American Water Works Company, Inc.

Moat: 4/5

Understandability: 2/5

Balance Sheet Health: 3/5

American Water Works Company, Inc. (AWK) is the largest publicly traded water and wastewater utility company in the United States, providing regulated services across several states and a portion of their business coming from non-regulated services.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Moat Analysis:

AWK possesses a notable economic moat, primarily stemming from its regulated business model and the high cost of entry into the water and wastewater utility sector. These factors create significant barriers to entry for potential competitors and establish a durable competitive advantage. I would give it a 4 / 5 due to its strong, but not perfect, moats.

  • Regulation: The company’s regulated business is subject to government oversight and rate regulation. This provides a degree of protection from competition, and also leads to a quasi-monopoly in certain markets. The regulators will allow AWK to charge rates that enable a reasonable rate of return, though those rates also cap the potential profit the company can make. This regulatory environment creates a barrier to entry as new entrants must go through arduous approval processes.

  • Natural Monopoly: The cost of infrastructure for water and wastewater utilities, including pipelines, treatment plants, and reservoirs, is incredibly high. This results in significant economies of scale, and it becomes difficult for competitors to duplicate AWK’s infrastructure and compete effectively. Further, it is usually best if one firm serves the water needs of a community in a highly efficient manner.

  • Customer Stickiness: Water and wastewater services are essential for everyday life, and customers are generally not price-sensitive or prone to switching providers due to inertia and inconvenience. Switching suppliers isn’t really possible. This creates a level of customer stickiness that further solidifies AWK’s competitive position.

  • Geographic Diversification: Although AWK’s regulated operations are focused on specific regions, the company diversifies its businesses by purchasing and operating in various markets. While diversification is not a moat by itself, it adds a stability layer that might prevent a significant loss in profits if some geographies face economic difficulties.

Risks to the Moat & Business Resilience:

While AWK enjoys a strong moat, it is not without risks:

  • Regulatory Changes: The regulated nature of AWK’s business, while a moat, also presents risks. Adverse changes in regulations or rate-setting decisions could significantly reduce the company’s profitability. Regulatory agencies often create rules that require the company to make large investments without a guarantee of profits. This is especially a concern in highly regulated geographies.

  • Increased Competition in Non-Regulated Business: While not as large as their regulated business, AWK has a non-regulated segment which is more exposed to competition and is less defensible. Therefore, increased competition in this sector could hamper growth.

  • High Debt and Interest Rates: AWK requires a lot of investments in physical infrastructure and it is often financed through debt. This can cause the debt-to-equity ratio to climb and with rising interest rates, this makes the business riskier. Further, this can reduce their capability to spend for acquisitions and improvements.

  • Environmental and Climate Changes: Factors such as climate change, droughts, severe weather conditions, and contamination can directly impact the operations of a water utility and may cause increase in expenses without increased profits.

  • Contamination and Aging Infrastructure: As a water utility, AWK is at risk of pollution, contamination, and other factors that can deteriorate the water quality and thus have a direct impact on their operational income. Additionally, their large infrastructure gets older each year and might require huge capital expenditures to improve. This capital expenditure may not be recovered by increased revenues.

Despite these risks, AWK demonstrates strong business resilience due to the essential nature of its services. Water and wastewater services are necessary for modern life, thus, demand is consistent and resilient to economic downturns. This combined with the fact that they are a large operator creates some scale benefits that help them weather difficulties as it arises. They also have a diversified base of customers that could help mitigate risks of default. They also have government backing, since they are very important for everyday life, which gives them an advantage during difficult economic times.

Detailed Explanation of the Business:

  • Revenue Distribution: AWK’s revenue is primarily derived from providing regulated water and wastewater services, making up approximately 85% of total revenue. This includes charges for water usage, wastewater collection, and fixed charges associated with service availability. Non-regulated businesses include operations and maintenance contracts with military bases, homeowners, and other specialized areas, which make up the remaining 15% of revenues.

  • Industry Trends: The water utility industry is characterized by aging infrastructure, stringent environmental regulations, and increasing demand for clean and reliable water sources. With increased awareness of lead and PFOA related pipes and contamination, a lot more investment is expected in this industry, thus putting more pressure on the bottom-line of water utilities. Further, the population is aging and moving to areas with less water, leading to greater investment needed to ensure consistent water supply.

  • Margins: As mentioned before, AWK is a regulated utility, with pricing regulated by the PUC. While this leads to protection from direct competition, it also caps margins. AWK’s Operating margins are usually below 30%. Historically they have been in the 18%-22% range.

