Why Water Utility Stocks Still Stink

By James Brumley | October 21, 2009 AAA

Barring a small miracle within the next few days, the water utility industry will end October on a surprisingly sour note. Yet, it still won't be sour enough to get these stocks back to reasonable valuations. By my estimates, the average water company stock is still overvalued by about 30%. Almost needless to say, these names are anything but "buys" at this point.

Just The Facts
At the time of this writing, the S&P 1500 Water Utility Industry Index is down 7.3% month-to-date, trailed only by the S&P 1500 Photographic Products Index, which is down 12.5% for the same time frame. For comparison, the S&P 1500 Index is up 3.3% month-to-date. (For more background, check out Water: The Ultimate Commodity.)

The bulk of the blame can probably be directed toward Aqua America (NYSE: WTR) - the second-biggest name in the index, and the biggest loser by far with its October dip of 8.7%. Don't be misled though - we've seen miserable results from WTR since November of last year, as the stock completely failed to participate in any subsequent rally.

And it's not like Aqua America doesn't have lots of company at the bottom of the barrel. American Water Works (NYSE: AWK) shares are only up 21% from their March low, and none of that gain was made after August. American States Water (NYSE: AWR) and SJW Corp. (NYSE: SJW) have been just as pitiful. The only stock that has turned in a decent performance lately has been California Water Service Group (NYSE: CWT), though even it's still in the hole year-to-date.

So what's the deal? I have a couple of theories. One's obvious, and the other's a little more obscured. I'll warn you now, the one I'm leaning toward (the obscure one) is probably not one you're going to like much if you're a current owner of one of these names.

What Gives?
The first theory is pretty straight-forward: We're at the beginning of an economic recovery, and the last thing anybody wants dragging their portfolio down is the dead weight of a utility stock. Utilities are for bear markets and the beginning of recessions. Now's the time for financials, capital goods and technology stocks, right?

OK - I'll buy into that, though to a very small degree. I really think, however, there's an even bigger problem taking a toll on this group. That's the second theory.

I'm hesitant to even propose "normal" benchmarks for any group of stocks any longer. A P/E ratio of 30 and a PEG ratio of 2.0 or more are just wicked in comparison to an era not that long ago, yet I've also seen stocks with those valuations crank out gains for years on end.

In some cases, though - as with water utility stocks - I'm not as shy about saying they're ridiculously overvalued. So, here goes... (Take an in-depth look at the various techniques that determine the value and investment quality of companies from an industry perspective; see Industry Handbook.)

0 For 4
With an average price-to-earnings ratio of 21.5 (and that's just of the profitable ones), and an average forward-looking price/earnings multiple of 17.7, water utility stocks are priced more like growth stocks than utility stocks. And trust me - there are a lot of single-digit growth numbers (sales as well as earnings) on a look-back as well as a go-forward basis. It just doesn't make a lot of sense.

The counter-argument against the "overvalued" opinion is that margins are generally low for utility names - one of the acceptable downsides to reliable income. I get that. That's not what's going on here, though. These stocks are sporting an average price-to-sales ratio of 2.3, and a PEG (price-to-earnings/earnings growth rate) ratio of 3.1. That's pretty expensive at any profit-margin percentage.

Like I said above, there is no absolute "normal" when it comes to benchmark measures anymore. On the other hand, an expensive stock is like talent - you'll know it when you see it. And from where I see things, water utility stocks are overvalued by an average of about 25% to 30%. Deflating them by that much would push P/E ratios closer to a reasonable 13.0 to 14.0 (for utilities), and whittle P/S ratios down to 1.5 or so.

Bottom Line
I know it's not what current owners wanted to hear, but it's a reality check you probably needed to hear.

You May Also Like

Related Analysis
  1. Stock Analysis

    Social App Momo Shines on U.S. Debut with Alibaba Support - Analyst Blog

  2. Stock Analysis

    American Water (AWK) Unveils Earnings Guidance for 2015 - Analyst Blog

  3. Chart Advisor

    How To Trade The Biggest U.S. Companies In 2015

  4. Chart Advisor

    'Tis The Season For Food And Beverage Stocks

  5. Chart Advisor

    Commodities Set Up For A Continued Move Lower

Trading Center