Essential Utilities

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Essential Utilities is a holding company for regulated utilities providing water, wastewater, and natural gas services to an estimated 5.2 million people in multiple states.

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

Essential Utilities is a utility company that provides regulated water, wastewater, and natural gas services to an estimated 5.2 million people, primarily in the US. The company operates in eight states: Pennsylvania, Ohio, Texas, Illinois, North Carolina, New Jersey, Indiana, and Kentucky.

  • Regulated Water Segment: This segment represents approximately two-thirds of Essential’s overall business and includes water and wastewater service to individual and commercial customers. This is a capital-intensive business, with significant investment in infrastructure and regulatory approvals required.
  • Regulated Natural Gas Segment: This segment primarily involves the distribution of natural gas to customers, serving over 1.1 million customers, primarily in Pennsylvania, Kentucky, and West Virginia. This segment also has high regulatory oversight and requires considerable infrastructure investments.
  • Other The Other segment includes some non-regulated activities that support the water and natural gas business.

The company’s revenue is mainly derived from regulated sales, with rates often subject to the approval of state regulatory commissions.

  • Essential Services: The utilities industry is inherently stable due to the essential nature of the products provided—water, wastewater, and natural gas. It’s a capital-intensive industry with high barriers to entry due to regulatory requirements and the need for extensive infrastructure.
  • Regulatory Environment: Utilities operate in a heavily regulated environment. They must constantly comply with safety and quality standards, and are subject to price approvals by the regulatory bodies.
  • Consolidation: The water and wastewater industries are often seen as attractive acquisition targets for larger players, as is the case with Essential Utilities’s growth-through-acquisition strategy.
  • Increasing Need for Infrastructure Investment: Many water and wastewater systems need substantial upgrades and repairs to aging infrastructure. Utilities need to manage large-scale capital projects as well as navigate changing environmental regulations.
  • Competition: In the regulated utility sectors, competition is typically limited to other regulated players within their service areas, which often resemble monopolies due to regional restrictions and the lack of economic incentives for competitors to build parallel infrastructure.

Despite the stability afforded by the regulatory environment, competition from unregulated utilities, coops, and other service providers can still have an impact, particularly in cases where public entities seek alternative energy solutions.

Financial Analysis

  • Revenue Growth: Revenue growth in the past few years has been driven primarily by increases in utility rates, acquisitions, and organic growth. Operating revenue increased by 4.4% in 2022, compared with 6.2% in 2021. The latest quarter shows revenue increasing 7.7% in the regulated water segment but decreasing 10.5% in the regulated natural gas segment.
  • Profitability: Essential Utilities’ net income in the first three quarters of 2023 was $339 million, compared to $431 million for the first three quarters of 2022. Profit margins are generally decent, and relatively stable thanks to the regulated nature of the industry.
  • Capital Expenditures: The utility industry needs to constantly reinvest in its infrastructure. This is clearly seen in Essential Utilities’ financials where cap ex has risen from $1.42 billion in 2021 to $1.71 billion in 2022. It is also expected to stay high at approximately $1.6 to $1.9 billion in 2023 and 2024, respectively.

High capital spending is necessary to meet customer demands and regulatory needs, but creates some volatility to their financials, mostly seen in changes in deferred taxes, and tax benefits.

  • Debt and Financial Stability: Essential Utilities’ financial statements show a significant amount of long-term debt, including the issuance of multiple tranches of first mortgage bonds which are typically used to help fund utility projects, as well as a reliance on short-term loans. Total long-term debt for the parent is approximately $9.6 billion and for subsidiaries, around $6.3 billion as of Sep 30 2023. This level of debt is somewhat typical of utilities.

