earnings growth). While that may not seem like a terrible return, it’s far less than most dividend kings are capable of and only half of what AWR has returned over the past two decades.

Source: DividendChannel.com

Conclusion

When it comes to safe and steadily growing dividends, they don’t get much better than American States Water, whose dividend growth streak towers over all other dividend kings.

However, given the stock’s historically high valuation and moderate long-term growth prospects, the company doesn’t appear to represent a good buy at this time, especially for those looking to live off of dividends during retirement.

American States Water seems better off left on a watch list for now as investors wait for a pullback to bring a more attractive valuation, yield, and total return potential.



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