American Water Works Company, Inc. (AWK), Large Cap AI Study of the Week

April 15, 2024

Weekly AI Pick from the S&P 500

Company Overview

American Water Works Company, Inc. (AWK) is the largest publicly-traded water and wastewater utility in the United States, servicing over 14 million people across 24 states. The company's primary business is regulated utilities, accounting for 93% of its $3,920 million operating revenue in 2023. AWK has a substantial capital investment plan of $34-$38 billion for the next decade to upgrade infrastructure, which is regulated by Public Utility Commissions to ensure fair customer and investor interests. The company's growth strategy includes acquiring water and wastewater systems to improve operational efficiencies and has recently sold its New York operations for $608 million, focusing on compliance with water infrastructure regulations.

AWK operates in the water and wastewater sectors, providing services that are critical to maintaining public health and safety, including cybersecurity and inspection programs. The company's regulated subsidiaries benefit from legislation that allows for private investment in public systems and promotes fair market value assessments. AWK faces minimal direct competition due to high industry entry barriers but competes with government entities and other utilities in acquisitions. The company is proactive in managing water supply risks through long-term planning and has invested in projects like desalination plants to combat droughts.

Revenue peaks in the third quarter due to increased water usage, with mechanisms in place to stabilize revenue against seasonal changes. AWK supports water affordability and expects average rate increases of 5-6% annually. The company's Other segment, including the Military Services Group, generated $314 million in operating revenues in 2023, and AWK recently divested its Homeowner Services Group for about $1.275 billion.

AWK operates in a heavily regulated environment and competes with firms like American States Water Company and Veolia Environnement S.A. The company is subject to stringent environmental, health, safety, and water quality standards under laws like the Safe Drinking Water Act and the Clean Water Act. To comply with these regulations, AWK plans to invest about $900 million over five years, with $200 million earmarked for 2024. Despite the significant costs of compliance, AWK is confident these can be recouped through the regulatory rate-setting process.

By the Numbers

Certainly, here's a numerical assessment highlighting key figures and changes from the annual and quarterly reports of American Water Works Company, Inc. (AWK):

Annual 10-K Report Summary (Year Ending December 31, 2023):

• Operating revenues: $4.234 billion (up from $3.792 billion in 2022)
• Net income attributable to common shareholders: $944 million (up from $820 million in 2022)
• Earnings per diluted share: $4.90 (up from $4.51 in 2022)
• Infrastructure investment: $2.7 billion in the reported year
• Planned infrastructure investment: $16-$17 billion over the next five years; $34-$38 billion over the next decade
• Adjusted regulated O&M efficiency ratio: 32.8% (down from 33.7% in 2022)
• Rate case revenue increases: Virginia ($11 million), Pennsylvania ($138 million), Illinois ($67 million)
• Proposed revenue increase for the test year 2024: $37 million
• Infrastructure surcharges: Additional $86 million in annualized revenue for 2023; expected $31 million more in 2024
• Regulated business operating revenues increase: $415 million in 2023
• Operation and maintenance costs increase: $96 million in 2023
• Net income attributable to common shareholders in regulated business: $971 million

Quarterly 10-Q Report Summary (First Nine Months of 2023):

• Diluted earnings per share (EPS): $4.03 (up from $3.70 year over year)
• Investment in infrastructure: $1.8 billion of a planned $2.9 billion for the year
• Customer growth: Approximately 22,100 new customers added
• Total regulated operation and maintenance expenses: $1,397 million (up from $1,332 million in 2022)
• Adjusted operating revenues for regulated businesses: $3,737 million (up from $3,413 million in 2022)
• Adjusted regulated O&M efficiency ratio: 32.6% (improved from 33.6%)
• Annualized incremental revenue from rate cases: $273 million
• Consolidated operating revenues for Q3 2023: $1,167 million (up from $1,082 million year-over-year)
• Net income attributable to common shareholders for Q3 2023: $323 million (up from $297 million year-over-year)
• Operating revenues for Regulated Businesses segment in Q3 2023: $1,095 million (up from $1,003 million in Q2 2022)
• Operating revenues for Regulated Businesses segment for nine months ended September 30, 2023: $2,960 million (up from $2,646 million in 2022)
• Valuation of Cal Am's Monterey system assets: Approximately $513 million

These figures reflect AWK's financial growth, increased revenues from rate cases, and significant investments in infrastructure, despite facing regulatory challenges and increased costs.

Stock Performance and Technical Analysis

Starting with the stock's price relative to its 52-week range, the fact that it is trading at the same level as its 52-week low with no gains implies potential undervaluation or underlying issues within the company or sector. However, being 23 percent below its 52-week high could also suggest that there is room for recovery if the market sentiment shifts or if the company demonstrates improved performance or potential for growth. The stock has shown relative stability over the past month, which could be a sign of consolidation before a move in either direction, but the 7.36% drop over the past three months indicates that there has been some recent bearish sentiment.

