Bottom of the Barrel: Diving In to American States Water

If you're looking for steady growth and income, American States Water (AWR Quote) should quench your thirst.

This utility provides water service to 10 counties in Southern California, including the greater Los Angeles area and Orange County. It also has a small presence in Arizona through its acquisition of Chaparral City Water in October 2000. American States provides electric service as well to about 22,000 customers in San Bernardino County, Calif.

There's nothing fancy about American States: It has a slow, steady track record of both earnings and dividend growth and a fairly straightforward balance sheet. Although it may not rank as one of the great growth stories of our time, stability and decent income are two hallmarks of solid portfolios in a difficult market.

A Steady Trickle

The stability of many utilities is measured in their dividend history, and American States stacks up against the best. It has paid dividends on its common shares every year since 1931 and has increased dividends paid annually since 1953. The current annual dividend of 87 cents will likely increase to 88 cents effective in the fourth quarter, giving investors a yield of 3.8%.

At a Glance American States Water (AWR:NYSE)
Current Price	$23.00
52-week Range	$29.05-$20.21
Price-to-Earnings Ratio*	15.90
Market Cap	$348.5 million
Avg. Daily Volume	41,545
Inst. Ownership	38%
Dividend Yield	3.80%
Beta	0.14
Company Web site	www.aswater.com
*Based on 2003 estimates. Source: Market Guide, First Call, company reports, TSC research

That dividend is well-covered by earnings, which continue to grow at a 5% to 6% clip per year, at the high end of regulated utilities' earnings growth. For instance, projected 2002 earnings of $1.40 per share provides for a modest 65% dividend payout, giving the company plenty of wiggle room.

American States recently reported second-quarter earnings of 35 cents a share, in line with estimates and on target to meet the annual estimate. The company noted that water volumes and rates increased modestly for its core water business, and earnings also benefited from an increase in rates for its electric power business.

Rate hikes from the power business could help American States beat the 2002 projected earnings estimate, because the California Public Utilities Commission, or CPUC, recently allowed the company to recover certain purchased power costs from ratepayers. That could add as much as $7 million in revenue annually over the next 10 years.

In addition, American States will likely be successful in securing more rate increases in the next three years to improve infrastructure and to meet return-on-equity targets. Although the CPUC is known for its stinginess, American States has largely stayed above the recent bickering between regulators and California's traditional electric utilities.

Overall, a combination of volume growth, modest rate increases and the company's continued focus on operating efficiencies and scale should help American States grow its bottom line by 5% to 7% annually. That growth combined with the current yield could enable the company to provide a stable 10% return year in and year out.

This year American States has benefited from a more normal precipitation pattern. Last year the company faced serious volume limitations from water restrictions imposed as a result of the West Coast drought. The lack of those restrictions should make revenue comparisons manageable. However, weather patterns do affect earnings potential at any water utility, especially a California company that relies so much on winter snowfall for both water and power generation.

Crystal-Clear Growth at American States
Year	Revenue (in millions)	Earnings per Share
2000	$184.0	$1.28
2001	197.5	1.35
2002*	215.0	1.40
2003*	230.0	1.45
*Estimates Source: First Call, Value Line, company reports, TSC research

Another major risk for a utility like American States is regulatory overhang. Investors need to keep careful watch on the CPUC's activities when owning a utility like American States.

One more issue is a possible equity offering. Management has hinted that it would like to issue equity to reduce debt levels and interest expense. The goals are positive, but such an offering might present a modest overhang for existing shareholders, although it shouldn't have a material impact on net earnings. (The company completed a 3-for-2 stock split on June 7.)

Despite the risks, American States is in a stable business. The company provides a necessary product that is only marginally impacted by economic conditions. While both weather and regulation present potential risks, they are both understandable and generally identifiable.

Historically, American States common stock, with a good yield, has provided a solid long-term return. An entry price of about $22 per share seems reasonable. It closed Tuesday at $23. As such, I give American States two and a half barrels and add it to the Bottom of the Barrel income portfolio. (For an explanation of our barrel rating system, see our description.)

Barrelology

A complete look at the portfolio will return next week. However, as indicated when I first wrote about Roadway (ROAD Quote), its potential for business growth from struggling Consolidated Freightways has now become reality.

Although shipping continues to struggle as a result of the anemic economy, Consolidated's bankruptcy filing and notice that it intends to liquidate is a prime opportunity for Roadway to grow from Consolidated's misfortune. The reaction in Roadway's price on Tuesday was a clear indication of what shareholders think: It jumped about 13% to close at $27.23.

As I noted last week, Roadway's success depends largely on the economy. But once the economy shows signs of meaningful improvement, Consolidated's absence in the over-the-road shipping business only increases the earnings leverage of the remaining players, including Roadway.