Better Buy: Aqua America, Inc. vs. American Water Works

Between trips to the beach, the pool, or the water fountain, there's no time like the summer to remind us of the value of water. And for investors, that leads to an obvious question: Which water utility stock is a worthy investment?

Although they may not be household names, there are a number of options -- ranging in size from micro to large cap -- from which investors can choose. For now, let's stay in the deep end and weigh two of the industry's largest companies, Aqua America (WTRG 1.39%) and American Water Works (AWK 1.19%), against each other to see which offers investors the better opportunity.

Image source: Getty Images.

Avoiding uncharted waters

We'll start with a quick round of introductions. Aqua America, the second-largest water utility operating in the United States, has been providing water services for more than 130 years. Currently, it provides water and wastewater services to about 3 million customers in eight states. American Water, however, is the largest publicly traded water service provider by market cap. Like Aqua America, it has been in business for more than 130 years; however, its customer base is considerably larger: 15 million customers in 47 states and Ontario. 

Before we wade in any farther, though, let's compare the companies on some common metrics to familiarize ourselves a bit more.

Data source: Morningstar.

Between the higher dividend yield and better return on equity, Aqua America seems more enticing than the industry's big dog, but we'll have to dive in much deeper to see if this brief look has been deceiving.

Swimming in profits

In light of the fact that American Water has a customer base about five times larger than that of Aqua America, it should come as no surprise that it reports significantly higher revenue. The greater consideration, though, isn't only how the company performed last year but how it performed in the past several years. 

WTR Revenue (Annual). Data by YCharts.

Operating primarily in regulated markets, water utilities recognize rate increases as a source of revenue growth. However, this is not a lever that they can continually pull in any one market. Consequently, they often rely on acquisitions to grow their top lines. This is where American Water Works excels. Over the past three years, it has grown its customer base by 41,000 customers as a result of $410 million in acquisitions.

In the past five years, Aqua America has committed about $202 million in cash and stock to acquisitions. Although it's illogical to conclude that American Water's superior bottom-line growth is solely attributable to its greater commitment to acquisitions, the correlation is worth noting. And the company shows no signs of slowing down; as of April 30, 2017, it had 17 pending acquisitions totaling more than 33,000 customers. Aqua America, in a recent presentation, reported that it has four pending acquisitions totaling about 8,800 customers.

Besides its edge in executing acquisitions -- one of its competitive advantages -- American Water Works maintains a leg up on Aqua America in terms of diversity in its customer base, mitigating the risk of adverse local weather phenomena. Whereas New Jersey represented the largest source of operating revenue for American Water Works -- about 25.4% -- for its regulated businesses, Aqua America was less diversified: Pennsylvania alone accounted for approximately 52% of operating revenue and about 74% of net income for 2016. 

Winner: American Water Works

Going with the flow

Seeing strong bottom-line growth is exciting, but strong cash flow growth is even more exhilarating. After all, the company's cash flow can't be finagled as easily as the income statement; therefore, it provides a more reliable measure of the company's financial health.

WTR Cash from Operations (Annual). Data by YCharts.

Again, we find that American Water Works is the winner, reporting growth of more than 33% in operational cash flow over the past five years. The strong cash flow affords American Water Works the ability to execute acquisitions and upgrade its infrastructure without having to resort to debt. The company also deserves kudos for how effectively it puts its cash to use, earning an almost 10% return on invested capital. Aqua America, on the other hand, failed to generate a positive return for the past two years.

For further proof of American Water Work's success in reinvesting its capital, we can consider its operations and maintenance (O&M) efficiency ratio -- a modified operating margin for its regulated businesses -- to confirm that the capital expenditures are effecting greater efficiency. In fiscal 2016, American Water Works reported a 34.9% O&M efficiency ratio. Aqua America doesn't break this out specifically in its earnings reports, but based on figures from its fiscal 2016 10-K, it has a 60.3% O&M efficiency ratio. Whereas expenses account for about 35% of American Water Work's operating revenue, they account for about 60% of Aqua America's operating revenue. 

Winner: American Water Works

Delving into debt

At this point, American Water Works appears to be the better opportunity, but let's check the companies' balance sheets to make sure there are no red flags.

Data source: Morningstar and author's calculations. All figures as of Dec. 31, 2016.

Although Aqua America appears to be more conservative, there's nothing to suggest that American Water Works is drowning in insurmountable debt. In fact, the company appears to be in sound financial health and capable of managing a larger debt load.

Winner: Aqua America

And the winner is...

For investors looking to dip their toes in a water utility investment, American Water Works currently offers the better opportunity -- despite a lower dividend yield. And moving forward, interested investors should look for the company's continual execution of acquisitions and improvements in its O&M efficiency ratio as green flags, proving that the investment thesis remains intact.