Is American Water Works Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does American Water Works (NYSE: AWK  ) fit the bill? Let's take a look at what its recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell American Water's story, and we'll be grading the quality of that story in several ways:

  • Growth: Are profits, margins, and free cash flow all increasing?
  • Valuation: Is share price growing in line with earnings per share?
  • Opportunities: Is return on equity increasing while debt to equity declines?
  • Dividends: Are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's take a look at American Water's key statistics:

AWK Total Return Price Chart

AWK Total Return Price data by YCharts

Passing Criteria

Three-Year* Change

Grade

Revenue growth > 30%

17.8%

Fail

Improving profit margin

50.7%

Pass

Free cash flow growth > Net income growth

93.9% vs. 77.4%

Pass

Improving EPS

67.3%

Pass

Stock growth + 15% < EPS growth

116.7% vs. 67.3%

Fail

Source: YCharts. * Period begins at end of Q1 2010.

AWK Return on Equity Chart

AWK Return on Equity data by YCharts

Passing Criteria

Three-Year* Change

Grade

Improving return on equity

58.1%

Pass

Declining debt to equity

(8.3%)

Pass

Dividend growth > 25%

33.3%

Pass

Free cash flow payout ratio < 50%

Negative FCF

Fail

Source: YCharts. * Period begins at end of Q1 2010.

How we got here and where we're going
American Water flows toward a respectable performance, with six of nine possible passing grades. However, despite coming through on free cash flow growth, it should be noted that the company is currently in the red on that metric -- just closer to green than it was three years ago. Can American Water turn off the leaky cash faucet, or will it be forced to call the plumber to patch up its holes with more debt? Let's dig a little deeper to find out.

According to the National Association of Water Companies and the U.S. Chamber of Commerce, the nation's water and waste-water infrastructure is in desperate need of repair and replacement, with more than seven billion gallons of treated drinking water lost to leaks in utility pipes every day across the United States. As of 2010, 45% of all pipes were in poor shape, and millions homeowners' pipes are also experiencing leaks and breaks due to a number of factors. Over the next 20 years, the water and water-waste utility market will require a massive $650 billion investment in infrastructure repairs. That's likely to keep American Water's free cash flow depressed for some time.

American Water is taking a proactive tack to combat this problem, offering water line and sewer line protection programs to more than 500,000 homeowners in Houston through an educational program sponsored by the city. These programs provide homeowners with comprehensive protection from the costs associated with leaks and breaks in water lines, as well as clogs or blockages in sewer lines running through their property. Since Houston is the eighth most frequent sufferer of leakages per household, such a move should help reduce long-term costs by encouraging customers to report problems early and often.

Increasing operational efficiency by reducing water waste is a major priority at American Water. American Water, in partnership with electronic pipeline controller manufacturer Steam Control, has bagged a $1.8 million, two-year contract from the Israel-U.S. Binational Industrial Research and Development Foundation for the development of an advanced pressure-management system. This project demonstrates the feasibility of installing modifications on existing pressure system controls that could reduce the pressure in a system in response to low customer demand. This innovation should the frequency of pipe failures and the volume of leaks through pipes by ensuring that pressure is only provided at necessary levels.

This particular industry also stands to cash in on the American energy boom as a result of the necessity for water during the fracking process, and investors should capitalize on this fundamental trend by positioning themselves in water service companies. American Water generated $2.87 billion revenue in 2012, and projections expect revenue to rise to $3.48 billion by 2017. If profitability holds up, and free cash flow doesn't collapse, this utility could keep gains flowing to shareholders for many years to come.

Putting the pieces together
Today, American Water has many of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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  • Report this Comment On July 15, 2013, at 9:52 PM, jay3069 wrote:

    I work for American Water...profit and shareholder returns certainly do come first. Treating employees fairly comes dead last.

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