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American States Water (NYSE:AWR) stock is not a good buy right now, in my opinion. In this article, I would like to explore some of the factors that affect the company’s growth prospects. One of these factors is the rate of population growth in California, which directly affects the number of AWR customers. Another important influencing factor is the increase in US military spending in the coming decade. In my opinion, this supports the business of AWR’s subsidiary American States Utility Services, Inc. (“ASUS”).
Business Overview
American State Water is the longest-running dividend king. To date, the dividend has been increased every consecutive year for 68 years. The company has three segments, namely Water, Electric and Contracted Services that contributed 69.3%, 8.1% and 22.6%, respectively, to total revenues for 2022.
The Water segment is represented by Golden State Water (“GSWC”), the Electric segment by Bear Valley Electric Service Inc and the Contracted Services segment by American States Utility Services, Inc. All of the above are subsidiaries of American States Water.
Golden State Water provides water services to 263,000 customers throughout California. Bear Valley Electric Service provides electricity to approximately 24,000 customers in and around the city of Big Bear Lake, San Bernardino County, California. The two aforementioned subsidiaries are regulated businesses whose rates are adjusted by state and local governments. A third subsidiary, ASUS, is somewhat different. ASUS currently provides operation, maintenance and construction management services for water and wastewater systems at 11 military bases across the country. Contracts are valid for 50 years and may be adjusted for inflation or other circumstances.
Thesis Explainers
California’s Population Growth Is Slowing
Since American States Water’s main business is in California, it is important to study the population processes in this state. The table below provides an overview of California’s population growth from 2000 to 2022. The table clearly shows that California’s population growth is slowing down. If in 2000 the increase was 2.54%, then in 2020 it was only 0.16%. In the years 2021-2022, the increase was even negative, probably due to the impact of Covid. So we can no longer talk about California’s population growth exceeding the US average.
| California – Historical Population Data | ||
|---|---|---|
| Year | Population | Growth Rate |
| 2022 | 39,029,342 | -0.29% |
| 2021 | 39,142,991 | -0.91% |
| 2020 | 39,501,653 | 0.16% |
| 2019 | 39,437,610 | 0.00% |
| 2018 | 39,437,463 | 0.25% |
| 2017 | 39,337,785 | 0.48% |
| 2016 | 39,149,186 | 0.63% |
| 2015 | 38,904,296 | 0.82% |
| 2014 | 38,586,706 | 0.87% |
| 2013 | 38,253,768 | 0.81% |
| 2012 | 37,944,551 | 0.82% |
| 2011 | 37,636,311 | 0.85% |
| 2010 | 37,319,550 | 0.97% |
| 2009 | 36,961,229 | 0.97% |
| 2008 | 36,604,337 | 0.98% |
| 2007 | 36,250,311 | 0.64% |
| 2006 | 36,021,202 | 0.54% |
| 2005 | 35,827,943 | 0.71% |
| 2004 | 35,574,576 | 0.91% |
| 2003 | 35,253,159 | 1.09% |
| 2002 | 34,871,843 | 1.14% |
| 2001 | 34,479,458 | 1.45% |
| 2000 | 33,987,977 | 2.54% |
source: https://www.macrotrends.net/states/california/population
At the same time, the recovery of the population is already noticeable. A recent U.S. Census estimate showed more than 125,000 new residents came to California last year after an uptick in people moving to the U.S. from abroad.
However, of more interest is the longer-term future forecast for California’s population. I mean what will happen in the next couple of decades. Below is the population forecast for the state of California until the year 2060.
| Year | 2024 | 2025 | 2026 | 2027 | 2028 | 2030 |
| California Population Projection | 40,574,215 | 40,808,001 | 41,028, |
41,245,009 |
41,456, 075 |
41,860,549 |
| Year | 2031 | 2032 | 2033 | 2034 | 2035 | 2036 |
| California Population Projection | 42,050,984 | 42,231, 577 | 42,403,084 |
42,565, 496 |
42,718,403 |
42,862,413 |
| 2037 | 2038 | 2039 | 2040 | 2050 | 2060 |
| 42,998,578 | 43,126,054 | 43,243,462 |
43,353,414 |
44,049,015 |
44,228,057 |
source: State of California Department of Finance
This forecast was made in 2019 and therefore does not include the impact of Covid. As we can see, the population of this state will grow quite slowly until 2040, and from there it will practically stop growing. Thus, until 2040, the annual population growth of California is only 0.61%. It cannot be said that such a low rate of population growth would particularly support American States Water and other regional companies. However, these are just predictions. Actual population processes may differ from this.
The Increase In Defense Spending Supports Subsidiary ASUS
ASUS, a subsidiary of American States Water, provides water and wastewater service to military bases throughout the United States. Last year, ASUS’s revenue was 22.6% of AWR’s total revenue. This subsidiary has growth potential. If in 2016 water service was offered to 9 military bases, today it has already been offered to 11. As the country’s defense spending increases, new military bases are built and existing ones are expanded, let’s take a look at the US defense spending trend and forecast for the next decade.
statista
Projection of US defense spending to 2033 source: statista
While US defense spending is $877 billion this year, it is projected to reach $1.105 trillion by 2033. The CAGR is therefore 2.34%. My personal opinion is that by 2033, US defense spending will be even higher than $1.105 trillion, as the tense situation around the world gives reason for it. In order to obtain new long-term water service contracts, ASUS must win the lowest bid tender. For this, it has to compete with other water service companies. One of the biggest competitors is, for example, American Water Military Services Group, a subsidiary of American Water Works Company (NYSE:AWK). The latter provides water service to 18 US military facilities.
