Pennsylvania-based Essential Utilities (New York stock market :WTRG), formerly trading as Aqua America, is the second most profitable and publicly traded U.S. water utility, now also offering diversification in the form of a growing natural gas business acquired in 2020. Aqua, sound water division, serves more than three million people in eight states (IL, IN, NC, NJ, OH, PA, TX, VA) and Peoples, its gas arm, serves more than two million people in three states of Rust Belt (PA, WV, KY).
(Always) a safe haven in uncertain times
While the Utilities sector has taken a hit and become quite volatile lately due to rapidly rising interest rates and changing Fed projections, I think it’s important to zoom out and to take stock of the underlying fundamentals and long-term stability of companies like Essential Utilities in order to view this moment as an opportunity to add to your defensive holdings at a historic discount.
Similar to some of my other favorite utilities like Casella Waste Systems (CWST) and American Water Works (AWK), Essential Utilities employs a slow-growth-by-acquisition business model, having gradually expanded west and south of its main metropolitan Philadelphia market over the decades by acquiring hundreds of smaller local utilities.
Its recent $4.3 billion acquisition of Peoples Natural Gas – Pennsylvania’s largest natural gas distribution company – also brought it to Pittsburgh, but most of the company’s growing geographic footprint spans smaller suburban and rural areas with favorable regulatory environments and FMV (Fair Market Value) legislation, which allows municipalities to sell water and wastewater systems to larger utility operators like Essential at lower prices lower.
Notably, three other states that have enacted GMF legislation (IA, MO, TN) border Essential’s current footprint and could allow them to expand further west and south in the coming years. Nonetheless, investors should be aware that they are primarily buying a Pennsylvania utility, with over 75% of WTRG’s rate base located in the state.
Water with kicker gas and risk
Perhaps one of the most attractive features of WTRG is that, unlike other water utilities, it has taken a prescient step into delivering natural gas at a natural gas price at its lowest since almost 20 years. In retrospect, the timing of the Peoples deal couldn’t have been better, and it marked a new era for the company, with natural gas now accounting for more than 30% of the revenue and infrastructure investment mix. of the company.
As the world now competes for natural gas resources and domestic investment and political support for natural gas infrastructure grows, I believe management can achieve its goal of a higher annual growth rate of 8-10% for its natural gas segment through 2024 compared to its 6-7% CAGR target for its water business. Given Essential’s forecast EPS growth of 5-7%, higher gas growth should allow the company to maintain its 7% dividend growth rate while remaining below its payout rate cap maximum of 65% (currently at 63%), especially since their efforts to expand sewage in the PA have suffered some setbacks in recent years.
That brings us to the main investment risk, which I believe is the difficulty Essential had in closing two major wastewater acquisitions in the counties around Philadelphia, particularly because wastewater in particular is the company’s main growth objective. While 2021 marked a below-average year of new water customer additions at just 7.7k (note that “customers” refers to households, not people), Essential has already added over 20k new customers in 2022 and has signed agreements for nearly 200k more, the vast majority of which is expected to come from the DELCORA plant, which provides wastewater treatment for Delaware Country, PA. The problem is that the conclusion of the DELCORA deal, originally signed in 2019, is by no means a certainty and looks murkier by the day.
County-level policy in Pennsylvania is convoluted to say the least, but the deal remains in limbo between the local county council, which voted to close the plant completely, and Aqua, which has a binding purchase agreement. Without going too far into the weeds, I personally believe that a financial settlement in favor of Essential is the most likely, with a lower chance of the original deal being honored. Either way, I think investors would be wise to keep the 200,000 DELCORA customers out of Essential’s projections to avoid disappointment if the deal falls through, although they may see money in the event of regulation.
At $276.5 million, the DELCORA deal won’t make or break the company’s fortunes, but it does raise questions about its ability to expand further in the greater Philadelphia area. This echoes Aqua’s last failed bid of $1.1 billion for sewage treatment assets in neighboring Bucks County, which was ultimately rejected largely due to local voter animosity. in the face of what they saw as exorbitant sewage rate increases awarded to Aqua by the AP’s Public Utilities Commission. Fortunately, Bucks County customers were never included in Essential’s projections, so it didn’t lead to any revisions to their outlook as a negative outcome would for DELCORA’s assets.
Look back, look forward
Although not indicative of future performance, the historical chart of the WTRG is extremely impressive. Founded in 1886, it has paid an increasing dividend since 1981, making it a dividend aristocrat and quite possibly a future dividend king. Since 1988, WTRG has generated a total return CAGR of 12.85% versus 10.25% for the S&P 500, which has more than doubled the total return of the S&P over the past 35 years with significantly less volatility and a rock-solid dividend growth.
Similarly, WTRG’s historic return chart may look ominous at first in a rising rate environment since the stock has fallen as much as 8% in the past, but a bit like my recent analysis of AWK we can see that the reason for its steadily declining yield is the strong appreciation in the share price which has almost doubled the CAGR of its dividend – in other words, it’s a problem we want to have .
As the chart in this article shows, WTRG is still trading at a significant discount to its 5-year average PE ratio (25.9x vs. 35.1x) while offering the highest yield among utilities. water. Additionally, WTRG boasts one of the highest dividend CAGRs in the sub-industry at 7% over the past 5 years. If the company can maintain this rate, investing at the current yield of 2.64% would yield a cost return of 5.19% over 10 years. This is in line with the current projected federal funds rate and should protect the stock from further rate-driven declines if these projections hold.
To me, this shows that the company has done an excellent job of maintaining both overall growth and dividend growth in a variety of challenging market conditions such as those we are currently facing. The higher expected growth of its new gas distribution business should help it meet its revenue, EPS and dividend growth targets over the next few years, even if its planned acquisition of DELCORA fails or results in a settlement. financial, and management is pursuing numerous other transactions that should help maintain their customer growth target of 2-3% per year despite recent setbacks in sewage expansion.
Without minimizing these risks, in terms of SWAN defensive stocks, I’d say Essential belongs to the top blue chip names like McDonald’s (MCD) and PepsiCo (DYNAMISM) in any DGI wallet. While it may be prudent for cautious investors to wait for the DELCORA sale to be resolved, I believe the company’s current valuation is compelling enough to recommend a cost average at these prices and add any other weakness.