Watered Down Stocks

By Chad Henage - August 8, 2012 | Tickers: AWR, AWK, WTR, YORW | 0 Comments

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When I hear an investor suggest purchasing shares of a water company, I immediately hit the mental snooze button. Water companies are not usually fast-growing and their dividend yields are not significant enough to attract attention as an income investment. However, not wanting to miss an opportunity, I had to do some additional research when Sean Williams of The Motley Fool suggested a water company had a “great dividend you can buy right now.” What I unfortunately found is that, at least in my opinion, most water companies deserve their relatively un-followed status.

Several of Sean's points are accurate, in the sense that water is a necessity, and the fracking industry creates a new growth opportunity. However, many of these companies are simply not in a position to be terrific investments. For instance, the subject of Sean's article was American Water Works (NYSE: AWK), which is both a regulated water utility and also is assisting companies with their water needs for fracking projects. While the company does have an impressive growth rate of over 8% expected in the future, the company's yield of 2.68% is not that impressive compared to other utilities. In addition, their free cash flow payout ratio has consistently been negative. In fact, to get an idea of the potential growth and yield opportunities in this industry, let's take a look at a few different companies to see what's available:

(Payout ratio and margin based on last full year results) 

This gives you an idea of both the growth and dividend yields available by investing in a water related company. As you can see, none of the yields currently exceed 3%, and there is a huge difference in both the payout ratio and gross margin of each company. If I were sorting this list, I would immediately eliminate American States Water. The two primary reasons are: The company's growth rate is the lowest, and with negative free cash flow their dividend could potentially be in trouble. One that I want to specifically focus on is Aqua America, as the company was recently named a dividend aristocrat. The first thing to look at is the company's free cash flow payout ratio over the last several years. This should give us an idea of the affordability of the company's current dividend payment.

In the last three years, Aqua America has run into challenges paying its dividend without borrowing more money or issuing shares. In fact, in 2009 the company's free cash flow was negative. To cover $74 million in dividend payments, the company issued $123 million in debt and $13 million in stock. This same trend played out again in 2010, when their free cash flow was again negative. The company went back to the well by increasing their debt and issuing new shares. In 2011, the company showed $36 million in free cash flow. With $87 million in dividends to pay, the company had to rely on profits from their investments, and they still issued $18 million in new shares. Water companies can request rate increases to cover new costs, but any company that has to issue shares and borrow money just to pay their dividend is one that I would generally stay away from. When it comes to dividend growth, over the last several years the company has followed a very consistent pattern of increasing its dividend by an ever smaller percentage.

Specifically, the company increases its dividend by $.01 each year. While the increase is extremely predictable, as the numbers get larger the growth rate gets smaller. Just as an example, from 2006 to 2007 the dividend was increased from $0.115 cents to $0.125 cents, representing a growth rate of 8.7%. In the 2011 to 2012 time frame, the dividend was increased from $0.165 cents to $0.175 cents representing growth of just over 6%. With analysts calling for EPS growth of around 6% for the next few years, normally I would suggest investors could expect dividend increases in the low single digits. However, with the company's obvious cash flow challenges, I don't have confidence that the company will continue increasing its dividend in a way that it has until now. If I were forced to choose between the above four companies, the only one that could get serious consideration is The York Water Company. There are several reasons: Their dividend yield is the highest, they have the lowest free cash flow payout ratio, and they have the highest gross margin. While the company's 4.9% expected growth rate won't excite investors, it is the only company with a reasonable payout ratio so at least investors shouldn't have to worry about the sustainability of the dividend. This is something that Aqua America shareholders can't necessarily count on, and in my eyes is reason enough to avoid this new dividend aristocrat.

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