Next, let’s take a look at how ASUS’ share in American States Water Company has changed over the past decade. The following table provides an overview of AWR’s diluted earnings per share and the share of ASUS within it.
|
Year |
2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 |
|
AWR total |
1.61 | 1.57 | 1.60 | 1.62 | 1.88 | 1.72 | 2.28 | 2.33 |
|
Contracted services (ASUS) segment |
0.30 | 0.31 | 0.32 | 0.33 | 0.37 | 0.42 | 0.47 | 0.47 |
| ASUS share of total profit | 18.63% | 19.75% | 20% | 20.37% | 19.68% | 24.41% | 20.61% | 20.17% |
AWR and ASUS diluted EPS source: AWR Annual Reports 2013-2022
|
Year |
2021 | 2022 |
|
AWR total |
2.55 | 2.11 |
| Contracted services segment | 0.48 | 0.46 |
| ASUS`share of total profit | 18.82% | 21.80% |
It can be noticed that in the period 2013-2018, the share of ASUS has continuously increased. If in 2013 ASUS provided 18.63% of the parent company’s diluted earnings per share, in 2018 its share was already 24.41%. In recent years, this share has not increased. Whether ASUS can continue to grow in the future is very important to the parent company. ASUS is a significant contributor to AWR’s ability to grow its dividend by at least 7% annually. The company has announced a policy to achieve a compound annual growth rate in the dividend of more than 7% over the long term.
Changes in sales and profit numbers
Sales and profit numbers for the first quarter of 2023 were affected by the California Public Utilities Commission’s decision to retroactively increase water rates starting January 1, 2022.
| Period End | EPS | Forecast | Revenue | Forecast |
| 03/23 | 0.93 | 0.51 | 161.4 M | 113 M |
AWR Q1 2023 Results source: investing.com
Updated water tariffs were approved for the years 2022-2024. At the same time the settlement agreement authorizes nearly $405 million in capital investment.
A 3-year time period for tariff renewal is quite common for water service companies. Therefore, the next tariff renewal can be expected in 2025.
| American States Water Annual Revenue(Millions of US $) | |
|---|---|
| 2022 | $492 |
| 2021 | $499 |
| 2020 | $488 |
| 2019 | $474 |
| 2018 | $437 |
| 2017 | $441 |
| 2016 | $436 |
| 2015 | $459 |
| 2014 | $466 |
| 2013 | $472 |
| 2012 | $467 |
source: macrotrends
As can be seen from the table, sales have been practically at the same level in 2020-2022. However, this year will bring significantly higher sales due to the increase in water tariffs. The years 2013-2018 were a period of declining sales, until finally in 2019, sales made a significant increase as a result of tariff increases. However, long-term 10-year sales have only increased by 1.47% annually.
Let’s look at the change in profit numbers below.
| American States Water Annual EPS | |
|---|---|
| 2022 | $2.11 |
| 2021 | $2.55 |
| 2020 | $2.33 |
| 2019 | $2.28 |
| 2018 | $1.72 |
| 2017 | $1.88 |
| 2016 | $1.62 |
| 2015 | $1.60 |
| 2014 | $1.57 |
| 2013 | $1.61 |
source: macrotrends
In the last 10 years, there have been only 3 such years when EPS has decreased. In my opinion, this confirms that the company has been well managed. This is especially so in conditions where sales have shown weak results in some periods.
AWR’s balance sheet is in a satisfactory state. The value of total assets is $2.060 billion. Total liabilities are $1.329 billion and equity is $730.8 million.
Sustainability Of Dividend Growth
For most investors, AWR is primarily a company that offers growing dividends every year. Growing profits are a prerequisite for growing dividends. Is the company’s profit growth of at least 7% per year realistic? Let’s look at past data first.
|
Name |
YoY |
3Y |
5Y |
10Y |
|---|---|---|---|---|
|
Revenue |
11.02% |
4.20% |
4.52% |
1.47% |
|
EBITDA |
12.03% |
6.46% |
5.88% |
2.49% |
|
Operation Income (EBIT) |
13.70% |
5.94% |
7.14% |
3.23% |
|
Net Income |
10.53% |
4.86% |
7.90% |
5.55% |
|
Normalized Net Income |
9.15% |
5.14% |
6.91% |
3.02% |
|
Earnings from cont. Ops |
10.53% |
4.86% |
7.90% |
5.55% |
|
EPS (Diluted) |
10.44% |
4.80% |
7.83% |
5.96% |
|
Tangible Book Value |
6.33% |
6.54% |
6.59% |
4.71% |
|
Total Assets |
7.65% |
7.45% |
7.67% |
4.80% |
American States Water Compound Annual Growth Rates, source: Seeking Alpha
The last year’s data give us an excessively optimistic picture, since the retroactive increase in water tariffs is also taken into account here. At the same time, the data of the last 3 years is probably influenced by the fact that the company has made significant investments in the renovation of its infrastructure during this period. However, this was during the validity of the former water tariffs. I think that we can get the most objective picture by looking at longer periods (5 or 10 years).
