Dividend Kings In Focus Part 25: California Water Service Sure Dividend

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Dividend Kings In Focus Part 25: California Water Service


Updated on October 21st, 2020 by Aristofanis Papadatos

California Water Service (CWT) has an amazing track record when it comes to increasing dividends to shareholders. CWT is part of the Dividend Kings, a group of stocks that have raised their payouts for at least 50 consecutive years. You can see all 30 Dividend Kings here.

You can also download an Excel spreadsheet with the full list of Dividend Kings (plus important metrics such as price-to-earnings ratios and dividend yields) by clicking on the link below:

 

Click here to download my Dividend Kings Excel Spreadsheet now. Keep reading this article to learn more.

Dividend Kings are the best of the best when it comes to rewarding shareholders with cash and this article will discuss CWT’s dividend, as well as its valuation and outlook.

Business Overview

CWT is the third-largest publicly-owned water utility in the United States. Due to considerable consolidation in the water utility industry in recent years, there are only 11 publicly-owned water utilities in the U.S. right now. CWT was founded in 1926 and has six subsidiaries that provide water to approximately two million people in 100 communities, primarily in California but also in Washington, New Mexico and Hawaii.

Just like the vast majority of utility companies, CWT is a slow-growth company. Utilities spend excessive amounts on the expansion and maintenance of their infrastructure and thus they accumulate high debt loads. As a result, they rely on the regulatory authorities to approve of rate hikes every year. These rate hikes aim to help utilities service their debt but they usually result in modest growth of revenue and earnings.

On the one hand, authorities have incentive to offer attractive rate hikes to utilities in order to encourage them to invest heavily in infrastructure. On the other hand, authorities offer limited rate hikes in order to keep the end consumers satisfied.

The reliable rate hikes that utilities enjoy result in a resilient business model, which is characterized by fairly predictable cash flows and earnings growth. This is clearly reflected in the exceptional dividend growth record of CWT. The company has raised its dividend for 52 consecutive years.

Moreover, CWT has a healthy payout ratio of 63% and thus it will easily continue to grow its dividend for several more years, particularly given its resilient business model. The company has grown its dividend at a 4.9% average annual rate over the last five years. Unfortunately, due to its rich valuation, the stock is currently offering just a 1.8% dividend yield, which is only slightly above the yield of the S&P 500 (1.7%).

The dilemma of the regulatory authorities between pleasing the utility companies and the end consumers was prominent in the earnings report of CWT in the second quarter. The company posted a 2% decrease in its revenue and a sharp decrease in its earnings per share, from $0.35 in the prior year’s quarter to $0.11, primarily due to the absence of resolution of the California General Rate Case.

If the regulatory authority of California had approved of the rate settlement proposed by CWT, the company would have posted additional revenue of $29.1 million and thus it would have grown its revenue 14%.

On the bright side, it should be a question of time for the regulatory authorities to approve of a rate hike for CWT, as the latter has already increased its cost base due to its recent investments in infrastructure and thus deserves a rate hike for these investments.

Growth Prospects

As mentioned above, utilities rely on modest rate hikes by regulatory authorities year after year, and thus they are mostly slow-growth stocks. CWT is not an exception, as it has grown its earnings per share at a 4.1% average annual rate over the last decade.

CWT has grown its investment amounts at a much higher average annual rate of 9.7% since 2008.

Source: Investor Presentation

However, due to the high interest expense, which has resulted from the accumulated debt load, and the lackluster approved rate hikes, CWT has been able to grow its bottom line at just a mid-single-digit annual rate throughout this period.

The chart below show that the regulated rate base of CWT has grown at a 5.2% average annual rate over the last five years.

Source: Investor Presentation

On the other hand, the company expects an approximate 12% annualized increase in its base rates over the next three years. However, we view these expectations as too optimistic. Overall, we expect CWT to continue to grow its earnings per share at a 4% average annual rate over the next five years, which will be in-line with its historical growth rate.

