With President Trump's call for improving American infrastructure echoing in their ears, investors are turning their focus to utility stocks. American Water Works (AWK 0.80%), a leader among water utility stocks, for example, is one name that's been drawing much attention. Whether testing the waters or ready to dive in and pick up shares, investors should have a sense of what they need to monitor. So let's look at three ways to evaluate the company.
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Smooth operator
American Water Works conducts the majority of its business in regulated markets. In fiscal 2015, for example, the regulated businesses segment accounted for 87% of the company's operating revenue. As a result, the company doesn't have the luxury of arbitrarily raising rates whenever it wants. Instead, it must file rate increase requests with utility commissions -- a well which it cannot return to too often. Therefore, the company must largely rely on its own prowess at maintaining efficient operations.
To assess this efficiency, the company turns to the operations and maintenance (O&M) efficiency ratio. Defined as its regulated O&M expenses divided by regulated operating revenues, the ratio is basically a modified operating margin. One of the reasons it's so valuable to investors is that it provides insight into whether the company is putting its capital expenditures dollars -- 37% of sales in fiscal 2015 according to Morningstar -- to good use.
Lowering its O&M efficiency ratio from 44.2% in fiscal 2010 to 35.9% in fiscal 2015, American Water Works has demonstrated its ability to consistently improve. And management has no intent on slowing down. It has established an O&M efficiency ratio target of 32.5% by 2021, providing investors a valuable and simple way to monitor the company.
Swimming in profits
Aside from increasing the efficiency of its operation, American Water Works relies on acquisitions to keep the profits flowing. Although the company hasn't released its fiscal 2016 earnings yet, management expects to report that it had added about 42,000 customers during the year due to acquisitions -- about 76% more than the approximate 24,000 customers it added through acquisitions in fiscal 2015. And according to an investor presentation from December, the company has over 145,000 customer opportunities in development.
How does this translate to the financial statements? In fiscal 2015, the company shelled out $64 million for 14 water and wastewater systems. How much it spent on acquisitions in fiscal 2016 remains to be seen. And looking ahead, management estimates that it will spend between $600 million and $1.2 billion on acquisitions of regulated businesses over the next five years.
With so much money being reinvested into the company, investors will want to be sure that management is making wise -- and profitable -- decisions. Therefore, keeping an eye on the company's return on invested capital (ROIC) is extremely important; moreover, this should be considered in the context of its peers: Aqua America (WTRG 1.85%), California Water Service Group (CWT 2.62%), and American States Water Company (AWR 2.48%).
AWK Return on Invested Capital (Annual) data by YCharts
Sporting a ROIC of 4.24%, American Water Works may not seem much better than its peers -- if at all -- at effectively investing in itself.
AWK Return on Invested Capital (Annual) data by YCharts
We're interested in the long term, though. And when we consider the company form that perspective, we find American Water Works has far exceeded its peers at improving its ROIC, showing that it has found a way to navigate some choppy waters, while others have not.
Keeping things in balance
Dealing in a capital-intensive industry, American Water Works is no stranger to taking on debt. For example, in terms of acquisitions, management acknowledges, in its more recent 10-K, that "acquisitions are funded initially with short-term debt and later refinanced with the proceeds from long-term debt."
Since its incumbent on us to pay attention to the company's debt, we'll make use of a tried and true metric: the debt-to-equity ratio. Over the past five years, the company's debt-to-equity ratio has hovered between 1.2 and 1.3 -- considerably higher than its peers.
AWK Debt to Equity Ratio (Annual) data by YCharts
Some investors may see this and start reaching for a red flag; however, when it comes to rating a company's balance sheet, it's worth hearing what Standard & Poor's and Moody's have to say. For them, American Water Works' is anything but drowning in debt. In the company's most recent 10-K, management notes that Standard & Poor's raised the company's corporate credit rating from A- to A and confirmed its stable rating outlook in May 2015. In addition, Moody's maintains a long-term rating of A3 and a stable outlook.
Lastly, when we return to the 10-K once more, we find insight into management's perspective on its debt:
Since we expect our capital investments over the next few years to be greater than or equal to our cash flows from operating activities, we have no plans to reduce debt significantly.
What does all of this mean in terms of the debt-to-equity ratio? Though it's high, neither is there anything to suggest that it's placing the company in a tenuous position nor is there an indication that the ratio will be dropping anytime soon. So we can consider the current 1.3 ratio as a guidepost. If the ratio creeps higher, it may certainly be a cause for concern and warrants further investigation.
The takeaway
Keeping more than 49,000 miles of distribution and transmission pipes, 1,400 pumping stations, 1,200 water storage facilities, and 81 dams (among other assets) in tip-top shape doesn't come cheaply. So it's imperative for investors to weigh heavily the effects that capex has on American Water Works' business. And with these three metrics, investors will have a good sense of how smoothly things are flowing.
