It should be noted upfront that we will be discussing a water utility, which may sound as dull as dishwater – but we, in the world of global real assets, have never had an aversion to safe, predictable, and yes boring companies. The type of company that pays a dividend that is as dependable as a birthday cheque from Grandma. We have specialist in-house capability dedicated to researching and investing in global real assets (infrastructure and real estate), which we see as complementary assets for many investment portfolios.
The company for discussion is American Water Works (AWK), a US water utility that owns pipes that distribute potable water (and a smaller business in wastewater) across several US states (the largest exposures being Pennsylvania and New Jersey). The company is a natural monopoly (you would never see two water pipelines side by side competing with each other) and therefore customer bills are regulated by the various states’ public utility commissions.
A key point to note about AWK is that this year the company really has done its job as a safe investment. Amidst the Covid-19 crisis, AWK has been highly resilient with only limited financial impact. As the company is fond of saying, people spending more time at home versus the workplace does not alter the aggregate number of toilet flushes. Despite this, AWK’s share price cratered with the market to U$97 in March but is now up at U$144 compared to U$133 at the start of the year.
AWK’s business is largely indifferent to the economic cycle, with water consumption patterns fairly stable over time. Earnings and dividends are expected to grow by 7 to 10% CAGR to 20241. And uniquely this outlook is to a large extent indifferent to the depth and duration of the current recession, the US election outcome, or other macro-economic / geo-political factors. Further, there is limited risk of disruption on the horizon, and AWK has exemplary ESG credentials: the S&P Global Ratings ESG Evaluation scored AWK 87 out of 100, the highest evaluation score given by S&P in the US and the 2nd highest globally.
In reality, earnings are largely a product of how much capital investment has been made and the ROE regulators allow them to earn. A basic tenet of corporate finance is that value is created where capital is deployed upon which an attractive return is earned. In the case of the water industry, investments needs are substantial, and ROEs are currently very healthy.
The need for capital investment is substantial in the water industry, due to aging infrastructure in need of replacement. AWK has 51,000 miles of pipes and is currently on a 120-year replacement cycle (0.8% pa), relatively high vs. a 250 year cycle several years ago. AWK will replace 2,000 miles of pipelines over 2019 to 2023. At about U$4.1 million per replacement mile, replacing their entire network of pipes would cost about U$210 billion. Total capital expenditure over the next decade is expected to amount to $U20 to 22 billion and remain substantial thereafter well into the future. Furthermore, about 84% of the US’ highly fragmented 50,000 water systems (and 98% of wastewater systems) are owned by municipalities, with dilapidated infrastructure and replacement at much lower levels. The American Society of Civil Engineers graded the US’ water infrastructure a D in 2017, and found that in 2019 the national annual shortfall in total capital investment on water infrastructure was $81 billion, which will have an impact on the extent of future shutdowns, flooding and leakages. It is a slow process, but AWK continues to make small ongoing acquisitions from muni owners, which is essentially another leg of capital investment opportunity for the company.
AWK currently earns an ROE on its U$9 billion rate base of about 10%. This is high both in an absolute sense, and relative to the low risk nature of AWK’s cashflows and the yield on US 10-year treasury bonds of 0.65%. While allowed ROEs are lower than they were some years ago, there is a stickiness to ROEs which is largely attributable to the substantial capital investment requirements discussed above and competition between states to attract this capital. While ROEs are likely to fall somewhat from here, we expect AWK to continue to earn attractive returns for the foreseeable future.
In conclusion, it is the case for AWK that still waters run deep. The company has both the exemplary defensive characteristics that we look for in global real assets, as well as a very substantial and value accretive growth outlook as they continue to heavily invest in the nation’s vital infrastructure.
