Basic Needs Portfolio Selection: American Water Works

Eight weeks ago, I outlined my plans to create a portfolio of 10 companies that all have one thing in common: They provide a basic need or deliver life's necessities. It's my contention that basic needs companies can offer investors stability and growth throughout any market environment thanks to consistent demand, incredible pricing power, and delectable dividends. This portfolio, which I have dubbed the "Basic Needs Portfolio", will be pitted against the S&P 500 over a period of three years with the expectation of outperformance for all 10 stocks. I'll be rolling out a new selection to this portfolio every week for the next two weeks.

You can review my previous seven selections here:

Today, I plan to introduce the eighth of 10 selections to the Basic Needs Portfolio: American Water Works (NYSE: AWK  ) .

How it fits with our theme
Whereas Ford may have been the biggest stretch for an addition to this basic needs portfolio, there is absolutely no one that's going to deny the importance of water in our lives. We need water to survive. Period! Water is essential for us to drink, is used in countless foods, and helps keep us clean via showers and baths. Don't even get me started on what kind of trouble we'd be in without water for our toilets!

According to the Environmental Protection Agency, the average American family uses about 300 gallons of water each day, with approximately 70% of that usage occurring indoors. You might be thinking to yourself, "The oceans hold 96.5% of our planet's water, so we can use as much as we want!" In actuality, ocean water is loaded with salt and potentially holds bacteria that can be harmful or deadly. This means the water received from your local utility is actually a lot scarcer than you might think. With water importation still too pricey an idea to consider, water utilities have some of the best pricing power and arguably the steadiest demand of the utilities sector through economic peaks and troughs.

The risk
It may seem illogical, but even the most necessary of items needed for our survival, water, comes with risks – at least for the company that supplies us with water, that is.

The first big risk for American Water Works and the water utility sector as a whole is the need for infrastructure and maintenance upgrades. The downside of expanding into new territories and picking up new customers is that pipe, sewer, and storage tank maintenance is needed just to keep operations running. American Water Works' primary rival, Aqua America (NYSE: WTR  ) , spent $1.4 billion in maintenance and upgrades alone between 2007 and 2011. American Water Works, by contrast, will spend $950 million just in 2013 for maintenance and upgrades. These costs are already painful to begin with, but when capex costs are unexpected it can negatively impact a water utility's bottom line.

Debt is another big concern in the utility sector. In order to expand and maintain its existing network of pipes and sewers, American Water and its peers have had to take on a significant amount of debt. American Water Works, for example, carries $5.6 billion in net debt on its balance sheet, but has brought in close to $1 billion in operating cash flow over the trailing-12-month period. By comparison, California's American States Water (NYSE: AWR  ) only has $303 million in net debt but generated only $106 million in operating cash flow over the past 12 months. American States may be in better financial shape than American Water Works with regard to debt to equity, but it doesn't have nearly the same bargaining or expansionary power.

Finally, geographic diversity, or lack thereof, can be a worry for water utilities. Although demand seems to be pretty consistent over time, certain regions of the country may be called upon to ration or conserve water usage depending on a drought. This can therefore reduce demand and profits for water utilities that are confined to a region of the country prone to droughts. SJW (NYSE: SJW  ) – which actually operates in two business segments, water utility and real estate – is one such company that could experience this shortfall. With just over 225,000 customers all located in the Cupertino and San Jose areas of California, any drought in this region could cause a serious fall in demand.

Why American Water Works?
Despite these risks, I feel American Water Works is the perfect way to play the water utility sector for a number of reasons.

Source: Steve Johnson, Flickr.

To begin with, the company is a mastermind when it comes to making acquisitions and incorporating them seamlessly into its current operations. Normally acquisitions result in bottom-line hiccups that are often negative for the acquiring company. However, that's been the case in relatively few instances for American Water Works which often keeps its acquisitions smaller in scale, allowing for an easier assimilation of the business operations and customers. Two deals in its latest quarter added nearly 22,000 new customers and pushed it past the 1 million contract mark.

American Water Works' consistent dividend growth is another selling point. You might be thinking that's sort of a moot point given that practically every company in the sector pays a dividend. But, as I'll show you, not all dividends are created equally.

Company

Payout Ratio

Yield

American Water Works

51%

2.70%

Aqua America

54%

2.30%

American States Water

57%

2.80%

California Water Service Group (NYSE: CWT  )

75%

3.10%

Source: Yahoo! Finance, author's calculations. Payout ratio based on estimated EPS in current fiscal year.

The list of payout ratios and yields here may appear pretty nondescript, but it tells me a lot about the sector. California Water Service may offer the best yield of the bunch, but it's also paying out way more in profits than the rest of its peers in terms of this year's projected EPS. That isn't necessarily a bad thing for shareholders, but it doesn't give the company much room to wiggle its dividend any higher. Similarly, it isn't very diverse with operations in only four West Coast states.

Compare that to American Water Works which recently boosted its dividend by 12% to $0.28 per quarter, its fifth such dividend hike in as many years.


Source: Nasdaq.com; * assumes quarterly payout of $0.28 for remainder of 2013 and 2014. 

Even with this boost American Water Works is paying out the least amount of its earnings as a dividend among its peers but clearly has the greatest room to boost its payout in the future. Relative to the group, though, its 2.7% yield fits in nicely among the average and is currently comparable to the yield on a 10-year U.S. Treasury note.

The final intriguing factor with regard to American Water Works is its geographic diversity. One of my bigger gripes of the smaller water utilities is their confinement to one or a couple states. That isn't the case for American Water Works which has more than 14 million customers and operates in close to 35 states and two Canadian provinces. The key to Warren Buffett's success is portfolio diversity, and the reason American Water Works will be successful is geographic diversity.

Stay tuned next week, when I'll unveil the ninth selection in the Basic Needs Portfolio.

Your search for the markets highest-yielding and most dependable dividends doesn't have to end here! The Motley Fool has compiled a special free report outlining our nine top dependable dividend-paying stocks called "Secure Your Future With 9 Rock-Solid Dividend Stocks." You can access your copy today at no cost! Just click here.


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