Stay Out Of The Water
The improving housing industry is supporting customer growth for companies that provide water and waste services. The market has taken notice, with water stocks one of the few bright spots in the utility sector this year. But going forward, water stocks could muddy up investors' portfolios.
Water utilities account for just eight of the 78 utility stocks we follow in our Utility Update (www.DowTheory.com/Go/Util). Water utilities have outperformed this year, averaging a 4% total return while the average utility has lost 4%.
Larger water utilities may supplement growth with acquisitions in a highly fragmented industry that includes more than 53,000 individual water systems in the U.S. The Environmental Protection Agency continues to raise its standards, making regulatory compliance increasingly expensive and forcing some water systems to put themselves up for sale.
Compared to other utilities, water stocks offer decent operating growth and above-average Quadrix scores for Momentum (average of 54, versus 51 for all utilities) and Quality (54, 45).
Yet just two of the eight water utilities merit an A (above average) rating. We recommend investors steer clear of the industry for the following reasons:
• The recent rally has left valuations stretched. On average, water stocks trade at 23 times trailing earnings, above the utility sector's average of 19.
• Operating momentum is slowing. On average, water stocks are projected to report flat earnings per share over the next 12 months, while the broader sector is expected to deliver 2% growth.
• Large outlays for capital investment limit cash available for dividends. In 2014, capital expenditures averaged 30% of sales for water stocks, a higher proportion than any other utility industry; the average utility's capital spending represented 24% of sales. Water stocks yield 2.8%, lagging the sector average of 3.7%.
LACK OF WATER HASN'T CAUSED DROUGHT
At the moment, our Top 15 Utilities portfolio contains no water utilities.
That lack is not an oversight, as no water utilities rank among our very favorites. As the nearby story mentions, water stocks as a group are pricey, with weak year-ahead growth expectations and heavy capital spending expected.
Nor is the lack of water stocks a big impediment to diversification. Water utilities account for less than 3% of the total stock-market value of our Utility Update. Water is such a tiny part of the industry that we can exclude it without concerns that we're failing to capture the essence of the sector.
All that said, we're not afraid of the water.
Our Top 15 Utilities portfolio outperformed its benchmark, the S&P 1500 Utility Sector Index, in six consecutive years before lagging marginally last year. We're on pace to outperform again this year, and if a water stock can help us maintain that edge, we'll add it to the list.
We're not making any rank changes today. But rest assured we pay close attention to utility stocks, and if earnings or other news suggests we should make a change, you'll read about it in a future issue of the Forecasts.
Artesian Resources ($24; ARTNa) distributes water in Delaware, Maryland, and Pennsylvania (89% of sales). It also provides regulated wastewater services in Delaware (5%) and nonregulated water-related services (6%). It earns an Overall rank of 75 and pays a dividend yield of 3.6% — both are the highest among the water stocks we follow. In September, Artesian increased its quarterly dividend 1.5%. The dividend has now increased in 19 consecutive years.
Helped by temporary rate hikes and rising water consumption, per-share profits surged 37% on 8% revenue growth in the 12 months ended June. The stock trades at 20 times trailing earnings, 7% below its five-year average and 14% below the average water stock in our Utility Update. But per-share profits for the 12 months ending June 2016 are projected to decline; the shares look pricier than peers on a forward basis. In our Utility Update, Artesian is rated A (above average).
SJW ($30; SJW) operates public utilities that distribute water in California and Texas. September-quarter revenue slumped 34%, due to the year-ago quarter containing a $47 million payment from a rate-case decision. As a result, SJW's Quadrix scores have fallen since the end of September — the Momentum rank is now 40, versus 93 one month ago, while the Overall rank is 59, versus 95.
However, excluding that one-time benefit in the year-ago quarter, SJW's sales rose 5% as rate hikes more than offset lower customer usage. Citing ongoing drought conditions, California officials in June imposed mandatory restrictions on water usage. SJW hopes to get reimbursed for at least some of the revenue lost by the mandatory reductions. Yielding 2.6%, SJW is rated A (above average) in our Utility Update.