Aqua America Inc. -- When will the cash-flow FLOW?

Company Overview

WTR is a U.S.-based publicly traded water and wastewater utility firm. WTR's services include primarily the distribution of treated and raw water supplies to households and businesses, wastewater hauling and disposal services, water and sewer line repair and protection services, backflow prevention services, infrastructure development services, and other non-regulated water and wastewater services. Services are awarded to WTR primarily through operating and maintenance contracts with municipal authorities.

In total, WTR serves approximately 3 million customers. Customers are located primarily in Pennsylvania, Ohio, Texas, Illinois, North Carolina, New Jersey, Indiana, and Virginia and are well diversified among residential water, commercial water, fire protection, industrial water, other water, wastewater customers and other utility customers. The company's largest customer-base is located in Pennsylvania (accounting for about 50% of total clients and 54% of total revenues). Residential customers make up the largest component of its customer-base (accounting for approximately 71% of its water and wastewater revenues).

Purchase Considerations and Reasons for Caution

What we like most about WTR is the monopoly-like competitive positions it controls in its respective markets. The fundamental importance of water to the survival and functioning of households, businesses, and governments and the stability and exclusivity of its utility contracts make WTR an attractive investment from a purely competitive perspective.

What we also like about WTR is its wide geographic coverage. Water consumption per customer is heavily affected by local weather conditions during the year. In general, an extended period of dry weather increases consumption, while above average rainfall decreases consumption. Also, an increase in the average temperature generally causes an increase in water consumption. The geographic diversity of its customer-base reduces the effect of its exposure to extreme or unusual weather conditions in any one area of its service territory.

We also like that WTR has been aggressively pursing growth opportunities, which is difficult to achieve in the water and wastewater markets. Growth can be primarily achieved through an increases in water and wastewater rates, growth in per-capita consumption, and through acquisitions. The majority of the increase in WTR's customer-base has been due to customers added through acquisitions. For the five-year period of 2009 through 2013, its customer-base, adjusted to exclude customers associated with utility system dispositions, increased at an annual compound rate of 2.2% and, this was primarily derived from utility systems that it acquired.

What we dislike about WTR, and water utility firms as a whole, is the massive infrastructure investment required to bring new facilities to operation. We also dislike the enormous investment needed to maintain investments once brought to operation--the costs are high and can represent a major drag on free cash-flows. Water consumption is also being negatively affected by changing consumption patterns from the installation of water saving devices and appliances that require decreased water usage. It is estimated that for every 0.50% decrease in residential water consumption, annual residential water revenues could fall by about $2 million. The more effective water saving devices become, the more it will hurt WTR's bottom line.

Financial Highlights

About $769M in revenues moved through WTR's door in 2013. WTR’s revenues for the Dec 2004 to Dec 2013 period clocked in at an average annual rate of growth of 6%. Improved water sales in unregulated markets, greater cost controls, and acquisitions have all led to solid revenue performance. Revenues grew at an annual rate of 4% over the last 5 years and 4% over the last 3 years.

Year-over-year WTR continues to make substantial sums of money off revenues after subtracting costs of goods sold (COGS) and other operating expenses. The long-term trend in operating income has been generally upward, rising from $177M in 2004 to $305M in 2013 (or 6% per year).

WTR's production costs appear well under control, with COGS and other expenses rising by 6% per year over the last 10 years against revenue growth of 6%. WTR does not appear to be experiencing any difficulties passing on the cost of inflation to consumers. Operating margins have held steady at around 40% between 2004 and 2013. In addition to holding steady, the strength of WTR's operating margins is exceptional. As a general rule, we want to see consistent operating profit margins above 35% for firms in the sector. Operating profit margins consistently above 35% for a firm in the sector is, in our opinion, indicative of a firm with a strong competitive advantage that has reasonable pricing power and significant control over costs. WTR has surpassed this target in each of the last 10 years.

WTR does, however, carry a substantial amount of debt on its books and, consequently, pays out about 25% of operating income on interest payments annually. While consistent with much of the competition in in the sector, we do consider this a poor result.

