American States Water (AWR) is trading 12.47% below its 52-week high of $96.00 – a high that came about as investors scrambled for a safe-haven investment in light of the U.S.-China trade war and the yield curve inversion of Treasury bonds portending recession in August – but despite this, and despite the undeniable quality of the underlying business, I still think that the stock is overvalued – though I can understand why it is overvalued.
American States Water is now trading 12.47% below its 52-week high of $96.00. Image provided by FinViz.
Why do I say that I can understand that this business is overvalued? The nature of the business itself provides a clue – water is a necessity to live, and a business that can monetize water can become a sustainably profitable one. American States Water can be seen as such a business. Its operations are divided into two wholly-owned subsidiaries: the Golden State Water Company, or GSWC, and American States Utility Services, or ASUS.
Water is a necessity, and so a firm like American States Water which can monetize this necessity can become very profitable. Image provided by Dreamstime.
GSWC, regulated and based in California, provides water service to around 260,000 customers within over 80 communities in California. The company also distributes electricity to almost 24,000 customers in California. ASUS is an unregulated segment which operates subsidiaries which provide operations, maintenance and construction management services for water and wastewater systems on military bases across the United States, and these services are guaranteed via 50-year privatization contracts with the U.S. government.
Either company by itself would prove a sustainable business. Taken together, they make American States Water a reliably profitable firm, as the last five years of revenue and net income figures illustrate.
|Year||Revenue ($)||Net Income ($)|
|2014||465.79 million||60.72 million|
|2015||458.64 million||60.1 million|
|2016||436.09 million||59.41 million|
|2017||440.6 million||68.99 million|
|2018||436.82 million||63.54 million|
Figures collated from annual reports available on American States Water’s investor relations page.
Quarterly figures for the present financial year show a continuation of this trend.
|2019 Quarter||Revenue ($)||Net Income ($)|
|Q1||101.73 million||12.79 million|
|Q2||124.65 million||26.66 million|
|Q3||134.5 million||27.88 million|
|Total||360.88 million||67.33 million|
Figures collated from quarterly reports available from American States Water’s investor relations page.
This profitability is supplemented by a solid balance sheet. Long-term debt of $487.04 million seems quite high against a net worth of $590 million, but utilities are capital-intensive businesses that require a lot of infrastructure maintenance, so a high-debt level is expected and American States Water is profitable enough to service its debt interest payments.
American States Water is also profitable enough to continue rewarding shareholders with consecutively rising dividend payments as it has done for sixty-four years, a record that makes the firm a Dividend King. With a payout ratio of 51.30%, it is very likely that this record will be sustained going forward.
However, the high debt and the fact that utilities are not high-growth businesses means that EPS growth over the next five years is 6.00%, which makes it more pertinent for a value investor to incept a position with American States Water at a price close to fair value. Currently, American States Water trades at a share price of $84.03 with a price-to-earnings ratio of 38.20, which is higher than the five-year average P/E of 30.94. Its current dividend yield is 1.38%, which is lower than its five-year average dividend yield of 1.88%. This suggests that the stock is overvalued – is that the case?
To determine fair value, I will first divide the current P/E by the historical market average of 15 to get a valuation ratio of 2.55 (38.20 / 15 = 2.55) and then divide the current share price by the valuation ratio to get a first estimate for fair value of $32.95 (84.03 / 2.55 = 32.95). Then I divide the current P/E by the five-year average P/E to get a valuation ratio of 1.24 (38.20 / 30.94 = 1.24), then divide the current share price by this valuation ratio to get a second estimate for fair value of $67.77 (84.03 / 1.24 = 67.77).
Next, I divide the five-year average dividend yield by the current dividend yield to get a valuation ratio of 1.36 (1.88 / 1.38 = 1.36), then divide the current share price by this valuation ratio to get a third estimate for fair value of $61.79 (84.03 / 1.36 = 61.79). Finally, I find the average of these three estimates to get a final estimate for fair value of $54.17 (32.95 + 67.77 + 61.79 / 3 = 54.17). The stock is overvalued by 55%.
American States Water is a quality business, no question about it. Its profitability, its sustainable dividend, and its business model ensure that it will remain a profitable holding for existing investors going forward. For prospective investors, paying a 55% premium for any business simply cannot be justified, and it would be best to wait for a pullback before starting a position here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.