Water and the Negative Free Cash Flow Problem

By Alvin Gonzales - December 4, 2012 | Tickers: AWK, WTR, SBS | 0 Comments

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The water utility industry is capital intensive. Regulatory agencies help companies cope with high costs by approving rate increases. In its 2011 annual report, American Water Works (NYSE: AWK), the largest investor-owned water and wastewater utility company in the US, states, “...based on certain legal and regulatory principles, utilities are entitled to recover, through rates charged to customers, prudent and reasonable operating costs as well as an opportunity to earn an appropriate return on and recovery of prudent, used and useful capital investment necessary to provide service to customers.”

King Cash

When it comes to capital intensive businesses, cash is king and the most important factor to look at is free cash flow. Back in June, I recommended Aqua America (NYSE: WTR) and American Water Works. Aqua America services nearly 3 million people in 10 states. American Water Works services approximately 15 million people in the US and Canada. On the surface, investing in a water utility stock looks good because water is a crucial need. Regardless of economic conditions people always need water.

However, Aqua America, American Water Works, and many other water utility companies struggle to consistently generate positive free cash flow. From 2007 to 2011, American Water Works only generated positive free cash flow in 2010. Aqua America generated positive free cash flow in 2011. The other years were negative. Check out the following table.

As shown, Aqua America hovers around zero free cash flow, but has consistently posted negative free cash flow. On the other hand, American Water Works has been more erratic with its capital expenditures, but the company has also consistently generated negative free cash flow. This trend has been going on for years. In addition, the two companies pay dividends. Currently, American Water Works and Aqua America have dividend yields of 2.62% and 2.74%, respectively. The problem with consistently generating negative free cash flow is that companies have to fund their capital expenditures and dividends through financing or by burning through cash.

WTR Financial Debt data by YCharts

An example of a big water utility company that has been generating positive free cash flow consistently is Sabesp (NYSE: SBS). The Brazil based water utility company provides water to 27.7 million people and sewage collection to 20.6 million people. From 2007 to 2011, the company generated positive free cash flow. It should be noted that 50.3% of the company is owned by the São Paulo State Government.

Huge Costs

The EPA estimated that from 2007 to 2026 approximately $335 billion of capital spending would be needed to guarantee water systems in the US are up to standards. In addition, $390 billion of capital spending would be needed to guarantee wastewater systems are up to standards. That comes out to $36.25 billion in annual capital spending needed in the water utility industry. Also, Aqua America and American Water Works both have a growth through acquisition strategy. In the first nine months of year 2012, Aqua America completed 12 acquisitions and American Water Works spent $44 million in acquisitions. While acquisitions fuel growth by increasing customers, they also increase the amount of assets that need to be maintained and hence increase capital expenditures.

The Bottom Line: Watch List

It is not all bad news. As was previously stated, water utility companies recoup their capital expenditures through rate increases. Over the long term, operating cash flow should exceed capital expenditures. In the first nine months of year 2012, Aqua America and American Water Works have positive free cash flows of $3.382 million and $54.657 million, respectively. In addition, Aqua America and American Water Works have five year compounded annual growth rates (CAGR) of 5.94% and 4.96%, respectively. However, these two companies need to show consistency. Also, at these levels, the two companies’ dividends are not sustainable without borrowing. In the first nine months of year 2012, Aqua America and American Water Works paid $68.932 million and $125.023 million in dividends, respectively. Until Aqua America and American Water Works can generate consistent positive free cash flows, it is probably best to leave these two companies on the watch list. 

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