  • Competitive Landscape: The water utility sector is fragmented with numerous public, private, and even non-profit operators, depending on the region. However, AWK is one of the largest players and enjoys certain benefits that come with it. Competition in the regulated space is limited, but other water utilities compete for acquisitions and contracts. On the non-regulated side, the company competes with contractors, engineering firms, and more.

  • What Makes AWK Different: AWK differentiates itself with its geographic scale, its technological capabilities, including its research and development center, and its ability to integrate acquisitions quickly and efficiently. The company has also shown a commitment to environmental goals. These factors help AWK operate more profitably than most other smaller competitors, especially for new acquisitions.

  • Other Relevant Information: AWK is highly susceptible to regional and state level regulations, which can be difficult to predict and can have major influence in profitability. As such, these state and local level regulations can be a key source of risk to the company.

Financial Analysis:

  • Revenue Growth: AWK’s revenue has steadily increased over the past decade, as it continues to buy assets and increase pricing. In recent years, organic growth has become increasingly important. However, growth is inherently limited due to population and economic conditions, therefore, growth is usually limited to low to mid single digit numbers.
  • Profitability: AWK’s profitability is somewhat lower than the average business because it is a utility. Given a regulated rate structure, growth in profit margins is mostly capped and the main source for improvement is operational efficiency, not price increases.

  • Balance Sheet: While AWK has a good balance sheet based on asset value, it does carry considerable amounts of debt and pension liabilities, all while having very little cash.

    • Debt: Long-term debt of approximately $11 billion is a notable part of the capital structure, with interest expenses of approximately $400 to $500 million. The company maintains a reasonable amount of debt, however, increasing debt levels can negatively impact the future business growth.
  • Pension and Other Post-Retirement Liabilities: AWK also has obligations from their employee benefits including pensions. These obligations are about $5-$6 billion and might vary wildly from year to year, impacting their balance sheet.
*   **Cash Position:** The cash on hand is comparatively small, usually below $500 million, not sufficient to immediately pay down debt obligations, or to finance future acquisitions.
  • Capital Expenditures: AWK has very high capital expenditure, usually around $2.5-3 billion per year, which is almost 50% of their revenues. This is due to the aging infrastructure which they must continuously upgrade.

Understandability Analysis: 2 / 5

I would give AWK an understandability score of 2/5. While the concept of providing water and wastewater seems simple, the regulatory complexity and accounting differences of AWK make it quite hard to understand. The company also has a lot of intricate debt and financial obligations. A new investor should spend considerable time in researching the business and the financial structure before considering making any investments.

Balance Sheet Health Rating: 3 / 5 I would give a rating of 3/5 to the balance sheet health for the business. The company is not particularly concerning based on their consistent revenue and profitability, but it also possesses a significant debt load. The pension obligations can be concerning, as well. A large proportion of their revenues need to be used to finance their heavy capital expenditures. While not terrible, investors should keep a close watch for the company’s debt load.

Recent Concerns, Controversies and Problems:

  • PFAS regulations: PFAS are a large group of chemicals that are used in industrial and consumer products. There are new regulations against them that may require water companies to spend money on filtration and treatment. However, they are not sure what level they will need to reduce these chemicals, and thus are finding it difficult to plan for their capital requirements. It may increase the capital costs significantly for water utilities, like AWK, and increase the risk they face.
  • Infrastructure Investments: Despite all the good things that the new spending and infrastructure bill will provide to utilities, it is also a concern that the demand for utilities is already somewhat steady and any excess in supply can lead to an underperforming business with over investment. The company expects to invest significant sums to modernize infrastructure in the coming years.
  • Lawsuit: In April 2023, a lawsuit was filed against the company that alleged the company failed to conduct routine maintenance, leading to poor quality of water, and then misrepresented their testing standards. Management believes that these complaints are frivolous and intend to fight the lawsuit. However, this could have a negative impact on its profits if it loses the lawsuit.
  • Rates: The company also has increased its water rates in various regions, and the regulatory agencies may deny or ask for smaller increases than required.

In conclusion, AWK is a stable utility with a decent moat. The company is a strong cash flow business and is protected against competition through its regulated operations, and its essential services. However, it faces certain challenges such as regulatory risks, increased debt and interest obligations, and new capital expenditures that can impact future profits. While the business itself is relatively straightforward, the financial statements and how the company handles debt are complex and require deeper thinking to understand completely. Investors should do their due diligence before making investment decisions.