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Industry Analysis: Water Utility
The Water Utility Industry is made up of domestic companies responsible for the safe and timely distribution of water and other related services, such as wastewater treatment. Most water systems are local or regional, but some of the companies under our review have operations across many states.
Since water is an essential resource, it would be easy to assume that the stocks of these companies would be high fliers. Demand from the industrial, agricultural and residential markets is expanding and the supply of potable water is shrinking. Big earnings and share-price gains have not been the case, here, however. The industry is subject to regulation, which can raise service costs, while limiting rates and return on investment.
This sector is mature and capital intensive. Water utility stocks are not growth issues, but they do usually offer solid yields and regular dividend increases. Too, they are good holdings for capital preservation. Heavy infrastructure outlays have led to highly levered balance sheets, and the companies have had to carefully manage significant operating costs and interest expense to maintain attractive dividend payout ratios. This group of equities often gains popularity when economic times are especially harsh and the broader stock market is in a downturn. Operations are seasonal, with demand highest during the summer months. Periods of excessively dry or wet weather can cause near-term share-price volatility, but such swings are generally not dramatic.
Water utilities are tightly regulated. They fall under federal, state and municipal jurisdiction. The Food and Drug Administration tries to maintain the safety of drinking water and the federal legislature and courts work to ensure fair distribution of supplies among the states. State and local authorities also endeavor to assure water quality and protect consumer rights. Periodically, water utilities, seeking to earn a fair return on assets, submit general rate cases to state regulators. Rate hikes are sought to cover the cost of expanding and/or improving service. Also, hikes may be required to make system repairs, sometimes after unusual events cause damage. Regulators typically review the prevailing cost of borrowing, when determining allowed rates of return.
Utility authorities are generally inclined to grant reasonable returns; they don't want to be blamed for any service problems. They will allow variations in determining rates, including price caps and weather normalization formulas, for example, as long as customer bills do not become overly burdensome. It's important to note that in tough times, when state budgets are under pressure, the tax component of utility bills may rise, which could limit the profitability of a utility if it can't implement an offsetting rate increase. At times, heightened concerns about water safety, due to threats from aging systems, natural contamination and possibly terrorism, prompt authorities to beef up returns to keep water companies' operations and finances healthy. We emphasize, it's important that investors be aware of the regulatory climate within which a utility operates.
Like other domestic infrastructures, the nation's water system has suffered from a long period of underfunding. Many systems are over a hundred years old and require substantial upgrades, if not complete reconstruction. The FDA estimates that over the next couple of decades hundreds of millions of dollars will need to be invested to bring our water systems up to standard. Good working relationships with regulators are essential to secure adequate returns on required funding.
A point of investor interest in water utilities is an account called Allowance for Funds Used During Construction, or AFUDC. It is a non-cash credit, similar to capitalized interest, found on the income statement. It is based on the current cost of financing. Over time, this cost is recovered from ratepayers as depreciation rises. AFUDC % to Net Profit on the Value Line page enables investors to gauge the level of a company's investment in its system. A high percentage of AFUDC is commensurate with heavy capital outlays. During periods of elevated spending, it's common for outlays to temporarily exceed cash flow.
The Value Line page also presents investors with a water company's Long-Term Debt Ratio and Common Equity Ratio. This measure provides an indication of the financial health of a utility. Managements usually aim for about a 50/50 weighting of debt and equity. Regulators base rate-of-return ranges on the proportion of common equity.
Water utilities seek to enlarge operations either by way of merger and acquisition activity or by venturing into non-regulated markets. Large companies have the financial wherewithal to target for takeover the many small private or municipal entities scattered around the U.S. They benefit from greater economies of scale. Over the years, non-regulated businesses, such as telemarketing, construction management, public works and military services, and utility billing, have had mixed success. Many money-losing ventures had to be shuttered or divested. Managements have found that it's best to stay close to activities that are very similar to core operations. Still, profitable unregulated assets can lift actual returns on investment above those specified by utility authorities.
All said, water utility stocks are conservative holdings, providing a measure of stability and income, with modest risk, to investor portfolios.