Moat Assessment: 3/5

  • Regulatory Moat (Wide): Utilities generally benefit from regulatory moats, as there are high barriers to entry given their essential function and the need for approvals. That’s why this is where the moat rating is the strongest.
  • Economic Moat (Narrow): The company benefits from having established water infrastructure, which is extremely expensive and time-consuming to replicate, this gives it a cost advantage. Some of its revenue is tied to long-term regulated contracts, but these agreements are subject to renewals, and new agreements can contain price restrictions that may hamper pricing power. Additionally, the commoditized nature of water makes differentiation difficult.
  • Customer Switching Costs (Low): Switching costs are minimal. Customers will find other water utilities that provide the same product for them and switching providers is as easy as switching a light bulb.

Although Essential has some sustainable moats stemming from its regulated and utility nature, those moats are far from impenetrable, making them a somewhat average business when evaluating moats.

Legitimate Risks Affecting the Moat & Business Resilience

  • Regulatory Changes: Changes in regulatory requirements or the way rates are determined, could impact profitability. Delays in regulatory approvals may also disrupt timelines for infrastructure improvements or acquisitions.
  • Increased Operating Expenses: The rising cost of materials, energy, and labor may increase operating expenses and reduce profit margins. Additionally, the current inflationary pressures and supply chain shortages may impact costs.
  • Cybersecurity Risks: The Company’s digital transformation, with the assistance of outside vendors, increases the risk of security breaches to customer data, trade information, financial records, and internal business records.
  • Interest Rate Risk: Since debt is a major component of their capital structure, rising interest rates could significantly increase borrowing costs, decreasing profits. The rising cost of interest can also impact how acquisitions are financed, as well as making those acquisitions more expensive.
  • Environmental & Climate Change Risk: The industry is highly dependent on water resources, and drought and climate change can negatively impact water availability. Additionally, the Company is subject to various stringent environmental regulations, including new EPA standards for PFAs. These have the potential to increase operating costs, as well as increase capital expenditure.

Weather-related incidents, such as severe storms and floods can disrupt operations and reduce revenues. Additionally, extreme weather conditions can cause damage to facilities and cause increased costs to repair or replace them.

  • Acquisition Risks: Growth by acquisition is a key part of Essential’s strategy. But acquisitions come with integration risk. Additionally, the company may pay a high price for assets that may not produce the required returns.

Despite these risks, essential Utilities have shown a certain degree of resilience as it operates in a highly regulated industry that provides an essential product. The company maintains a diversified portfolio of regulated operations and continues to pursue disciplined cost management and growth initiatives.

Understandability: 2/5

  • While the basic concept of providing water, wastewater, and natural gas services is relatively straightforward, the details of the utility business and its regulation can be difficult to grasp for the average investor. It’s complex because of all the state-to-state regulation, infrastructure requirements, and capital spending necessary.

The company’s financials are somewhat complicated to understand because the business’ activities are heavily intertwined with regulated markets and have complex requirements.

Balance Sheet Health: 4/5

  • Despite large long term debt the company has been steadily growing and generating revenue. Debt is carefully managed and is being used to fund expansion, which will continue to grow value for the company.

The company’s current assets to liability ratio and current capital are both good signs for the balance sheet being able to pay off near-term obligations.

  • However, it’s important to keep an eye on the amount of long-term debt, and whether it’s being overused compared to total assets, so that the company can still manage its obligations in the long run.

Recent Concerns and Management Views

  • Rate Increases: Essential Utilities is currently seeking rate increases in multiple states, which has led to questions about the company’s profitability. Management has expressed confidence that they will be able to reach an agreement with regulators and receive an appropriate level of return.
  • Acquisition Integration: Essential Utilities is actively acquiring other companies in the industry to expand, and the question of whether the company can successfully integrate the newly acquired businesses is constantly on investor’s minds. Management has said that the company intends to fully integrate the newly acquired assets to help with future growth opportunities.
  • Inflationary Pressures: Rising costs related to inflation are a concern for Essential Utilities. The company has been actively working to mitigate these pressures through rate increases, efficiency improvements, and leveraging technology.

The management has noted that their priorities remain to maintain reliable, high-quality service and enhance the financial health of the business. They have communicated their plan to work on managing inflationary pressures and have stated their intention to continue to improve service delivery.