American Water Works remains a core dividend growth stock
Last January, I was writing about my long-term thesis for American Water Works (NYSE:AWK): American Water: Basic hold with potential for dividend growth for decades.
My thesis was that American Water Works has a proven business model in the water utility industry and a track record of shareholder returns that have outperformed the S&P 500 (SPY). It has a growth streak due to CapEx opportunities in its existing footprint. It can also consolidate the fragmented water services sector.
The action is a basic asset. I expect periods of volatility, especially in a rising interest rate environment. My plan is to hold the stocks I own for many years, collect dividends, and look for opportunities to increase my ownership when the stocks sell.
American Water Works has seen a few updates to its business model over the past year.
1. Sale of Owner Services Group
The company is known for making acquisitions of other water utility companies. But, in October 2021, it announced a big divestment with the $1.275 billion sale of its Homeowner Services Group (HSG). HSG is not a regulated company and the sale allows American Water Works to become a pure-play regulated water utility company. Cash proceeds from the transaction are intended to be used for CapEx projects in the regulated utilities segment, which will drive future EPS growth.
2. Long Term EPS Tips
On Investor Day on November 8, 2021, the Company announced some adjustments to its long-term guidance.
Management lowered the long-term EPS growth range from 7-10% to 7-9%. This was mainly due to the sale of HSG. With the sale of HSG, the company is potentially foregoing some earnings potential in exchange for increased earnings visibility from its regulated businesses.
Importantly, management has not changed the earnings growth outlook for regulated capital expenditures and regulated acquisitions.
The second significant change was to increase the target dividend payout ratio from 50-60% to 55-60%. For dividend investors, the increase in the target payout ratio partially offsets the impact of slightly lower EPS growth.
3. Outlook 2022
On Investor Day, management launched 2022 EPS guidance of $4.39 to $4.49. The 2022 EPS midpoint is only 5% above the 2021 EPS midpoint. Although management expects EPS growth of 7-9% over the long term, 2022 should see growth below trend.
Management explained that the slower growth in 2022 is due to the sale of HSG. Although the proceeds from HSG are intended to be invested in regulated investment CapEx and regulated acquisitions, it will take time for these investments to grow. Therefore, there will be a decline in earnings growth in 2022 as the reinvestment plan unfolds.
The 2022 EPS growth rate puts pressure on the stock in the short term but does not change my long-term outlook on the company.
Stock prices and interest rates
American Water Works stock price is sensitive to changes in interest rates. Over the past few weeks, the 10-year Treasury yield soared to 1.77%, sending the stock price down to $163.57 per share. Looking back over the past year, American Water Works shares have fallen during periods of rising rates and rallied during periods of falling rates.
At the start of 2021, the dividend yield was higher than the 10-year Treasury yield. Currently, the 10-year Treasury yield is still around 30 basis points higher than the dividend yield, despite the recent rise in the dividend yield as the stock price sold off. This gap suggests that there is room for further declines in stock prices in the near term.
My Model Updates
I made the following updates to my model from my estimates from last year:
- $4.44 2022E EPS – Based on midpoint of management’s 2022 forecast. That’s down from $4.61 in my model last year. The main driver is the sale of the HSG division. Management also said during the November 8, 2021 Investor Day that the impact of the sale of the HSG division would be approximately $0.10 on 2022 EPS. So there appears to be some slight weakness in addition to the impact of the sale of HSG.
- $4.77 2023E EPS – This represents growth of 7.5% year over year. I expect further growth acceleration in 2023, but still within the low end of long-term EPS targets of 7-9%. It will take more than a year for investments from the proceeds from the sale of HSG to have a full impact on EPS growth. I expect EPS growth to accelerate to 8.5% year-over-year in 2024.
- $2.55 Dividends 2022E per share – This is based on a dividend payout ratio of 57.5%, which is the midpoint of the long-term range of 55% to 60%. Given that 2022 will be an investment year, I don’t expect the payout ratio to be at the high end of the range. Despite the investments, I expect management to want to keep the payout ratio at least at the midpoint to offset the lower EPS growth. In my 2021 model, I also estimated 2022 dividends per share at $2.55, but that was based on higher EPS with a lower dividend payout ratio.
- $2.79 Dividends 2023E per share – This is based on a dividend payout ratio of 58.5%. I expect the ratio to improve slightly after the 2022 investment year.
- Multiple P/E – I assume a P/E ratio of 35x in my “Method A” valuation. This is down from 40 times last year due to rising interest rates. A P/E ratio of 35x remains high for a stock whose EPS is increasing by 7 to 9% per year. However, American Water Works is benefiting from the growth of ESG investing. Historically, the investor base has been comprised primarily of dividend growth investors. Adding ESG investors can result in a higher valuation.
- Dividend yield – I assume a dividend yield of 1.75% in 2022 and an increase of 25 basis points per year to 2.50% in 2025. Rising interest rates will drive up the dividend yield and be a headwind for the stock price. In my model from last year, I assumed 1.50%. It was too low.
AWK price target
When my article was published last year, the stock was at $156.64 and my price target was $163 for 2021 and $177 for 2022. In fact, the stock has traded up at $189 in September and again in late December.
My current price target is $151 for 2022. This is based on “Method C” in the chart below, which is the average of my valuation based on the P/E multiple (Method A) and the yield of dividends (Method B).
In fact, my model suggests a stock price target of $150-$160 through 2024.
The model also suggests a stock price target of $247.55 by 2030, plus $33.03 in cumulative dividends. As an investor who plans to hold stocks for the long term, this is what I focus on.
American Water Works is a long-term grassroots holding. I expect it to meet management’s target of 7-9% EPS growth and increase its dividend each year. The fundamentals of the company remain solid. Water is an essential commodity and the company has a long organic growth track as well as acquisition potential.
2022 will be a hectic year. The company will face below-trend EPS growth due to the sale of HSG and the ramp-up period for returns on reinvestment of proceeds from the sale.
In addition, interest rates are rising, putting pressure on the valuation multiple.
However, if management can execute the reinvestment of HSG’s proceeds well, it will have accelerated EPS growth through 2023 and beyond.
My pattern suggests further decline for the stock. I see this as an opportunity. If the stock price hits $150, the stock would have a dividend yield of 1.7%, which is almost the same as the 10-year treasury bill. I will monitor stock price volatility to find good entry points to add to my long-term position.