When thinking about an uncertain investing future, the most prudent course is to buy bonds, which are loans to governments and financially strong businesses. However, bonds normally have fixed terms and fixed yields, exposing them to inflation and opportunity-cost risks.
To mitigate those issues, some investors look for bond substitutes, corporations with conservative businesses that provide reliable returns with little risk and have potential upsides (share prices for capital gains).
American States Water Co. (AWR, Financial) may be one of those companies. We will examine its stability and other bond-like qualities.
About American States
The company owns three subsidiaries that provide utility services, primarily in California. According to its 10-K for 2021 and its third-quarter 2022 news release:
- Global State Water Company buys, produces, distributes and sells water in 10 California counties. It is the biggest contributor to revenue; in the first nine months of 2022, it provided $561 million of the company’s total revenue of $366.16 million.
- Bear Valley Electric Service is, as the name suggests, an electrical company. It distributes electricity to several mountain communities in San Bernardino County of California.
- American States Utility Services contracts with the U.S. government to supply water and wastewater services at military bases.
Based in San Dimas, California, the company reports that it serves over a million customers in nine states. It has a market cap of $3.56 billion and had trailing 12-month revenue of $482.78 million.
Most of its revenue is not subject to competition from other suppliers. Instead, it negotiates rates with public regulators.
Financial strength
American States receives a low score for financial strength at 4 out of 10. That is based on three metrics tied to its debt: interest coverage ratio, debt-to-revenue ratio and its Altman Z-Score.
Before looking at those ratios and score, it is worth noting that utilities often carry high debt loads. They need to invest large, upfront sums in infrastructure and then can start collecting from consumers. Some investments are one-time costs, but there are also ongoing maintenance costs and new capital spending. In a sense, utilities are like banks that lend money.
Regulators know these costs and in American States’ case, use that plus a return to shareholders to set rates. While regulators normally will not let utilities fail or let the rates be too volatile, there are issues that affect utility revenues. They include the timing and amount of increases and reductions, the amount of demand and costs for "raw materials"; here, those are wholesale water and electricity costs.
The interest coverage ratio is 5.3, which is considered adequate, but not necessarily very good by GuruFocus.
The debt-to-revenue ratio is 1.43, based on short- and long-term debt of $688.70 million and revenue of $482.78 million. Again, it is a reasonable ratio.
The Altman Z-Score clocks in at 2.3, which is in what is called the grey area. Anything at 1.8 or below is considered in the distress zone and anything at 3 or above is in the safe zone. American States comes about halfway between the latter two zones.
The bottom line on the table provides the WACC versus ROIC relationship. The weighted average cost of capital is 2.35%, while the return on invested capital is 5.06%. As the colored bars indicate, the company makes good use of its borrowed capital and equity. It earns more on its capital than it pays.
Profitability
The profitability ranking is based on five factors: the operating margin, the trend of the operating margin, the Piotroski F-Score, the consistency of its profitability and the predictability rank.
On those criteria, American States scores a high profitability ranking of 8 out of 10.
The operating margin is currently 26.63%, which is good, but as this quarterly, five-year chart shows, it routinely varies between 20% and 35%.
On an annual, five-year chart, the trend looks more consistent, but is interrupted by a big dip in 2019. Nevertheless, the operating margin has grown by an average of 1.40% per year.
The Piotroski F-Score is 4 out of 9, which GuruFocus calls typical for a stable company. And it has a predictability score of three out of five stars.
The predictability score may not be very high, but the company does score very well on the consistency of its profitability:
Growth
Although American States is a utility, it has posted reasonable growth to its top and bottom lines. It receives an 8 out of 10 ranking for its three- and five-year revenue growth, the predictability of that growth and its five-year Ebitda growth rate.
Since the most important of the company’s claims to fame is its dividend, the growth of free cash flow should also get our attention.
The chart exhibits what appears to be a seasonal pattern, yet I cannot count to four without finding a major variation. In its annual report, the company notes that demand for water and electricity varies by season. But other issues affect its free cash flow as well, including regulatory terms that help smooth out water revenue and electricity demand that is "greatly affected" by winter snow levels.
On an annualized basis, it appears the company is well positioned to increase its dividend each year.
Dividends and share repurchases
American States has increased its dividend for more consecutive years than every other publicly traded company in the U.S. It has logged 68 straight years of increases, slightly more than the 66 years of four other Dividend Kings: Genuine Parts (GPC, Financial), Procter & Gamble (PG, Financial), Northwest Natural Holding (NWN, Financial) and Parker Hannifin (PH, Financial).
As the table shows, its dividend yield is not rich when compared to the regulated utilities industry, which has a median of 3.64%. That is a consequence of having a share price that has risen more than we might expect from a utility.
Otherwise, the dividend payout ratio is reasonable and leaves ample room for future increases.
As for share buybacks, the company repurchased roughly 2 million of them in 2014, 2015 and 2016. Since then, the number has crept up by about 0.08% per year.
Valuation
This is not the kind of price chart we expect from a utility, having delivered what guru Peter Lynch would call a five-bagger over the past decade.
The GF Value Line finds American States to be fairly valued at its current price. That is based on historical multiples, an adjustment factor for past returns and growth and estimates of its future performance.
One of those historical multiples is the price-earnings ratio, which at 43.02 is significantly higher than the industry median of 16.30.
Couple 43.02 with a five-year Ebitda growth rate of just 3.20% and you have an overvalued PEG ratio of 13.44.
Still, it is unlikely we will find a bargain when shopping for a dividend stock with such exceptional growth.
Gurus
The gurus have limited interest in American States, with only three of them invested in it at the end of the third quarter. What’s more, their positions are relatively small.
Chuck Royce (Trades, Portfolio)'s Royce Investment Partners held 10,219 shares after boosting its position by 69.13%. Joel Greenblatt (Trades, Portfolio) of Gotham Asset Management owned 9,264 share after adding 26.18% and Murray Stahl (Trades, Portfolio) of Horizon Kinetics purchased 5,306 shares, a new holding for him.
However, institutional investors are heavily engaged; they owned 91.83% of the shares outstanding. Insiders, led by Director, President and CEO Robert J. Sprowls, own 1.64% of the company.
Conclusion
American States Water appears to have the makings of a bond substitute. It has a modest but highly reliable dividend history. If it were not for the stock’s steadily increasing share price, the dividend yield would be higher.
The company offers respectable fundamentals, meaning it is unlikely to face financial distress in the future. Given that strength and dividend growth, it may be suitable for income investors who also want at least the prospect of capital gains.