Volume analysis shows that recent daily volume is higher than the longer-term average, which could signify increased investor interest or volatility. This could be due to a number of factors, including earnings releases, sector movements, or market-wide events. The Money Flow indicators suggest that the stock is under moderate selling pressure, which could be a sign that investors are taking profits or reducing their positions. However, the indication of accumulation suggests that some investors may be seeing value at the current levels and are starting to build positions.

The MACD (Moving Average Convergence Divergence) being bearish at -0.32 indicates that in the short term, the stock has been losing momentum and could suggest a continuing downtrend unless there's a positive catalyst. However, the RSI (Relative Strength Index) indicates that the stock is neither overbought nor oversold, which may imply that while there has been selling pressure, it hasn't been to extremes that typically precede a reversal.

In summary, the technical analysis presents a stock at a potential inflection point. The proximity to its 52-week low, combined with signs of accumulation, could present a buying opportunity if one believes in the company's fundamentals and potential for a turnaround. However, the bearish MACD and the recent downtrend necessitate caution. It would be prudent to look for additional fundamental analysis and possibly a technical confirmation of a trend reversal before making an investment decision.

The ‘Bull’ Perspective

Investing in American Water Works (AWK): A Resilient Utility Poised for Growth

Key Takeaways:

1. Robust Financial Performance: AWK reported a strong increase in EPS from $3.70 to $4.03 year over year, with adjusted operating revenues for regulated businesses rising from $3,413 million to $3,737 million.
2. Strategic Capital Investments: The company is on track with its $2.9 billion investment plan for the year, enhancing infrastructure and customer base growth, adding approximately 22,100 customers.
3. Regulatory Environment Adaptation: Despite regulatory challenges, including potential PFAS-related costs, AWK is actively engaging in cost recovery litigation and policy advocacy.
4. Rate Case Authorizations: Rate case authorizations across various states are expected to contribute an annualized incremental revenue of $273 million, demonstrating regulatory recognition of AWK’s capital investments.
5. Resilience Against Market Volatility: With a focus on essential services and a diversified customer base, AWK’s business model provides stability against economic downturns and market fluctuations.

Elaboration on Key Takeaways:

1. Robust Financial Performance:
   American Water Works has demonstrated a solid financial trajectory, with its EPS increasing to $4.03 from $3.70 year over year. This growth is a testament to the company's ability to effectively manage costs and implement new rates to support its capital and acquisition investments. The rise in adjusted operating revenues from $3,413 million to $3,737 million further underscores the company's expanding business operations and ability to generate higher revenues despite increased production costs and inflationary pressures. This financial strength positions AWK favorably for continued investment in infrastructure and services, which is critical for long-term value creation for shareholders.
2. Strategic Capital Investments:
   AWK's commitment to investing $2.9 billion for the year in infrastructure improvements and regulated acquisitions is a clear indicator of its growth-oriented strategy. By adding approximately 22,100 customers through these investments, the company is not only expanding its revenue base but also ensuring the sustainability of its operations. These strategic capital investments are essential for maintaining and upgrading aging water and wastewater infrastructure, thereby enhancing service reliability and regulatory compliance, which are key drivers of customer satisfaction and, ultimately, shareholder returns.
3. Regulatory Environment Adaptation:
   The regulatory environment presents both challenges and opportunities for AWK. The company's proactive stance in addressing the potential $1 billion capital expenditure for PFAS regulations through litigation and policy advocacy is a strategic move to protect its financial interests and customer base. By fighting to recover costs related to PFAS contamination, AWK is working to mitigate the impact of these regulatory hurdles on its bottom line and maintain its reputation as a responsible and responsive utility provider.
4. Rate Case Authorizations:
   Rate case authorizations are a critical component of AWK's financial health, as they allow the company to recover the costs of infrastructure investments and operational expenses. The expected annualized incremental revenue of $273 million from various state authorizations reflects the confidence that regulators have in AWK's business model and investment strategy. This revenue stream will support the company's ongoing capital projects and contribute to its overall financial stability, making it an attractive investment for those seeking steady growth and reliable returns.
5. Resilience Against Market Volatility:
   In the face of economic uncertainty and market volatility, AWK's focus on providing essential water and wastewater services offers a defensive investment opportunity. The company's diversified customer base across residential, commercial, and industrial sectors ensures a steady demand for its services, regardless of economic conditions. This resilience is a key differentiator for AWK, as it reduces the company's exposure to market fluctuations and positions it as a stable investment option for long-term investors seeking to balance their portfolios with stocks that have a lower correlation to the broader market trends.

