California Water Service Group

Moat: 3/5

Understandability: 1/5

Balance Sheet Health: 4/5

California Water Service Group (Cal Water) is a regulated water utility company that provides water and wastewater services to customers in California, Washington, New Mexico, Hawaii, and Texas. The company is publicly owned, but operations are heavily dependent on its relationship with regulatory agencies.

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.

Business Overview: Cal Water provides regulated water utility services across multiple states, with the majority of its operations in California. The company’s revenues are primarily derived from providing water to residential, commercial, industrial, and public authority customers. In California, it operates under the jurisdiction of the California Public Utilities Commission (CPUC). The company is organized into several different districts, each reporting to the commission.

Revenue Distribution: Cal Water’s revenue is broken down into four segments, reflecting customer classes:

  1. Residential: Primarily from sales of water and wastewater services to single-family homes.
  2. Commercial: From sales of water and wastewater to commercial businesses.
  3. Industrial: From industrial companies.
  4. Public Authority: From public institutions. A significant portion of its revenue is derived from residential customers.

Industry Trends:

  • Increasing Regulatory Scrutiny: The water utility sector faces growing regulatory oversight, mainly regarding water quality, supply, and drought response.
  • Aging Infrastructure: Much of the nation’s water infrastructure is aging, requiring substantial investments in maintenance and upgrades.
  • Water Scarcity: In regions like California, water scarcity is a persistent concern, resulting in conservation efforts and increasing water prices.
  • Decentralization and Decentralized Sources: Increased need to tap into smaller more diverse water sources than just big rivers, and groundwater.
  • Climate Change: Climate change poses new challenges, leading to more volatile weather, water shortages, and changes in the way people consume water.

Competitive Landscape: Cal Water does not have direct competitors in most of its markets due to its status as a regulated utility. The main competitive threat arises from companies in neighboring utility districts who may entice a new commercial or industrial customer to switch service. Within the water utility space, competition for acquisitions are frequent, creating a robust market for consolidation. The market for water utilities is oligopolistic, and only a few companies tend to dominate regions.

What Makes CWT Different?

  • Geographic diversification: Cal Water operates in more than one state, a rarity in the industry.
  • Operations in multiple different markets: The company sells water services to different types of customers, such as residential, industrial and public institutions.
  • Strong regulatory compliance: Cal Water maintains solid standing with state regulations and consistently complies with them.
  • Long-standing reputation: Cal Water has a history that goes back nearly a century.
  • Consistent Dividends: Cal Water has an impressive dividend history.
  • Acquisitive: Cal Water is an avid acquirer of smaller companies.

Financials:

  • Income Statement:
    • Revenues show moderate year-over-year growth due to volume increases and some base rate increases by the regulators.
    • Operating expenses are primarily driven by purchased water and power costs, maintenance, depreciation, and taxes.
    • Interest expenses are very significant, accounting for a large percentage of income.
    • Profits and margins are relatively stable, despite expenses being mostly fixed.
  • Balance Sheet:
    • The company maintains a high level of debt to fund its operations, mostly as long-term debt for infrastructure investments.
    • Goodwill and accumulated amortization is a significant part of total assets due to the numerous acquisitions.
    • Equity is relatively high compared to debt due to equity raises in the last year and consistent earnings.
  • Cash Flow:
    • Operating cash flows are very positive and stable.
    • Investing activities are mostly focused on CAPEX with acquisitions playing a smaller role than in the past.
    • Financing activities mainly represent payments of dividends and debt repayments.

Moat Rating: 3 / 5

  • Justification: Cal Water possesses a narrow moat due to its status as a regulated utility that faces limited competition. The company has the benefit of a stable demand for its product due to the nature of its service as a basic necessity, and it has high barriers to entry due to high capital requirements and difficult regulatory approvals. These elements can translate into pricing power, at least up to what the state regulators allow. Additionally, being a regulated monopoly within the industry provides a form of geographic economic moat, which reduces the likelihood of competitors coming in and taking away customers. However, the company’s “moat” isn’t as strong as other companies that are able to earn supernormal profits or a greater ability to push rate increases, since those aspects are constrained by regulations. The company is also unable to use its scale to aggressively reduce costs and expand margins in the short term as they may need regulatory approval for these actions. This means it’s moat is not as wide as we’d prefer.
  • Sources of Moat:
    • Economies of Scale: While not as great as other utilities, it is difficult to replicate its size and infrastructure for new competitors.
    • Barriers to Entry: Regulatory hurdles, high capital expenditure, permits, and extensive infrastructure requirements all create a strong barrier to entry.
    • Regulation: The heavily regulated nature of the business guarantees a relative stability in profit for the long-term, while providing the ability to recover and make a return on its investments.
  • Switching Costs: There is a lack of willingness for consumers to switch to a different provider even if a company offers slightly better prices, due to the inconvenience of changing utility providers.

Understandability Rating: 1 / 5

  • Justification: Cal Water has operations which are complex but very easy to understand. They provide water to cities and towns, a very easy and understandable concept. They earn money from selling water, they are regulated, which also makes their revenue stable, and most of their costs are fixed, which makes it easy to predict their profitability. The basic business model is very easy to understand.

Balance Sheet Health Rating: 4 / 5

  • Justification: Cal Water’s balance sheet is good overall. Their debt is used to fund capital expenditure and is matched by a large amount of assets. However, debt is still a main concern in the company with relatively high debt-to-equity levels. There are good cash flows as well, and the ability to easily service debts and fund expansion. The company is relatively safe from a debt crisis, unless new regulatory action dramatically cuts profits.

Risks to the Moat and Business Resilience:

  • Regulatory Changes: The regulatory environment under which Cal Water operates is subject to change. Any adverse decisions by the regulators regarding permitted rates of return and tariff structures could materially affect their profitability.
  • Rate Decisions: While the regulatory structure typically allows Cal Water to earn a reasonable return, delays or negative decisions regarding rate increases can impact earnings. In certain cases, like in the recent California proceedings, where the final decision is pending with the CPUC can create short-term uncertainty and limit profitability.
  • Interest Rate Risk: The company utilizes large amounts of debt, and fluctuations in interest rates may greatly increase interest expenses. The company will be particularly vulnerable to high-interest rates, since it has a hard time increasing prices.
  • Water Scarcity & Droughts: Water scarcity and the increased volatility in weather may significantly hamper the company’s ability to secure water supplies and manage them effectively.
  • Capital Expenditures: The continuous need to replace and maintain its aging infrastructure will continue to present a burden in the way of heavy capital expenditure.
  • Inflation: Inflation may increase operating and maintenance costs at a rate which is faster than the rate increases in prices.
  • Public perception : Bad press related to service outages, or quality of water can significantly hurt the company’s brand, and decrease its political power.
  • Mergers & Acquisitions: Companies are highly acquisitive, and the pressure to find new acquisitions can cause overpayment, and integration difficulties.
  • Political Risk: The local and state politics in the regions where it operates may negatively affect the company, through taxes, laws, or public discourse.

Recent Concerns / Controversies / Problems & Management Response

  • The most recent earning calls and press releases indicate concerns over delays in California regulatory cases which are affecting revenues and rate increases. Management have emphasized working closely with California regulators to reach a suitable conclusion. They also mentioned plans for capital raises to offset debt.

  • Water costs have generally been increasing, causing more expense. Management hopes that regulatory bodies will take notice of these pressures.

  • The company also noted continued efforts to deal with supply chain challenges.

  • Finally, new growth will be primarily driven by acquisitions, and also by new innovative technologies.

I hope that this information is useful for analysis.