Free Again, U.S Water Works Play Holds Promise

By Michael Brush
Exclusively for InvestorIdeas.com
May 1, 2008

In the game of Monopoly, Water Works sits precariously between “Go to Jail” and a railroad called B.& O. It’s nestled in among a bunch of middling Atlantic City properties.

A moderate income producer, Water Works was never the kind of must-have property you needed to win. But it was cheap enough to buy for some steady cash, and to possibly throw in as a sweetener on a trade, to break down a stubborn negotiator.

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That’s pretty much how I look at American Water Works (AWK), a big, U.S. water utility partially spun out of a German company last week.

It’s got lots of debt and a few challenges, and the parent company that spun it off still has a lot of shares to unload.

But it will pay 80 cents a year per share in dividends for a 3.8% yield -- which is better than you get from a bank, and many bonds, these days. That dividend will probably increase over time.

There’s also the potential for growth long-term through acquisitions of mom-and-pop water companies as the sector continues to consolidate. Towns and cities strapped for cash will continue to outsource operations, as well.

The insider buying

Insiders put a sizeable $1.5 million into the stock on the initial public offering last week. The buying is intriguing because it’s scattered across senior and upper level management. While utilities and banks often have a “let’s get the gang all together” spirit when it comes to insider buying which sort of negates the signal, the purchases here do stretch far and wide.

Buyers include everyone from the head of human resources and communications ($60,000 and $75,000), to chief executive Donald Correll ($539,000), finance chief Ellen Wolf ($226,000) and operations chief John Young ($344,000). Those feel like more than token purchases made as a show of good faith.

Keep in mind also that executives at this company have an average of around 25 years experience in the business – at a water company that has been around since 1886. Those are reasons to think they know what they are doing.

So why are they pouring good money into a stock that has gotten such a tepid response from pundits and punters alike in the initial public offering (IPO) market? Let’s drill down and take a look.

Sloppy-market discount

First off, in a sense you’re getting this water company at a discount. The parent company, a German utility called RWE AG, originally wanted to sell the American Water Works for as much as $26 last fall.

Since then, of course, a lot of bad things have happened in the market and the economy, which has dampened the appetite for IPOs. So this IPO finally rolled out at an official price of $21.50 last week. You can say they had to discount the stock to get the deal done. But another way to look at it is: Not long ago some smart people thought this company was worth $26 per share. But they had to knock the price down by 15%-20% because RWE was anxious to get the deal done.

The debt non-issue

Critics of this deal like to complain about the company’s debt level, which at $5 billion, is high. To make matters worse, in an apparent sneaky move RWE seemed to have added a dollop debt to American Water Works between the time it bought the company in 2003, and the time it began spinning it off last week -- so it could extract payouts.

But the debt – even at its higher levels thanks to RWE -- isn’t necessarily such a big issue.

After all, it’s nearly impossible to build a whole new water system beside an existing one to compete. American Water Works has the ultimate high barriers to entry. Plus its not like water is suddenly going to go out of style creating a suprise downdraft in revenue that will make it hard to meet debt obligations.

Yes, the company also has some heavy capital obligations ahead. It estimates that it may have to lay out $4 billion to $4.5 billion through 2011 to upgrade infrastructure. But I’m guessing it can probably count on adequate rate increases from regulators to offset the costs. What politician is going to want to scrimp on something as important as the water supply?

Growth ahead

Now that American Water Works is breaking free of its German parent, it can focus more on growth. There are plenty of opportunities to expand, since much of the water infrastructure in the U.S. is in poor repair. This means the small and private water companies that dot the landscape, as well as municipalities, are looking for a way out of the coming capital upgrade. Why not sell to a bigger player like American Water Works?

The company is well positioned to snap up smaller players and handle outsourcing from municipalities. American Water Works treats and delivers over 1 billion gallons of water to 15.6 million people daily across North America -- in 32 U.S. states and Ontario, Canada.

It does have a heavy concentration in Pennsylvania and New Jersey account for approximately 45% of overall revenues. But as the largest investor-owned water company, it’s got a broad geographical presence that exposes it to lots of potential acquisition opportunities, with time.

Last December, for example, it purchased water assets serving four townships from Trenton, NJ. Expect more to come. “Our experienced development team evaluates potential acquisition targets across the country, particularly in higher-growth areas,” says the company, in its prospectus.

Solid cash flow

One scary thing about American Water Works is that it produces regular, large losses. On a stand alone basis, the company would have lost $2.14 per share last year. A lot of its $2.2 billion in annual operating revenue is leaking out because a portion of a huge chunk of goodwill – booked at $2.46 billion – has to be written down each year.

But at a company like this, cash flow is as important as reported earnings. And last year, cash flow was up 26% to $ 473.7 million.

As for operating revenue, it grew 6% last year. But I expect bigger things ahead – because there’s a twist in this story. As part of its acquisition by the German company a few years ago, American Water Works agreed with several states not to file for rate increases. But all those bans expired at the end of last year. With the rate increase ban lifted, expect higher fees to get approved, boosting revenue.

The stock overhang

The stock overhang is a complaint by the critics that’s harder to write off. RWE has spun out about 58 million shares. It has nearly another 100 million to go. RWE has said it wants to sell most of that stake by the end of 2008. A 180-day lock up lifts in August.

This means two things, for you as an investor. First it’s ok to buy your position now, for the long term. But you may get a chance to buy more at a good price 180 days from the IPO, in August.

The bottom line: You might get shares cheaper in August, but that’s no guarantee. So it’s probably worth buying at least part of your position in this water play right now.

Disclaimer
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column. Mr. Brush is an independent columnist for this web site.
For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp. InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.

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