Stock Idea...Essential Utilities Inc. (NYSE: WTRG)
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Company Profile
Essential Utilities Inc., formerly Aqua America, Inc. is a publicly traded water and wastewater utility holding company with operating subsidiaries serving approximately five million people in Pennsylvania, Ohio, North Carolina, Illinois, Texas, New Jersey, Indiana, Kentucky, West Virginia and Virginia. In addition to its water/wastewater utilities, the company purchased a natural gas utility in March of 2020. The combined company has roughly 2,000 employees. The company has a long record (75 years) of paying dividends.
Investment Thesis
BUY-rated Essential Utilities Inc. (NYSE: WTRG) has a solid business model, a history of steady earnings growth, and a growing dividend. We think the company will continue to provide shareholders with solid risk-adjusted returns. Essential stands to benefit from aging water infrastructure that, according to many industry observers, will soon require substantial investment. In 2019, EPA Chief Andrew Wheeler projected that $700 billion would be needed over the next 20 years to upgrade/overhaul water infrastructure. In August 2020, the American Society of Civil Engineers released a report detailing chronic underinvestment in drinking water and wastewater systems. The report highlighted the difficulties plaguing legacy systems, with many treatment facilities nearing the end of their design lives of 75-100 years. Looking ahead, we expect Essential Utilities to benefit from both new investment in water infrastructure and upgrades of existing systems.
In addition, Essential expects to grow its customer base. Essential has operations in states such as North Carolina and Texas, where population growth is above the national average. The company also benefits from an experienced management team and balanced rate regulation. Our 12-month price target is $55, raised from $50.
Recent Developments
On November 3, the company reported 3Q adjusted EPS of $0.23, in line with the consensus forecast but down from $0.38 in 3Q19. On a GAAP basis, EPS fell to $0.22 from $0.38 in 3Q19, as higher costs weighed on margins. Revenue rose 43% to $348.6 million. The Peoples natural gas utility, acquired in March 2020, contributed substantially all of the revenue growth.
In a transformative deal, which closed in 1Q20, the company acquired Peoples, a natural gas distribution utility, for $4.2 billion in cash, including the assumption of $1.3 billion in debt. (The Canada Pension Plan invested $750 million into the company to help it close the deal.) Peoples serves about 740,000 customers in Pennsylvania, Kentucky, and West Virginia.
Along with the 3Q earnings release, management reiterated its 2020 guidance calling for adjusted EPS of $1.53-$1.58, but shaded its guidance toward the high end of that range. The guidance assumes compound annual earnings growth of 5%-7% through 2022; infrastructure investments of $2.8 billion through 2022 to strengthen water, wastewater, and natural gas systems; and total customer growth of 2%-3% per year in the regulated water segment, dependent on regulatory approval.
Earnings & Growth Analysis
The company's top-line growth is driven by acquisitions, volume increases, and rate increases. In 3Q20, revenue rose substantially due to the March 2020 acquisition of Peoples. Excluding the impact of the acquisition, revenue rose 5.3%. The growth in water utility revenue reflected higher residential water usage, partially offset by lower usage from commercial and industrial customers.
On the regulatory front, to date in 2020, Essential's regulated water segment has received rate awards or infrastructure surcharges in Illinois, Indiana, North Carolina, Ohio, Virginia and Pennsylvania that total an estimated $21.0 million in additionally annualized revenue. The company currently has proceedings pending in Indiana, New Jersey, Virginia and Ohio for its regulated water segment that would add $2.8 million in incremental revenue. Additionally, Essential's regulated natural gas segment has received rate awards or infrastructure surcharges in Kentucky and Pennsylvania totaling an estimated $1.0 million in annualized revenue. Below the top line, O&M expense in 3Q20 increased 66.1% from 3Q19 due to Peoples O&M, partially offset by realized transaction and integration synergies.
Turning to our estimates, we are raising our 2020 adjusted EPS estimate to $1.58 from $1.55, in line with management's guidance. Our 2020 estimate implies growth of 7% from an adjusted $1.47 in 2019. We think the company will control costs and improve the efficiency of acquired assets, invest in infrastructure projects, and grow its customer base both organically and through acquisitions.
The company plans to invest $950 million in gas and water infrastructure in 2020, following investments of $550 million in water infrastructure in 2019. WTRG will use the funds to replace pipes and strengthen service reliability, among other projects. We look for continued growth in 2021 and are raising our adjusted EPS forecast to $1.66 from $1.64.
Financial Strength & Dividend
Our financial strength rating for Essential Utilities is Medium, the midpoint on our five-point scale. Our three main criteria include debt levels, fixed-cost coverage and profitability. Moody's rates the company's debt at Baa2 with a stable outlook and S&P rates the company an A.
WTRG had $9.3 million in cash and $5.4 billion in debt at the end of 3Q20. The company's total debt/total capitalization ratio was 53%. On April 13, the company completed a $1.1 billion public debt offering, with $500 million of 10-year notes issued at 2.7% and $600 million of 30-year notes issued at 3.3%, for a weighted-average maturity of 20.9 years and a weighted-average coupon of 3.0%. On April 14, the company priced $175 million of first mortgage bonds for Aqua Pennsylvania. The proceeds were used to pay off short-term borrowings and to fund an acquisition.
As of May 1, after considering the effects of these financings, the company had $1.1 billion in borrowing capacity on various credit facilities. On August 4, the Essential Utilities board approved a dividend hike. The quarterly cash dividend is now $0.2507, up from $0.2343. The annual distribution of roughly $1.00 yields about 2.1%. WTRG has grown its dividend at a 7% average annual rate over the last five years. It has paid consecutive quarterly dividends for 75 years, and has raised the dividend 30 times in the past 29 years. Our 2020 dividend estimate is $0.97 and our 2021 estimate is $1.04.
Management & Risks
Christopher Franklin has been the company's CEO since July 2015. Mr. Franklin is a 25-year company veteran, and previously served as president and COO of its regulated operations. The COO is Richard Fox, who has served in the role since 2015, and the CFO is Daniel J. Schuller, who has been in the position since 2018. In August 2020, management announced that Mike Huwar would succeed Joe Gregorini as president of Peoples. Mr. Huwar has more than 30 years of industry experience and an established reputation with Pennsylvania regulators.
The U.S. water industry is fragmented, with more than 53,000 individual water systems. Many of these systems cannot afford to meet the EPA's increasingly stringent standards, and have put themselves up for sale. Several companies have even sought to be acquired by Essential Utilities. The range of acquisition targets has also grown as cash-strapped municipalities look to monetize their utility assets. We believe that WTRG will be able to acquire additional municipal water systems in the coming years as cities look to raise cash to deal with COVID fallouts, such as increased unemployment. Key risks for water utilities include the effect of adverse weather on revenues, regulatory issues (especially related to construction cost recovery), and potential environmental and safety-related liabilities. In addition, the utility's heavy capital needs create ongoing liquidity risk.
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Analysis by Angus Kelleher-Ferguson, December 11, 2020,
(Edited Argus Report)
©2020 Argus Research Company
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Postscript
It might be a good idea for growth investors to consider buying Essential Utilities either before the announcement of 4Q20 results on February 24, 2021, or sometime in the third quarter of 2021 at a point of lower natural gas demand and revenues, and thus potentially lower stock price.
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