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Utility - Water Supply Outlook: Near-Term Prospects Weak

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The 24x7 availability of clean supply of water has been taken for granted and hence water stocks are underrated as investment. Since a major portion of water infrastructure is buried under soil, hidden from public glare, the proper upgrade and maintenance of water infrastructure is often ignored.

Massive funding will be needed to upgrade the quality of the U.S. water infrastructure. Per a U.S. Water Alliance release, nearly $448 billion to $944 billion will required from the 2010 to 2050 time period to upgrade the quality of deteriorating U.S. water infrastructure.

One of the primary reasons for weakening water infrastructure is the gradual decline in Federal government funding of water infrastructure projects. Per the U.S. Water Alliance four decades ago, the federal government funded 63% of spending in water infrastructure, which has come down to 9%. Government funding is not going to increase dramatically, so regulated companies in the industry will have to take an initiative to upgrade water infrastructure.

Also, we have noticed consolidation in this highly fragmented U.S. water industry. Big water companies are trying to acquire small water utilities and extend quality services to customers.

Though regulated utilities are cash generators, funds generated from internal sources are not sufficient to carry out long-term projects. The rate-sensitive, capital-intensive utility stocks also had to accommodate the Fed’s rate hike. The rise in interest cost will no doubt increase the cost of capital for utilities and might limit their ability to pay out dividends and buy back shares.

Industry Lags in Terms of Shareholder Returns

Looking at shareholder returns over the past year, it appears that the broader economic recovery wasn’t enough for enhancing investors’ confidence in the industry’s growth prospects. And this is despite the fact that the domestic-focused water utilities enjoy steady demand and are not too much dependent on the movement in economic trend.

The Zacks Utility Water Supply Industry, which is a 12-stock group within the broader Zacks Utility Sector, has underperformed the Zacks S&P 500 Composite but outperformed its own sector over the past year.

The stocks in this industry have gained 0.5% and the Zacks Utility Sector declined 6.0% but the Zacks S&P 500 Composite rallied 13.9%.
 

One Year Price Performance



Utility Water Supply Industry Stocks Trading Cheap

Since water companies have a lot of debt on their balance sheets, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio.

This is because the valuation metric considers not just equity but also the level of debt. For capital-intensive coal companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structure and ignores the effect of noncash expenses.

The valuation of the industry still appears cheap in comparison to the market at large. The industry currently has a trailing 12-month EV/EBITDA ratio of 11.24, which is above the median level of 11.30.

The trailing 12-month EV/EBITDA ratio for the Zacks S&P 500 Composite is 11.84 and the median level is 11.57.
 

Enterprise Value/EBITDA (EV/EBITDA)
 

 

Weak Earnings Outlook Could Impact Future Performance

Utilities are among the safest investment bets, due to their domestic focus, regulated nature and demand from customers.  However, aging infrastructure and funding gap are the major concerns for water utilities in United States.

The Fed has raised interest rates from the near-zero level for eight times till September 2018, which will hurt the capital intensive water companies. Making things worse, the Fed might hike interest rates one more time in 2018, if economic conditions remain conducive. If water supply companies fail to pass on higher costs of financing to customers through rate hikes, their profitability will be affected and appeal among income investors will be lost.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The valuation analysis above shows that the Utility Water Supply industry is presently trading cheaper than the Zacks S&P 500 composite.

One reliable measure that can help investors understand the industry’s prospects for a solid price performance is its earnings outlook. Empirical research shows that the earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.

The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for it and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.

Price and Consensus: Zacks Utility Water Supply lndustry
 



Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings potential.

The current consensus earnings estimate for the Zacks Water Supply stock industry of $1.30 per share implies a 15.03% year-over-year decline.
 
Current Year EPS Estimate Revisions


 

Zacks Industry Rank Indicates Cloudy Prospects

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.

The Zacks Utility – Water Supply industry currently carries a Zacks Industry Rank #161, which places it at the bottom 37% of more than 255 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Utility Water Supply Stocks Promise Long-Term Growth

A recent release from United Nation shows that global demand for potable water has been increasing by 1% per year due to increase in population. The report indicates that economic development, rapid urbanization and change in consumption patterns will drive demand for potable water in the next two decades.

The United Nation reports call for nature-based solutions (NBS), which will involve conserving or rehabilitating natural ecosystems to counter the issues of potable water. However, we believe that in the development of NBS, water utility suppliers across the globe will have a key role to play.

Water utility operators will have to make arrangements for proper distribution channels to ensure that safe drinking water reaches end users. In addition, the desalination of water projects in the United States is an attempt to meet rising demand for potable water. Per an International Desalination Association report, more than 2,000 desalination facilities are operational in the United States and the number of these projects is gradually rising.

For the regulated water utilities in the United States, there is ample opportunity for growth over the long term and companies like Eversource Energy (ES - Free Report) from the electric utility space have started to show interest in the water supply industry due to its long-term potential.

While near-term prospects look unwelcoming for investors, the long-term (3-5 years) EPS growth estimate for the Zacks Water Supply industry appears promising. The long-term EPS growth of industry compares unfavorably with the Zacks S&P 500 Composite but compares favorably with its Utility sector.

Mean Estimate of Long-Term EPS Growth Rate
 

 

An important indicator of solid long-term prospect is the improvement in the group’s return on equity (ROE), which is a key metric for evaluating Water Supply stocks. After touching its highest point in fourth-quarter 2016, ROE for the Water Supply industry is currently showing a downtrend. This in a way justifies the Zacks rank of the industry which is the lower half of our industry classification.
 


Summing Up

The water utility space is highly fragmented with thousands of water suppliers serving a few hundred customers. Per the United States Environmental Protection Agency, the United States has more than 52,000 water systems but 8% of these serves nearly 82% of the total population. So, consolidation of small water utilities and will help the water industry to evolve and effectively meet rising demand from an expanding customer base.

American Water Works (AWK - Free Report) and Aqua America Inc. (WTR - Free Report) are the active acquirers. Apart from consolidation, the public-private partnership model is being increasingly being formed to take care of the aging infrastructure, increase production of potable water and provide surety of water supply.

The unemployment rate in the United States decreased to 3.7% in September from 4% in June, matching the expectations of the market. In addition, the United States Building Permits is expected to see a decline in near term but touch 1,315 thousand in 2020, as per projections provided in a Trading Economics report. These factors indicate some near-term prospects but higher potential for increase in demand for water supply services over the long term.

Even though the water supply industry currently has an industry rank in the bottom half of the Zacks Industry Rank, it has the potential to reach a higher rung.

At present, among the stocks witnessing positive earnings estimate revisions, only one stock currently carries a Zacks Rank #1 (Strong Buy) and one holds a Zacks Rank #2 (Buy). Leaving out one stock, all other stocks in the space carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank stocks here

Middlesex Water Company (MSEX - Free Report) : The stock of this Iselin, NJ based water utility has gained 8.7% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 11.5% upward over the last 60 days. The stock currently sports a Zacks Rank #1.

Price and Consensus: MSEX
 

Aqua America Inc.: The stock of this Bryn Mawr, PA based water utility has gained 8.3% over the past year. The Zacks Consensus Estimate for the 2019 EPS has been revised 0.7% upward over the last 60 days. The stock currently has a Zacks Rank #2.

Price and Consensus: WTR
 



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