Last January, I wrote about my long-term thesis for American Water Works (NYSE:AWK): American Water: Core Holding With Dividend Growth Potential For Decades.
My thesis was that American Water Works has a proven business model in the water utility sector and a track record of delivering shareholder returns that outperformed the S&P 500 (SPY). It has a growth runway due to the CapEx opportunities in its existing footprint. It can also consolidate the fragmented water utility sector.
The stock is a core holding. I expect periods of volatility, especially in a rising interest rate environment. My plan is to hold the shares that I own for many years, collect dividends, and seek opportunities to increase my ownership when the stock sells off.
American Water Works experienced a few updates to its business model in the last year.
1. Sale of Homeowner Services Group
The Company is known for making acquisitions of other water utility companies. But, in October 2021, it announced a big divestiture with the $1.275 billion sale of its Homeowner Services Group (HSG). HSG is not a regulated business and the sale allows American Water Works to become a pure-play regulated water utility company. The cash proceeds from the transaction are intended to be used for CapEx projects in the regulated utility segment, which will drive future EPS growth.
2. Long-Term EPS Guidance
At the November 8, 2021 investor day, the Company announced a few tweaks to its long-term guidance.
Management lowered the range of long-term EPS growth from 7-10% to 7-9%. This was mostly driven by the sale of HSG. With the sale of HSG, the company is potentially giving up some upside earnings potential in exchange for increased earnings visibility from its regulated business.
Importantly, management did not change the earnings growth outlook for Regulated Investment CapEx and Regulated Acquisitions.
The second important change was to increase the target dividend payout ratio to 55-60% from 50-60%. For dividend investors, the increase in the target payout ratio partially offsets the impact of slightly lower EPS growth.
3. 2022 Outlook
At the investor day, management initiated EPS guidance for 2022 of $4.39-$4.49. The 2022 EPS midpoint is only 5% above the 2021 EPS midpoint. Although management expects 7-9% EPS growth over the long term, 2022 is expected to have below-trend growth.
Management explained that the slower growth in 2022 is due to the sale of HSG. While the proceeds from HSG are intended to be invested in Regulated Investment CapEx and Regulated Acquisitions, it will take time for those investments to ramp up. Therefore, there will be a drop in earnings growth in 2022 while the reinvestment plan plays out.
The 2022 EPS growth rate put pressure on the stock in the near term but doesn’t change my long-term outlook on the Company.
Stock Price and Interest Rates
The share price of American Water Works is sensitive to the change in interest rates. Over the last few weeks, the run-up in the 10-year treasury yield to 1.77% drove the stock price down to $163.57 per share. Looking back at the last year, American Water Works shares dropped during periods of rising rates and rallied during periods of declining rates.
At the beginning of 2021, the dividend yield was higher than the yield on the 10-year Treasury. Currently, the yield on the 10-year Treasury is still about 30 bps higher than the dividend yield, despite the recent rise in the dividend yield as the stock price sold off. This gap suggests that there is room for further near-term stock price declines.
Updates to My Model
I made the following updates to my model from my estimates last year:
- $4.44 2022E EPS – Based on the midpoint of the 2022 guidance from management. This is down from $4.61 in my model last year. The main driver is the sale of the HSG division. Management also said at the November 8, 2021 investor day that the impact of the HSG division sale would be approximately $0.10 on 2022 EPS. So, there seems to be slight weakness on top of the impact of the HSG sale.
- $4.77 2023E EPS – This represents 7.5% growth year-over-year. I expect a re-acceleration of growth in 2023, but still at the low-end of the 7-9% long-term EPS targets. It will take more than one year for the investments of the HSG sale proceeds to have a full impact on EPS growth. I expect EPS growth to accelerate to 8.5% year-over-year in 2024.
- $2.55 2022E Dividends Per Share – This is based on a 57.5% dividend payout ratio, which is the midpoint of the long-term range of 55%-60%. Considering that 2022 will be an investment year, I don’t expect the payout ratio to be at the high-end of the range. Despite the investments, I expect management will want to keep the payout ratio at least at the midpoint to offset the lower EPS growth. In my 2021 model, I also estimated $2.55 of 2022 Dividends Per Share, but that was based on higher EPS with a lower dividend payout ratio.
- $2.79 2023E Dividends Per Share – This is based on a 58.5% dividend payout ratio. I expect the ratio to improve slightly after the 2022 investment year.
- P/E Multiple – I assume a 35x P/E ratio in my valuation “Method A”. This is down from 40x last year due to the increase in interest rates. A 35x P/E ratio is still high for a stock growing EPS 7-9% per year. However, American Water Works benefits from the growth of ESG investing. Historically, the investor base was mainly dividend growth investors. The addition of ESG investors may result in a premium valuation.
- Dividend Yield – I assume a dividend yield of 1.75% in 2022 and increasing 25 bps per year to 2.50% in 2025. The rise in interest rates will drive up the dividend yield and be a headwind for the stock price. In my model last year, I assumed 1.50%. This was too low.
AWK Price Target
When my article was published last year, the stock was at $156.64 and my price target was $163 for 2021 and $177 for 2022. In fact, the stock traded as high as $189 in September and again at the end of December.
My current price target is $151 for 2022. This is based on “Method C” in the table below, which is the average of my valuation based on P/E multiple (Method A) and Dividend Yield (Method B).
In fact, my model suggests a stock price target of $150-$160 through 2024.
The model also suggests a stock price target of $247.55 by 2030, plus $33.03 of cumulative dividends. As an investor that plans to hold shares for the long term, this is what I am focused on.
American Water Works is a core, long-term holding. I expect it will achieve management’s target of 7-9% EPS growth and grow its dividend each year. The fundamentals of the business remain strong. Water is an essential commodity and the company has a long runway of organic growth as well as acquisition potential.
2022 is going to be a choppy year. The company is going to face below-trend EPS growth due to the sale of HSG and the ramp-up period for returns on the reinvestment of proceeds from the sale.
Furthermore, interest rates are rising, which is putting pressure on the valuation multiple.
However, if management can execute well on the reinvestment of HSG proceeds, it will have accelerated EPS growth going into 2023 and beyond.
My model suggests further downside for the stock. I view this as an opportunity. If the share price reaches $150, the stock would have a dividend yield of 1.7%, which is almost in line with the 10-year treasury. I will be watching the share price volatility for good entry points to add to my long-term position.