Despite Downgrade, American Water Works Remains a Smart Buy

The company serves about 15 million people in the U.S. and Canada and is cash flow positive.
By Devesh Kumar ,

American Water Works (AWK) - Get Report is the largest publicly traded U.S. water and wastewater utility company.

With shares up 36.55% year to date, a clutch of Wall Street firms like BofA/Merrill Lynch and Janney have rushed to downgrade the stock. Shares were down slightly in Thursday trading.

Big mistake. With the global macroeconomic environment shaky, rock-solid utility companies such as this S&P 500  member will continue to benefit from demand for quality and safety. American Water Works provides services that people need in good times and bad. In addition, it has been expanding and is strongly profitable. 

The company is a great buy. Below, we also lift the curtain on a little-known but ingenious investment method that makes big gains in bull and bear markets.

Brexit helped utilities.

As Treasury yields tumbled to multi-year lows, NextEra Energy, Edison International, Consolidated Edison, American Electric Power, PG&E and American Water Works witnessed solid gains.

Such safety in markets comes at a premium. With JPMorgan Chase's equity strategists suggesting that bond yields "are not going anywhere but lower," it's foolhardy to exit a solid long-term growth opportunity like American Water Works.

There are very few businesses that are resistant to economic slowdowns; imagine your life without water. American Water offers high-quality water and wastewater services to 15 million people in more than 1,600 communities in the U.S. and Canada.

Principally aiding residential homes and businesses, it also completes market-based contract operations for municipalities that operate utility systems.

The company's also been expanding its business. This year, American Water Works subsidiary Pennsylvania American Water agreed to acquire the wastewater assets of the Scranton Sewer Authority for $195 million.

Late last year, California American Water, a unit of the company, completed an acquisition of Dunnigan Water Works.

The recent downgrade shouldn't deter an investor who digs a little deeply into the company.

Experts may be uncomfortable with valuations but should you be the same? Paying 26.8 times for one-year forward earnings isn't that astounding, if you consider that its peers California Water Service Group (24.12 times), American States Water Company (25 times) and Aqua America (24.32 times) are trading at similar valuations.

We believe only evaluating forward price/earnings without adjusting for growth isn't the most prudent thing to do.

The Price/Earnings to Growth ratio or PEG allows us to have a vantage point and view the big picture.

American Water Works trades at a PEG of 3.97 compared to 6.77 for American States Water Company and 4.26 for Aqua America Inc. So, American Water Works is clearly not overvalued.

Over the next five years, the projected earnings growth of American Water Works is far better than its competitors, Aqua America and American States Water Co.

The company is also free cash flow positive, not only on a trailing 12-month basis but also for the last two calendar years.

Its peer California Water Service Group has never been FCF positive in the last 10 years. American States Water is FCF negative on a TTM basis. Ditto for Aqua America Inc

It's evident that American Water Works is the most efficient among its peers at converting sales into free cash flow, driven by stronger management levers and improvement in return ratios.

The dividends are frugal. Against the utilities average yield of 7.9%, American Water Works fetches you a mere 1.84%.

However, the company's grown dividends for the past seven years, and its 53% dividend payout ratio means dividend raises are surely in the offing.

With close to 15% profit margins (almost double that of California Water Service Group), a solid financial profile, concrete earnings growth and moderate dividends, American Water Works valuation story will only grow stronger.

We think analysts' consensus 52-week target will get pushed up, even as observers of the company and utilities sector recognize the potential of this safe-as-a-locker investment.

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This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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