American leaves utility peers in the dust

 

American Water Works led the charge, rising by nearly 26% in 2011, which effectively left everyone else standing. “They basically did everything right in 2011, and the market rewarded them for it,” commented Michael Gaugler, an analyst at Brean Murray, Carret & Co. “They’ve done some things structurally that set them up very well for the future, and they were able to redeploy the capital from selling their Arizona and New Mexico properties into areas where the regulatory environment and returns are more favourable.”

 

Most of the performance came in the first half of the year, although the company was able to hold onto the gains it made by negotiating a series of shrewd asset sales, posting good earnings numbers, and cutting costs.

 

“I think that they benefited by coming a little bit more in line with their brethren on valuation,” said Debra Coy at Svanda & Coy Consulting. “They were relatively undervalued to begin with, and while the valuation gap has not completely closed, American went a long way towards closing it in 2011.”

 

American Water’s main competitor in the sector, Aqua America, also barely put a foot wrong last year, but a widespread perception that it is still too richly valued kept the lid on the stock price, which finished the year down 2%.

 

“With the two of them starting to trade more in line with each other, it might actually provide some upside headroom for Aqua,” commented Gaugler. “They’ve been at such a premium relative to the bigger player in the space that you haven’t seen the willingness on the part of investors to pay up. American came at such a cheap valuation that there was some reallocation from Aqua shares to American shares on the institutional side at the time of the IPO, but I think Aqua will finally get some momentum this year. It’s still a first-class operation with an unparalleled track record.”

 

Despite the narrowing of the valuation gap, Gaugler still believes there is considerable upside potential left in American Water. “I think there’s still some good steam left in that name for 2012,” he told GWI. “Their ROE’s not where it needs to be yet, and they still have a lot of rate case activity outstanding that they should do well on. We had a lousy weather year to comp against this year, so if we get a normalised weather pattern in the summer, you’ll get some upside just from the weather. In addition, I think there’s still costs to be taken out of the business.”

 

The implementation of an interim investment recovery (DSIC) mechanism in New Jersey in 2011 was also a positive factor which should benefit American, Aqua and Middlesex Water, and reinforces the state as one of the most favourable regulatory environments for water utilities in the US.

 

Last winter’s fears over personnel changes at the Calilfornia Public Utilities Commission, meanwhile, have so far proved to be largely unfounded, although a number of question marks remain. “If there’s going to be a negative impact, it might not show before 2013, given that most of the California water utilities had already gotten their general rate cases before the change occurred,” said Gaugler.

 

The cost of capital proceeding which hung over the California investor-owned water utilities for most of last year has still not been resolved, despite an initial agreement to set the ROE for the four largest companies at 9.99% (against applications in the 11.25-11.50% range). The threat of a further haircut is still very real, and evidentiary hearings are due to be held on 23-25 January.

 

As a group, the West Coast utilities had a mixed year, with Cal Water and American States Water ending 2011 roughly flat, against a 10% decline for SJW Corp. “The problem with SJW is it’s just not growing its earnings,” said Gaugler. “I don’t think they’ve had meaningful EPS growth in five years, so as long as those conditions continue, they’re probably going to have issues getting a higher stock price.”

 

He is cautiously optimistic, however. “Their infrastructure is at a point now where they need to get more aggressive on replacement, so as their capex needs increase going forward, they’ll be able to earn on that additional rate base, so we should actually start to see earnings momentum return.”

 

The widespread adherence to water conservation measures in California will also inevitably have hurt SJW’s earnings, particularly given that fact that Cal Water and AWR have revenue decoupling mechanisms in place, whereas SJW does not. While the East Coast utilities are reckoning with a longer-term fall in demand of about 1% each year, in California the figure has been in the high single digits for the past couple of years.

 

“There’s a fundamental conservation direction that’s impacting volume and usage in California, and so the companies out there have had to do much more in the way of pricing mechanisms to accommodate that,” said Coy. “The people that originally thought they could get away without decoupling are finding that that’s simply not going to be the case.”

 

SJW is one of the top candidates to raise equity in 2012, as is Connecticut Water, which is expected to push through a share offering to part-fund its $36 million purchase of Aqua America’s regulated operations in Maine, which went through earlier this month. In general, however, the pace of equity offerings in the sector has slowed noticeably as companies have found ways to lengthen the interval between visits (only Artesian Resources tapped the equity market in 2011).

 

The main impetus for an equity issue in 2012 is likely to be a major acquisition by one of the larger quoted companies. Utilities, Inc., which is currently on the block for around $500 million, could provide just such a trigger. “Anybody who would go in and buy Utilities, Inc. for north of book value would have to recover that somehow, unless you could get the state utility commissions to agree to give you a premium to book value in your rate base – and that’s always a tough go,” said Coy.

 

“That deal could go so many different ways. Does one of the bigger guys with the bigger balance sheets buy it with side commitments to sell off pieces they don’t want? That’s possible, but anybody that buys it is going to have to do equity,” predicts Gaugler.