Bottom line results show a strong upward long-term trend in earnings, with minimal volatility, growing at an average annual rate of 12% over the last 10 years. We consider this a sign of earnings quality strength when viewed against average annual revenue growth of 6%. Earnings are expected to tick slightly upwards in 2014 and 2015 driven by population growth, business sector growth, and public sector substitution out of utilities.

WTR’s monopoly-type position has allowed it to maintain net margins of about 19% over the last 10 years, expanding significantly from 18% in 2004 to 29% in 2013. We do not expect margins to expand much further without an improvement in pricing power, the introduction of new services, further acquisitions/divestures, or an expansion into new markets.

Diluted EPS has shown strong results, growing by 10% per year from $0.51 per share in 2004 to $1.25 in 2013. EPS growth has lagged earnings growth by 2% per year, with growth in the firm's share-base having a dilutive effect on earnings. The Street is currently forecasting EPS of $1.20 in 2014 and $1.27 in 2015.

WTR's ROE performance has been acceptable, averaging 12% over the last 10 years. This has been, however, largely fuelled by its use of debt and is apparent in the firm's poor ROA performance which averaged only 3% over the same period respectively. Accounting for the effects of leverage, the firm's return on invested capital averaged 7% over the last 10 years--an acceptable result but nothing phenomenal.

WTR had operating cash flows of $368M in 2013, rising by 9% per year since 2004. This is well in excess of revenue growth over the period and slightly behind income growth. WTR's operating cash flows exceeded earnings in all of the last 10 years, exactly what we want to see. Free cash flows, however, have been negative in 7 of the last 10 years, improving only in the last 3 years--not a terribly reassuring result for investors looking for fundamentals-based price appreciation.

Return Estimation

Since 2004, WTR has shown an 144% increase in earnings per share – never with a losing year, compounding at a rate of 10%. With EPS of $1.25 in 2013 and a market price of $27.35, it can be argued that WTR is producing an initial rate of return of 4.6%. Since 2004, WTR’s book value per share has grown by 82% – with no declining years and growing at a compound rate of 6.9%. WTR continues to hold a dividend payout rate of approximately 50%.

To estimate what rate of return we expect to recieve for holding WTR stock:

(1) We use econometric processes to make long-term projections of what the company will be capable of earning;

(2) We estimate a Bear, Bull, and Normal price earnings multiple by which to multiply our projected per share earnings to estimate the stock price 10 years out;

(3) We estimate cumulative dividend payments over the 10 year period; and

(4) We calculate an annual compounding rate of return based on projected dividend payments and the expected stock price.

Based on our econometric projections, we estimate that WTR’s EPS will grow at an annual rate of only about 3.5%. This means that WTR should have per share earnings of $1.76 in 2023 (Figure 1).

Figure 1: High, Low, and Target EPS Projections

What will WTR’s earnings growing at a rate of 3.5% be worth in 10 years? The answer to this question will depend on what P/E multiple the market is using to value the stock in 2023. It is useful to look at the distributional properties of WTR’s historical P/E multiple.

Table 1: Distributional Properties of WTR's P/E Multiple

WTR’s per share earnings has grown by 10% annually over the last 10 years and holds a dividend payout rate of approximately 50%. Using econometric methods, we project that WTR will have per share earnings of $1.76 in 2023 reflecting growing volume, stable margins, and moderate but declining capital expenditures. If WTR trades at Bear multiples, then the market price for the stock in 2023 will be $31.68. If WTR trades at Bull multiples , then the market price will be $66.88. Based on historical data, in normal conditions WTR trades at 25-times earnings. The price of the stock will then be worth $44.00. Bought today at $27.35, WTR would produce a before-tax compound annual rate of return of 4.9% excluding dividends. Assuming dividends remain at current levels, they would generate $7.40 in additional income over the forecast horizon. Added to the price of $27.35 the before tax compound rate of return estimate jumps to 6.5%.

The question that remains is: is a compound annual return of 6.5% sufficient enough to qualify for investment?