In conclusion, American Water Works represents a compelling investment opportunity for those seeking a combination of steady growth, financial resilience, and strategic positioning in the essential services sector. The company's robust financial performance, strategic capital investments, adept handling of the regulatory environment, favorable rate case authorizations, and inherent stability against market volatility collectively make a strong case for considering AWK as a valuable addition to any investment portfolio.

The ‘Bear’ Perspective

The Case Against Investing in American Water Works Company, Inc. (AWK)

Upfront Summary:

1. Regulatory Risks and Rate Hike Approvals: AWK faces significant regulatory risks, with approvals for rate hikes being highly uncertain, potentially impacting profitability and liquidity.
2. Environmental and Compliance Costs: Emerging contaminants and stringent regulations could lead to increased operational expenses, affecting the company's bottom line.
3. Capital Expenditure and Infrastructure Vulnerability: The company requires substantial capital for infrastructure maintenance, and any funding difficulties or project delays could harm finances.
4. Seasonal Variability and Water Supply Challenges: Seasonal variability affects revenue, and water supply issues due to climate change or contamination could disrupt services.
5. Acquisition Risks and Competition: AWK's growth strategy through acquisitions is fraught with risks from increased competition and industry consolidation, potentially leading to unexpected costs and operational issues.

Elaboration on Key Points:

1. Regulatory Risks and Rate Hike Approvals:
   AWK's ability to adjust rates and recover costs is at the mercy of Public Utility Commissions (PUCs), which significantly influence the company's profitability and liquidity. The uncertainty surrounding rate hike approvals is a major concern for investors. For instance, if AWK invests $1 billion in infrastructure improvements but fails to secure the necessary rate increases from PUCs, the company's return on investment could be significantly compromised. This regulatory uncertainty makes it difficult to predict future revenue streams, and hence, the stock's performance. Additionally, political shifts can result in tougher laws and regulations, making it even more challenging for AWK to achieve desired rate increases and maintain its service standards.
2. Environmental and Compliance Costs:
   AWK is subject to stringent environmental, water quality, and safety regulations that can lead to high costs, fines, and reputational damage. The potential imposition of new regulations for PFAS substances, for instance, could require an estimated $1 billion in capital expenditure over three to five years, plus $50 million annually in operating costs. These increased costs are not necessarily recoverable through rate adjustments, which could squeeze margins. Moreover, water supply contamination incidents can lead to service interruptions, regulatory actions, and litigation, with significant costs that may not be recoverable, thus posing a substantial financial risk to the company.
3. Capital Expenditure and Infrastructure Vulnerability:
   AWK's heavy reliance on substantial capital for infrastructure maintenance and upgrades presents a financial risk. The company's planned investment of $2.9 billion for the year highlights the scale of this challenge. Aging infrastructure can lead to increased failures and costs, with the potential for extensive damage and repairs from infrastructure risks such as dam or pipeline failures. While some states have mechanisms to stabilize revenue against such risks, others may experience operational impacts due to seasonality, which could negatively affect AWK's financial condition.
4. Seasonal Variability and Water Supply Challenges:
   The company's revenue is affected by seasonal variability, with higher sales in warmer months. While mechanisms exist in some states to stabilize revenue, others may not have such protections, which could lead to operational impacts during off-peak seasons. Additionally, water supply challenges, such as droughts, resource overuse, and severe weather, can disrupt service. For example, the challenges in California regarding the Carmel River demonstrate the vulnerability of AWK's water supply to government actions and environmental changes, potentially affecting revenue and leading to unrecoverable costs.
5. Acquisition Risks and Competition:
   AWK's growth strategy hinges on acquisitions in a sector facing increased competition and industry consolidation. This strategy introduces the risk of unexpected costs and operational issues post-acquisition. For instance, if AWK acquires a smaller utility company for $500 million but faces unforeseen integration costs or competitive pressures leading to a loss of market share, the investment could significantly underperform. Additionally, the regulated nature of its business exposes the company to the risk of asset condemnation through eminent domain, which could result in the loss of assets without fair compensation.

In conclusion, while American Water Works Company, Inc. (AWK) has demonstrated solid financial performance in recent times, the combination of regulatory hurdles, environmental and compliance costs, capital expenditure requirements, seasonal variability, water supply risks, and the uncertainties associated with its acquisition-driven growth strategy present significant challenges. These risks, quantified in terms of potential billions in expenditures and lost revenue opportunities, make a compelling case against investing in AWK at this time. Investors should carefully consider these factors and their potential impact on the company's future financial performance before making investment decisions.