Competitive Advantages & Recession Performance

Utilities invest enormous amounts on the maintenance and expansion of their network. These amounts result in high amounts of debt but they also form extremely high barriers to entry to potential competitors. It is essentially impossible for new competitors to enter the markets in which CWT operates. Overall, utilities have the widest business moat investors can hope for.

In addition, while the vast majority of companies suffer during recessions, water utilities are among the most resilient companies during such periods, as economic downturns do not affect the amount of water consumed by customers.

The resilience of CWT was evident in the Great Recession. Its earnings-per-share during the Great Recession are below:

Therefore, not only did CWT not incur a decrease in its earnings during the Great Recession, but it grew EPS by 20% throughout the 3-year period of 2007-2010.

The exceptional resilience of CWT is also evident in the ongoing recession, caused by the coronavirus pandemic. While most companies have incurred a material decrease in their earnings this year, CWT is poised to grow its earnings per share 3% this year. Put simply, CWT is one of the most resilient companies during recessions and bear markets.

Valuation & Expected Returns

CWT is expected to generate earnings-per-share of $1.35 this year. As a result, the stock is currently trading at a price-to-earnings ratio of 34.1. This is much higher than its average price-to-earnings ratio of 25.6 in the past 10 years. We consider 20.0 to be a fair earnings multiple for this stock.

The extremely high price-to-earnings ratio can be partly attributed to the depressed interest rates, which have resulted from the pandemic. Low interest rates make income-oriented investors starve for yield and thus they render the dividend yields of utilities more attractive. As a result, utility stock prices benefit from suppressed interest rates.

The economy has begun to recover from the pandemic but it will take many years for the unemployment rate to return to its pre-pandemic level. As a result, the Fed is likely to maintain near record-low interest rates for a considerable period. This bodes well for the stock price of CWT.

On the other hand, the market has already priced the benefit from low interest rates in the stock of CWT. Moreover, investors should pay special attention on the valuation of slow-growth stocks, such as utilities. If they overpay for a utility, it may take several years only to breakeven.

In this case, the downside risk of CWT is significant whenever the company faces an unforeseen headwind, such as poor rate hikes or rising interest rates. If CWT reverts to our assumed fair price-to-earnings ratio of 20.0 over the next five years, it would incur a 10.1% annualized drag in its returns. This could more than offset the positive returns of earnings-per-share growth and dividends.

Due to its lofty price, the stock is offering just a 1.8% dividend yield. It is also likely to grow its earnings per share at a 4.0% average annual rate over the next five years. Combined with a 10.1% annualized contraction of the price-to-earnings ratio, CWT is likely to offer a negative annual return of -4.0% over the next five years.

It appears that the market has fully appreciated the reliable earnings growth and the defensive nature of the stock, and as a result investors should wait for a meaningful correction before purchasing it.

Final Thoughts

CWT has exhibited an exceptional dividend growth record, thanks to its reliable earnings growth, which is secured by rate hikes that are approved by regulatory authorities. In addition, thanks to its healthy payout ratio and its solid business model, the company should easily continue raising its dividend at a mid-single-digit rate for many more years.

While CWT is a “boring” stock, it is exceptionally resilient during recessions. When most companies see their earnings collapse, CWT provides a safe haven to investors. Its resilience in the ongoing downturn caused by the pandemic is outstanding. While most companies have been severely hurt by the pandemic, CWT is on track to grow its earnings per share ~3% this year.

On the other hand, the market has fully appreciated all the virtues of this water utility stock. Due to its resilience and depressed interest rates right now, CWT is currently trading at a nearly decade-high P/E ratio. As a result, the stock is likely to offer poor returns in the long run. Potential headwinds include a lower-than-expected rate hike, or higher interest rates. As valuation is paramount in slow-growth stocks such as utilities, CWT is rated as a sell around its current price.

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