Water May Be Essential, But That Doesn't Make Aqua America Cheap

By Stephen D. Simpson, CFA | August 02, 2012 AAA

Eventually, almost everyone who writes online about stocks and investments gets around to writing their "water article." Yes, water is essential for life and access to clean water is going to be an increasingly significant issue for many people in the coming decades. That doesn't automatically make water a great investment, though, as investors have frequently bid these stocks up to unreasonable levels only to see gravity take hold once again.

And that is the problem today at Aqua America (NYSE:WTR). The company's decision to rationalize its holdings (selling off businesses in less-promising areas like Maine) was a wise one, and the company's venture with Penn Virginia Resource Partners (NYSE:PVR) to bring water supplies to energy companies in the Marcellus is a good growth opportunity outside of the regulated residential water business. Nevertheless, this is a stock priced for virtual perfection today.

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Q2 Results - Water Is Boring, but in a Good Way
It hopefully won't surprise investors to learn that Aqua America is a pretty consistent business where major earnings surprises are relatively uncommon. There can be some variability in consumption and costs, but for the most part this is a stable business that allows for predictable performance.

Operating revenue rose 8% this quarter, with operating income up 22%. Rate increases continue to benefit the company, as have selected tuck-in acquisitions in key operating areas like Pennsylvania. At this point, the Aqua-PVR Water Services joint venture is not making a major impact on reported results.

SEE: Analyzing An Acquisition Announcement

Can Marcellus Make a Difference?
The company's Marcellus water supply joint venture may not be making a significant near-term impact, but this is still an intriguing long-term opportunity. Companies like Range Resources (NYSE:RRC), Southwestern Energy (NYSE:SWN) and Royal Dutch (NYSE:RDS-A, RDS-B) need water for their fracking operations, but the infrastructure has not been in place to facilitate this. Consequently, the companies (or their contracted service providers) have to send fleets of trucks out to collect water to fill on-site retention pools. That takes time, costs money and adds to the mess of these operations.

Building a better system of delivering water to these companies seems like a logical venture. At the same time, it may take a while for this to really pay off. Low natural gas prices have forced companies to de-prioritize (if not stop) dry gas development and that is cutting into fracking demand. Odds are good that this will reverse in the future, but it could very well extend the payback period for Aqua America for this venture.

Always Keeping the Assets Moving
Aqua America has always been pretty active when it comes to the M&A scene - adding and disposing water systems as the regulatory and operating environments shift. Relatively recently, the company swapped assets with American Water Works (NYSE:AWK) to expand in Ohio, while selling off its Maine assets to Connecticut Water Service (Nasdaq:CTWS). Although I wouldn't expect any major moves again soon, investors should never assume that the company is done dealing - there are almost always small tuck-in deals in its current operating regions that can add a little incremental revenue and earnings.

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
Aqua America has posted positive free cash flow exactly once in the last 10 years and earns a low rate of return on its assets. Some of this is the nature of the business, and it hasn't precluded the company from delivering solid book value growth over the years. Nevertheless, the company is always going to be in a position where it has to reinvest substantial funds in its infrastructure and then try to leverage rate increases to earn a good return on those investments.

Trading at over 13 times trailing EBITDA, I think Aqua America is simply too popular right now. Yes, it's a liquid dividend-paying water investment vehicle, but I think it will be hard for the company to post even high single-digit EBITDA growth on a sustained basis, and I'm not going to pay a multiple of twice that growth. At this point, both American Water and American States Water (NYSE:AWR) seem like relatively better investment options, though without that unregulated business growth kicker.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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