Published on March 23rd, 2018 by Aristofanis Papadatos
In 2018, California Water Service Group (CWT) raised its dividend for the 51st year in a row. Therefore, it is one of the extremely few companies that have become Dividend Kings, i.e., companies that have grown their dividends for at least 50 years. You can see all 25 Dividend Kings here.
Surprisingly, this stock flies under the radar of most investors. In addition, it has lost 15% in the last two months. Therefore, the big question is whether the stock has become a bargain, or if there is more downside ahead.
CWT is the third-largest publicly-owned water utility in the U.S. and has six subsidiaries, which provide water in California, Washington, New Mexico and Hawaii. The company provides its services to approximately two million people in 100 communities. 2017 was a surprising year of growth for CWT, particularly since utilities are not typically known for high revenue and earnings growth.
Source: Earnings Presentation, page 6
CWT exhibited great performance last year, as it grew its revenues by 9% and its earnings per share by 39%. The greatest portion of the growth resulted from the rate hikes that were approved by the regulatory authorities. This is healthy, as all the utilities rely on rate hikes in order to grow their earnings and service the debt from their excessive investments.
Utilities are slow-growth companies. Due to the enormous amounts they spend on infrastructure, they all carry excessive amounts of debt and thus bear huge interest expenses every year. Therefore, they completely rely on the regulatory authorities to approve of rate hikes year after year. These rate hikes secure the servicing of the debt but they tend to result only in single-digit growth of the revenues and the earnings per share in the long run.
Source: Earnings Presentation, page 20
On the one hand, regulatory authorities always try to secure rate hikes in order to encourage utilities to spend huge amounts on capital expenses, which are required for the maintenance and the expansion of the utility network. On the other hand, authorities also do their best to satisfy the end consumers and thus tend to limit the magnitude of the rate hikes.
This was evident in a judge’s proposal last month, according to which the ROE for CWT would be reduced from an average 9.56% for water utilities to 8.22%. If this proposal is eventually adopted, it will mark the lowest ROE authorized by any state commission and will significantly limit the upcoming rate hikes and hence the growth potential of CWT.
Moreover, thanks to the recent tax reform, most companies will enjoy a significant tax benefit this year. However, this is not true for utilities. More precisely, the regulators have already initiated procedures to make sure that the end customers will benefit from the reduced tax rate. The market seems to be aware of this, as it rewarded all the sectors except for utilities when the tax reform won approval.
Nevertheless, despite the above negative factors, CWT still expects to see its regulated rate base rise this and next year.
As a result, the analysts expect the company to grow its earnings per share by 3% this year and by 6% next year.
Competitive Advantages & Recession Performance
As mentioned above, utilities invest enormous amounts on the maintenance and the expansion of their network. As a result, it is almost impossible for a competitor to enter the market and make a meaningful profit. Therefore, like most utilities, CWT enjoys a wide moat in its business.
In addition, as recessions do not affect the amount of water that people consume, CWT is completely unaffected by recessions. To be sure, during the Great Recession, when most companies saw their earnings collapse, CWT exhibited resilient performance. Its earnings per share were:
- 2007 earnings-per-share of $0.75
- 2008 earnings-per-share of $0.95 (27% increase)
- 2009 earnings-per-share of $0.97 (2.1% increase)
- 2010 earnings-per-share of $0.90 (7.2% decline)
Therefore, not only did the company not see its earnings per share decrease in 2008 or 2009, but it also increased them by 27% in 2008 and another 2% in 2009. Earnings fell in 2010, but the company resumed earnings growth thereafter.
As a result, it can be concluded that CWT is a highly recession-resistant company. This should not be surprising, as resilience during economic downturns is one of the most attractive qualities for utility stocks.
Valuation & Expected Returns
Utilities are slow-growth stocks and hence their valuation is much more important than in any other sector. If investors significantly overpay for a slow-growth stock, it may take them several years only to breakeven. Therefore, while investors may make compromises in the premium they pay for high-growth stocks and still enjoy great returns, they should pay particular attention to the valuation of utility stocks before they pull the trigger and purchase them.
CWT is no exception in this rule. ValueLine analysts expect the company to generate earnings-per-share of $1.55 in 2018. As a result, CWT stock is currently trading for a price-to-earnings ratio of 24.5, which is excessive for a utility stock.
In the past 10 years, CWT stock held an average price-to-earnings ratio of 22.0. Thanks to the almost record-low prevailing interest rates of the last few years, the stock has doubled during the last two and a half years. As its earnings per share have increased only 50% during this period, it is evident that the P/E ratio of the stock has greatly expanded.
Moreover, after years of record-low interest rates, the Fed is now determined to continue to raise interest rates aggressively. As most shareholders of utilities hold these stocks for their generous dividend yields, utilities are the most sensitive stocks to interest rates. More precisely, as interest rates rise, utility stocks become less attractive because the risk-free yield increases and hence investors can find decent yields elsewhere.
Therefore, the rising interest rates are the major reason for the 15% correction of CWT off its peak. Even worse, as interest rates are expected to remain on the rise for the next few years, they are likely to exert additional downward pressure on the valuation of CWT. As a result, the stock currently bears significant risk of P/E multiple contraction due to the upcoming hikes of interest rates.
We believe fair value for CWT is a price-to-earnings ratio of 16-18. Using 2018 earnings guidance, this would represent a share price of $24.80 to $27.90. This price range is approximately 27% to 35% below CWT’s current share price, which implies significant downside risk.
If it took five years for the stock to reach our estimate of fair value, the contracting valuation would reduce annual returns by approximately 5% to 7% each year. As a result, even assuming 6% to 8% earnings growth, and a 2% dividend yield, total annual returns would be just 3% per year. This is not an attractive rate of return.
The dividend payout ratio remains very healthy, at 51.4%. Therefore, the company has ample room to continue to raise its dividend for years. Nevertheless, while utility stocks usually offer remarkable dividend yields, the lofty valuation of CWT has resulted in a current dividend yield of just 2.0%, which is certainly lackluster for a utility.
As utilities are characterized by slow growth, they tend to raise their dividend at a slow pace. This is true for CWT, as it has raised its dividend at an average annual rate of 3.2% during the last five years. Therefore, while CWT has an exceptional dividend growth streak, the combination of its current dividend yield and its dividend growth rate are not appealing right now.
Thanks to its reliable free cash flows, which are secured by the rate hikes that are approved by regulators, CWT has an exceptional dividend growth record. In addition, thanks to its healthy payout ratio, it is likely to continue to raise its dividend for years. Nevertheless, due to its lofty valuation, its dividend yield has dropped to an almost 5-year low level. Therefore, given also the headwind from the rising interest rates, investors should probably wait for a better entry point.