Please ensure Javascript is enabled for purposes of website accessibility

3 Utilities That Income Investors Should Be Watching

By Bob Chandler – Feb 3, 2014 at 9:31AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Where can investors looking for income go? Water utilities might be a consideration. Companies like American Water Works, California Water Service, and American States Water could offer shareholders both decent dividend yields and noticeable price appreciation.

Water utility companies, or businesses responsible for providing water and sewer services to residential and commercial customers, appear to be an attractive choice for investors searching for income. Product demand is secure, competition is limited, and pricing is set by regulation -- an environment well suited to provide steady and ample dividends. But some water utilities, like American Water Works (AWK -2.06%), California Water Service Group (CWT -1.48%), and American States Water (AWR -1.73%) may also offer shareholders noticeable capital gains. How can these companies offer income and potential price appreciation? 

Water and sewer systems need repair
The water-service industry could be in for some plentiful growth. Water and sewer infrastructure investment is desperately needed. Much of the U.S. water pipeline system is in need of repair. Reports indicate that a major water main breaks about every two minutes. The nation's sewer systems could be in worse shape. Of the nations' estimated 800,000 miles of sewer mains, almost half could be classified as poor or life elapsed by 2020. Water companies, which typically get nicely compensated for any capital improvements they make, should be major beneficiaries from the required repair work.

A large and aggressive beneficiary
One company likely to profit is American Water Works. The largest publicly traded U.S. water and sewer utility, it aims to produce 7% to 10% long-term earnings growth. This aggressive utility's latest quarter was slightly disappointing. Income from continuing operations was down around 2% year over year, mainly due to unfavorable weather reducing demand. While water sales were down around 1%, American Water's total company sales were basically flat thanks to a compelling growth avenue, homeowner services.

American Water offers domestic homeowners and small companies protection service for damaged or blocked pipes inside and outside their locations. This business has become very popular. Revenue in the latest quarter rose 5% year over year and looks to continue growing. Recently expanding into Florida and Washington, D.C., homeowner services has added more than 250,000 new customers so far this year.

American Water currently offers a dividend yield of around 2.6% and looks fairly valued at around 14 times cash earnings. Though slightly higher than its average 12x multiple over the last couple of years, the pricing seems reasonable given the industry's outlook and the company's projected earnings growth.

Regulatory decisions matter
California Water Service is a smaller, less active water utility but also has growth potential. In its latest quarter, the utility posted a revenue gain of around 3.5% with net income down slightly from the prior year. The profit falloff was mainly due to higher purchasing costs and increased expenses from infrastructure improvements put into service. The sales gain came from approved rate increases.

Utilities need regulatory-body approval for rate changes. Regulators typically allow companies to recover their costs and gain a reasonable rate of return. California Water is in a desirable market. Most of the company's more than 500,000 customers reside in California with about half located in the Los Angeles and San Francisco areas. The company is therefore reliant on the California Public Utilities Commission's rulings for its results.

One regulatory difficulty is the time lag between submitting a rate increase and its approval. California Water reached a regulatory settlement over its 2012 rate submission only in October. The agreement, which will provide additional revenue of $45 million in 2014, $10 million in 2015 and 2016, and up to $19 million upon completion of certain infrastructure projects, won't be officially sanctioned until early 2014.

California Water Service, delivering around a 2.8% dividend yield, appears to be richly priced at around 19 times cash earnings. That figure might be deceiving, however. A more accurate valuation may be enterprise value (stock market capitalization plus debt) relative to sales, given the regulatory lag in reported results versus what assets are really earning. California Water's enterprise value of roughly 2.8 times sales, noticeably lower than American Water's enterprise value/sales ratio of around 4.5, looks more reasonable.

Providing water to the military
American States Water is another California-based water company. It provides service to approximately 256,000 customers located in Northern, Coastal, and Southern California. The company is doing well, reporting a year-over-year 11% net income increase in its recent quarter. The gain was helped by its water business, where revenue increased 3.2% due to regulatory-approved higher water rates.

As good as the water operations were, equally exciting is the company's non-regulated contract business. Providing water systems operating services to military bases throughout the country, American States typically derives secured profits on these long-term contracts. Additional revenue can also be obtained from new construction activity. Though, as construction activity varies, results can be inconsistent. Recent quarterly contract revenue dropped about 18% due to reduced construction at two military locations. The company is looking to add business, however. It received $18.5 million in new construction project orders in the last quarter.

American States appears fairly priced at around 18 times cash earnings and an enterprise value of roughly 2.8 times revenue. With a dividend yield of near 2.9%, this water provider could have possible upside from its military-contract opportunities.

Bottom line
Water utilities might have what income investors are looking for and more. These businesses offer a generally safe dividend and potential capital gains, thanks to the growing need for water-infrastructure renewal, and investors may want to consider companies such as American Water Works, California Water Service, or American States Water for their income portfolios.

Bob Chandler owns shares of American Water Works Co. and California Water Service Group. The Motley Fool recommends California Water Service Group. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

California Water Service Group Stock Quote
California Water Service Group
CWT
$64.56 (-1.48%) $0.97
American Water Works Stock Quote
American Water Works
AWK
$149.75 (-2.06%) $-3.15
American States Water Stock Quote
American States Water
AWR
$97.75 (-1.73%) $-1.72

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
356%
 
S&P 500 Returns
118%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 11/29/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.