Global Infrastructure

Stock story: American Water

The decrepit and splintered US water system is an opportunity for the country’s largest listed water utility.

Stock story: American Water

January 2020

In the US, more than two trillion gallons (9.1 trillion litres) of water are lost each year – that means 20% of treated water is wasted. About 900 billion gallons (4.1 trillion litres) of untreated sewage every year pours into US waterways. The problem is about 240,000 water mains break each year, which is no surprise given that many of country’s pipes were laid early to mid-last century and they had a lifespan of only 75 to 100 years. This year, 44% of US water-pipe infrastructure is expected to be assessed as ‘poor’, ‘very poor’ or ‘life elapsed’, another way of saying ‘needs replacing’. As for quality, the American Society of Civil Engineers gave US drinking water a ‘D’ in 2017 while the country’s wastewater facilities was rated ‘D+’ – some of the body’s harshest assessments of US infrastructure.

Billions of dollars would need to be spent in coming years to improve the US’s water and wastewater systems. But this will be difficult given the size and fragmented nature of the industries. The US is home to about 50,000 water systems where 84% of the population is served by water systems run by municipal authorities. About 10,000 of the US’s water systems serve fewer than 3,000 customers and about 1,400 are under some sort of enforcement action to remedy deficiencies. The country maintains 15,000 wastewater systems where 98% of the US population is served by city authorities. About 2,200 of these wastewater systems are under some sort of formal enforcement action. (By way of comparison, the US hosts only 3,800 electrical and 1,400 gas systems.)

American Water Works, the largest listed water utility in the US, eyes the problems with the US’s water and wastewater systems as an opportunity to expand while earning higher returns for investors from what is a low-risk industry operationally – unlike gas lines, water mains and pipes typically don’t explode. The strategy of the New Jersey-based company that earned US$3.4 billion in revenue in fiscal 2018 from servicing 14 million people across 46 US states and one Canadian province has three prongs.

American Water’s main focus is to boost the amount of capital on which it can earn a regulated but fair return by spending US$20 billion to US$22 billion over the next 10 years to improve its network. In the US (and elsewhere), utilities are granted monopoly rights in an area. In exchange, regulators ensure essential services stay affordable by limiting the return a utility can earn on its capital investment. The setup means that the best way for a utility to boost revenue is to increase the amount of approved capital spending on which it can earn a regulated return.

American Water, which enjoys an average weighted return of 9.8% from its regulated activities, expects to replace nearly 2,000 miles (3,200 kilometres) of mains and collection pipes over the next five years. As American Water has typically replaced only about 0.8% of its pipeline network a year (which, in industry jargon, translates to a 130-year replacement cycle), the company has a vast opportunity to invest in its network to ensure robust growth in regulatory revenue in coming years.

American Water’s second prong is to expand through takeovers. American Water plans to spend up to US$1.2 billion on acquisitions from 2020 to 2024 and there are plenty of targets because only 16% of the US’s water systems and just 2% of the wastewater systems are investor-owned. Last year, the company finalised 19 purchases in eight states that added more than 50,000 regulated connections. That boosted the number of deals completed since the start of 2015 to 82, which came with 173,000 new customers in 10 states.

The city authorities that operate many water systems in the US are keen to sell because offloading assets eases their financial stress and they are under political pressure to improve water quality – something American Water is better at than they are. That American Water has a strong operating history, a good reputation and is familiar to many state regulators streamlines takeover approvals.

The third prong is that management is focused on running American Water more efficiently. Management intends to reduce expenses to 31.5% of revenue by 2023, down from 35% in 2019 and from 46.1% in 2010. The company is cutting its cost-to-income ratio by adopting technology, improving supply systems and by scrutinising costs. 

The three prongs have helped American Water deliver solid shareholder gains in the past five years – the company has recorded a compounded growth rate of 10% in dividend payments and average annual revenue growth of 3% over the period. In coming years, they are likely to help American Water deliver to investors what they expect from infrastructure and utility assets – namely, dependable and transparent earnings streams spiced with some capital growth.

To be sure, none of American Water’s strategies is guaranteed to succeed to the extent sought; dealing with so many regulators has its time-consuming side and regulators could always make unfavourable decisions when it comes to regulated returns. In addition, climate change could complicate operations of water utilities and the company has financed takeovers and capital spending with debt of US$7.6 billion at the end of 2018. Even allowing for these qualifications, American Water has fulfillable plans in place that are likely to provide investors with secure cash flows and some capital growth from low-risk activities in coming years.

Four arms

The history of American Water traces to 1886 when the American Water Works & Guarantee Company was founded. While much happened in between, 2003 was a year of note because American Water was acquired then by the German utility RWE, which in 2008 listed the company via a ‘spin-off’.

American Water these days consists of four businesses. The most important is the regulated business that operates metered water services in about 1,600 communities in 15 states, each with a regulator. This unit’s assets consist of 51,000 miles (82,000 kilometres) of pipes, 621 water-treatment plants, 1,000 wells, 130 wastewater plants, 1,300 water-storage facilities and 1,400 pumping stations. This regulated business brings in more than 85% of the company's revenue even though water customers on average pay less than one US cent per gallon. About 25% of regulated revenue is sourced from New Jersey while another 20% comes from Pennsylvania.

American Water’s unregulated arm (or ‘Market-Based Business’ as the company calls it) includes its Contract Operations Group, which runs water facilities for cities and businesses. Another is the Homeowner Services Group, which offers services to 1.5 million homeowners and small businesses to guard against the cost of repairing water and sewer pipes. Lastly, the Military Service group provides water services to about 16 US military bases.

With these businesses, American Water is primed to help improve the US’s decrepit water and wastewater systems in coming years while keeping investors happy.

Sources include company filings and website, Bloomberg and Hoover’s, a Dun & Bradstreet Company and infrastructurereportcard.org.

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