The average earnings growth over the last 5 years (7.83%) and the last 10 years (5.96%) gives hope that a 7% dividend growth rate is realistic. However, American States Water’s sales growth numbers are more modest, and this is a sign of danger. Therefore, the results of the subsidiary ASUS, which has shown good growth in the past, are very important for AWR.
But let’s look at the diluted earnings per share growth forecast offered by analysts.
| AWR | Sector Median |
AWR 5 Y Avg. |
|
|
EPS Diluted Growth (FWD) |
4.95% | 4.48% | 6.89% |
American States Water Diluted EPS Growth (FWD), source: Seeking Alpha
Given the next 5-year diluted earnings per share growth of 6.89%, it is almost realistic to increase the dividend by 7% per year based on this growth rate.
AWR debt equity ratio (fullratio)
AWR Debt vs. equity 2013-2022 source: fullratio.com
From 2017 to today, there is a noticeable increase in the ratio of debt to equity. If 6 years ago this ratio was 0.72, today it has risen to 1.08. In my opinion, this is a sign of weakening financial health of the company. At the same time, nothing is too bad at the moment.
AWR’s dividend payout ratio is slightly below average compared to its peers. The average dividend payout ratio of the entire group is 61.3%.
| AWR | CWT | SJW | MSEX | YORW | ARTNA |
| 59.22% | 75.37% | 54.89% | 59.36% | 58.04% | 60.92% |
Dividend payout rate of water service companies, source: Seeking Alpha
Valuation
Valuation is probably American States Water’s weakest point. I use Graham’s model to determine the intrinsic value of AWR. I assume that the company’s profit growth for the next 7-10 years will be 7% and the next year’s profit will be $2.86. Plugging these numbers into the formula, AWR currently has an intrinsic value of $64.35.
2.86 x (8.5+ 2 x 7)= $64.35
Let’s also try to find the valuation of the company based on DCF. Since the change in water tariffs in the last quarter would give a slightly distorted picture, I will use the data from 2022 here.
| Free Cash Flow | $78,400,000 |
| Total Cash | $ 6,000,000 |
| Total Debt | $734,400,000 |
| Shares Outstanding | 37,000,000 |
| Expected Growth Rate | 7% |
| Growth stage duration | 10 years |
| Terminal Growth Rate | 2% |
| Terminal stage duration | 5 years |
By entering this data into the DCF calculator at a discount rate of 8%, we get an intrinsic value of $66.00.This is quite similar to the valuation obtained from Graham’s model. At a 9% discount rate, the intrinsic value of AWR would be only $55.1
We can get a somewhat more optimistic result by using the average P/E ratio of the last 10 years and the projected profit for the next year. The average P/E ratio for the period 2013-2022 was 28.8. Given a forward-looking EPS of $2.86, we get a price target for AWR of $82.36.
2.86 x 28.8= 82.36
However, I consider the intrinsic value of $64.35 as a result of the first calculation to be more realistic because we are currently living in a high interest rate environment. Therefore, the share of American States Water is currently significantly overvalued.
Risks
As the biggest risk for American States Water, I see a significant decline in the stock price as prices and ratios move toward their historical averages in the long term. At the same time, according to my understanding, it is a very stable business, whose subsidiary ASUS is additionally supported by the increase in US military spending. If the company is not able to grow profits by approximately 7% per year in the long term, there is also a risk that the announced annual dividend growth of at least 7% is not realistic. At the moment, however, I do not see the realization of the last-named risk.
One risk factor for AWR is the obligation to ensure the quality of drinking water. If for some reason it cannot be fulfilled, then a large-scale fine or even restrictions on the water supply license may follow. If systemic drinking water quality problems should arise in some of the military bases served by ASUS, it would be quite difficult for this subsidiary to obtain new service contracts in the future.
American States Water’s business may also be affected by climate change. Prolonged periods of drought can cause the quality of drinking water to deteriorate and increase the price of water purchased from water wholesalers. If at first glance it might seem that the higher price of water is beneficial to AWR as a water service provider, this is not the case. In fact, the high price of water purchased from wholesalers reduces AWR’s profit margin because the company resells drinking water to its customers based on a set tariff.
There are also upside risks for short sellers. If, for some reason, California’s population were to grow at a faster rate than projected, it would significantly increase American States Water’s profits and probably boost its stock price in the long run.
Conclusion
A future decline in California’s population growth will not bode well for American States Water’s business. At the same time, the growth of US military spending in the coming decade is a positive factor for AWR’s subsidiary ASUS. The company is likely to be able to deliver on the announced annual dividend growth of at least 7%. Given subsidiary ASUS’ growth potential, I rate American States Water a hold.
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