Dividend stocks are everywhere, but many just downright stink. In some cases, the business model is in serious jeopardy, or the dividend itself isn't sustainable. In others, the dividend is so low it's not even worth the paper your dividend check is printed on. A solid dividend strikes the right balance of growth, value, and sustainability.
Today, and one day each week for the rest of the year, we're going to look at one dividend-paying company that you can put in your portfolio for the long term without too much concern. This isn't to say these stocks don't share the same macro risks that other companies have, but they are a step above your common grade of dividend stock. See last week's selection.
This week, I plan to focus on life's greatest, but most often overlooked necessity -- water -- and plan to show you why American Water Works
Feeling parched?
With a terrible drought and unrelenting heat wave sweeping much of the country, I bet water sounds like a darn good investment to you right about now -- and I feel you're right to think that way.
Water utilities as an investment aren't without their challenges. For one, water pipelines, much like natural gas and oil pipelines, have a finite lifespan. True, no one complains too much when there's a water leak as opposed to an oil spill, but there are still heavy investments needed to maintain pipeline infrastructure. Secondly, there has been a national trend toward water conservation in recent years which has put pressure on total volumes sold to residential consumers. For the investable portion of the water industry, residential consumers are the bread and butter of the business and accounted for 91.1% of American Water Works' sales in 2011.
Reasons to H2Own it
But, for all these negatives, there are far too many long-term trends in place that signify American Water Works is a company to own for a long, long time.
For one, being one of the largest water providers, it commands incredible pricing power. We may take water for granted, but purified and drinkable water is a finite resource that American Water is able to translate into healthy and growing sales and profits. With 12 separate rate and infrastructure increases either already implemented or on the way, American Water is targeting return on equity ranging between 9.4% and 10.6% which should help add $200 million to revenue. In short, this means that as water usage declines, American Water is able to easily pass along rate increases to its customers to boost revenue and profits.
Second, there are vast growth opportunities available to American Water that investors are discounting. Although the effects of fracking -- the process of using water, sand, and chemicals to retrieve hard-to-reach underground natural gas reserves -- are still being studied, American Water stands to add to its bottom line by assisting drillers in the Marcellus Shale region of Pennsylvania. Comprising 21.8% of total revenue, American Water supplied 250 million gallons of water to drillers last year alone and this figure is only likely to rise.
Finally, American Water holds distinct advantages over its peers when it comes to size, valuation, and liquidity.
| Company | Price/Book | Price/Cash Flow | Forward P/E | Debt/Equity | Dividend Yield |
|---|---|---|---|---|---|
| American Water Works | 1.5 | 8.0 | 14.4 | 130.4% | 2.6% |
|
American States Water |
1.8 | 8.9 | 11.9 | 82.1% | 2.7% |
|
California Water Service Group |
1.8 | 7.2 | 17.0 | 121.1% | 3.3% |
|
Aqua America |
2.9 | 9.9 | 18.7 | 124.8% | 2.5% |
|
York Water |
2.4 | 14.5 | 18.9 | 91.0% | 2.9% |
Source: Morningstar, Yahoo! Finance.
Diversification is what really excites me about American Water Works. California Water Service, for example, has little diversification, serving just four West Coast states, and is seeking rate increases of 28%-32% across some Californian regions it serves over the next three years -- including the recently bankrupt city of Stockton.
Sometimes it's just a matter of valuation as we can see here with both Aqua American and York Water. York, which strictly operates in Pennsylvania, is the priciest of this group at nearly 19 times forward earnings and 14.5 times cash flow. Aqua America, which is the only company here that even begins to rival American Water in terms of geographic diversity, trades at nearly three times book compared to American Water at just one-and-a-half times book value.
American States Water has notable advantages based on debt-to-equity over American Water Works, and has a marginally higher yield, but the projected five-year growth rate is no comparison with American Water crushing American States by a margin of around 8.4%.
Let the income flow like water
Now let's really dig into what makes American Water special: its dividend.
As you can imagine, since water is a blatant necessity, cash flow for water utilities is pretty predictable. Capital investments (pipeline replacements, new investments) can also be relatively predictable. In short, Wall Street loves the predictable, and predictability has led to steady dividend growth.
Source: Dividata; * = assumes quarterly payout of $0.25 for remainder of 2012.
In May, American Water announced yet another increase to its quarterly dividend payouts, an 8.7% boost, to $0.25. The company has targeted a payout ratio of 50%-60% which is both sustainable and gives it the ability to raise its dividend in the future unlike some of its peers (e.g. York Water with a payout ratio of 77%).
It's also worth noting that although American Water has $5.3 billion in debt, its repayments are spread out over the next 30 years with favorable average interest rates of just over 6% and only $209 million due through 2016.
Foolish roundup
To sum this up: It's water, we need it, American Water has it, and you can profit from them selling it! It sounds so simple and yet so many investors completely overlook water utilities as a steady source of income.
If you're craving even more dividend ideas, I invite you to download a copy of our special report "Secure Your Future With 9 Rock-Solid Dividend Stocks," which is loaded with income-producing companies hand-selected by our top analysts. Best of all, this report is free, so don't miss out!
