Inside Wall Street: An Interesting Play in the Water Business

Would you believe that investors are down on water?

Even as water – especially the bottled brands – appears to be the drink du jour everywhere, and with Wall Street high on water companies, the bulk of investors aren't hankering for water stocks. Shares of water utility companies have been perennial market laggards, mainly because of rising infrastructure and financing costs. The industry has continued to rank near the bottom of Value Line's Investment Survey for timeliness. Not a single stock stands out, says Value Line analyst Andre J. Constanza, for appreciation potential for either the coming six to 12 months, or over the next there to five years.

However, there may be one exception to the rule: American Water Works (AWK), the largest investor-owned U.S. water and wastewater utility that provides services to 15 million people, as well as commercial and industrial customers, in 32 states and Canada. Costanza says it has "interesting prospects," although Value Line doesn't include it in its ranking for timeliness or "price stability score" because of its short trading history. It went public in 2008, and currently trades on the Big Board at $21 a share. Ironically for Wall Street, it is one of the few stocks that have withstood the market onslaught, still trading close to its 52-week high of $23. A year ago, the stock was trading at a 52-week low of $18.70 a share.

An Infrastructure Play

To some savvy investors, American Water isn't just about providing water services. "American Water is attractive based on its 4% dividend yield and its management's focus on improving returns to shareholders," says Peter A. Zuger, portfolio manager at Lee Munder Capital Group, which owns shares. A lot of the water infrastructure systems are aging and needs vast improvements, he notes, which assures companies like American Water of sustained sales and earnings. "Higher returns combined with a large rate base as the water infrastructure is renewed support earnings and dividend growth," says Zuger

American Water's stock, he says, is undervalued since it is trading below its historic average annual price-earnings ratio of 20. Its current PE ratio is 15, based on earnings estimate for 2010 of $1.45. He sees earnings rising to $1.70 next year. The company earned $1.25 last year.

The company's regulated utilities, which involves ownership of regulated water and wastewater utilities for residential, commercial and industrial customers, generated revenues last year of $2.2 billion, or about 90% of total revenues. They are subject to economic regulation by the Public Utility Commission. The non-regulated operations include contract operations, waste management, and homeowners services.

The water business, despite its unpopularity among investors, is actually a conservative type of business that should appeal to prudent investors. "We regard American Water as a high quality conservative utility with unique growth opportunities," says Tim Winter, analyst at Gabelli & Co., who rates the stock a buy. The stock, he adds, is relatively inexpensive when compared to other publicly traded water utilities.

Improving Outlook

Management raised its earnings guidance for 2010 to $1.42-$1.52 a share from its previous $1.33-$1.40, based on a solid second quarter results. So Walter Liptak, analyst at Barrington Research, raised his 2010 profit forecast to $1.50 a share from $1.39, and also boosted his 2011 estimate to $1.65 from $1.59. Rating the stock as outperform, he sees the stock rising to $25 in 12 months.

Of the 19 analysts who track American Water, 13 recommend buying the stock and six rate it a hold. None rate the stock a sell. The bulls' price targets for the stock range from $23 to $31 a share.

Right now, the large institutional investors are among the top buyers of the stock, including J.P. MorganChase, which owns a 5.87% stake. The individual investor isn't yet as high on water stocks, but that could quickly change. In the current volatile market environment, investors are getting more inclined towards a stock paying an attractive dividend yield plus decent growth prospects, like American Water.