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Water is a precious resource. One that we can’t live without.
The news of the drought in California has died down a bit, but it’s still very intense there. The state is well into the fourth year of a record-breaking drought.
Recall that earlier this year California Governor Jerry Brown declared a state of emergency due to the drought. Right now, the drought concerns are contained, but it’s easy to forget just how finite a resource water is.
Along those lines, one of the purest and most underrated plays on water is the water utility companies. While much of the market is pining over how rising interest rates might impact utilities, they could be missing out on a great opportunity. One that could make them an awful lot of money.
American Water Works (NYSE: AWK) is one such opportunity.
It’s the biggest player in the water utility industry and offers a 2.7% dividend yield. Over the last five years, the return of American Water Works shares have been nearly triple that of the S&P 500.
But what about in the short term, especially with the threat of higher interest rates?
Interest rates will rise sometime in the future, which is generally bad news for utilities. With rising rates, investors will typically trade in bond-like utility stocks for higher-rate debt as rates rise.
But for water utilities, over the last few years the valuation multiples haven’t been stretched like with other utilities. Where investors were bidding up other utilities in the low-rate environment, water utilities are still attractively priced. Especially American Water Works.
There are other major water stock players in the utility space that investors could look at. These include Aqua America (NYSE: WTR) and American States Water Company (NYSE: AWR).
But both offer a lower dividend yield than American Water Works. Both are also more expensive in terms of valuation. American Water Works trades at around 1.8 times book value and at a forward price-earnings ratio of around 21 based on next year’s earnings estimates.
In a highly regulated industry like water utilities, acquisitions are a key growth outlet. And American Water Works is seeing the benefits of being the biggest player. In drought-ridden California, it’s been on a buying spree, with multiple purchases of waste and water services companies and assets.
The economic moats for water utilities are wide, with the cost to replace water infrastructure being quite high. According to Forbes, the cost to replace this infrastructure could be as much as $22 trillion – a goldmine of an opportunity. The bolt-on acquisitions that American Water Works is pursuing are a great source of cheap growth, but they are also expanding its moat.
Further fueling American Water Works’ growth is its innovation with unregulated projects. This includes its water reuse system at major sports stadiums like the New England Patriots’ Gillette Stadium. It also operates the country’s largest seawater desalination plant in Tampa, Fla., which uses reverse osmosis to create drinking water from seawater.
It is innovation like this that makes American Water Works more of a growth story than many investors realize. Meanwhile, it still has a large regulated water utility business that provides steady income for its sizable dividend.
“The Paramount Megatrend of our Time”
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