Utility expert: Favorite water sector ideas

by Roger Conrad, editor The Utility Forecaster

US water utilities entered and exited the 2008-09 market crash/credit crunch/recession with barely a scratch.

With fears of another recession running high, US water utilities are even better positioned on their current fundamentals. Here's a look at Aqua America (WTR) and American Water Works (AWK).

As a group, they have virtually no refinancing needs through the end of 2012. Payout ratios average well below 70 percent. Regulatory relations are strong, with only California a potential question mark for the future.

Average yields still rank the lowest in the US utility universe. But the best are growing dividends robustly--ensuring more of the same reliable total returns that have paced the group over the past decade and more.

Aqua America, for example, has returned nearly 11 times as much as the S&P 500 since mid-2001. And these stocks are far less volatile than almost any other equities.

The result is a combination of superb safety, moderate but growing yields, low volatility and reliable long-term growth that’s tough to beat in these uncertain times.

If you don’t already own a basket of my favorite water companies, now’s a great time to stock up.

State and local governments’ busted budgets partly explain the dearth of water system funding. The result is that needed investment simply hasn’t been made in many areas of the country for decades.

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 and American Water Works -- 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 recently 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 percent 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.

Meanwhile, the numbers at American Water were also extremely robust, with earnings per share up 14 percent.

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 percent 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.

Learn more about this financial newsletter at Roger Conrad's The Utility Forecaster.