In my ongoing effort to find great companies that are reasonably recession resistant, I decided to look in on Essential Utilities, Inc. (WTRG). I’ll just leap to the point. I think this is a great business and the stock is trading on the low side of its historical range, and for that reason, I think it’s a great buy at the moment. While I think the dividend is less well covered now than it has been anytime over the past five years, I consider this to be a reasonably safe cash cow investment. For those who are nervous about buying at current prices, I recommend a short put strategy that I think presents a win-win for investors. In my view, this dividend grower will continue to benefit from the drive to consolidate the very fragmented industries that it serves. I think this will lead to a growing top line for the next several years.
On February 3, 2020, the company changed its name from Aqua America, Inc. to Essential Utilities, Inc. in order to align the name of the business with the anticipated activities of the company post Peoples Gas Acquisition. The name reflects the proposed combination of water and natural gas utilities. While I’m generally not a fan of acquisitions, I think Essential Utilities has done a great job with acquisitions. For example, in 2019, the company completed eight acquisitions that added 21,613 new customers. In 2018, it completed 8 for an addition of 22,741 customers. In 2017, it completed 4 for an addition of 10,584 customers. Future acquisitions are a significant source of growth for the firm, given that the industry in the United States is quite fragmented. Specifically, there are over 50,000 community water systems in the United States, 81% of which serve less than 3,300 customers. In my view, these will be a significant source of top-line growth over the next several years.
In my view, Essential Utilities has generated decent financial results over the past five years, and this is especially so given the nature of the business. Specifically, revenue and net income have grown at a CAGR of about 1.8% and 2.2%, respectively. Management has been quite good to shareholders, having returned just over $732 million to them in the form of ever growing dividend payments.
Nothing’s perfect, though, and Essential is no different. Growth in total debt has far outstripped sales growth by growing at a CAGR of ~11.5% since 2015. This trend is unsustainable in my view. Also unsustainable is the fact that the dividends per share have grown at a CAGR of 5.7% in the face of earnings growth less than half that rate. This is reflected in the fact that the payout ratio has risen from the low 60s in 2015 to just over 87% today.
Comparing the dividends to cash from operations makes things look significantly better, obviously. Given that TTM cash flow per share is about $1.57, the payout ratio from this figure is closer to 58%. I’m not interested in getting into an accounting lecture, but I should point out that cash from operations, like net income, is an imperfect measure. For example, a compelling argument could be made to suggest that depreciation is an economic reality, and to “add it back” on the cash flow statement may be as troublesome as removing it from the income statement. Whatever measure the investor chooses, though, the payout ratio for both earnings and cash from operations has deteriorated over the past several years.
In spite of the large growth in debt over the past few years, I’m actually relatively sanguine about the capital structure here. In particular, I like the fact that debt repayments are stretched out, per the following:
Source: Latest 10-K
Note that only about 3% of long-term debt is due this year, and about 1.9% is due in 2021. This is particularly important in my view, given that there’s a growing need to roll over corporate debt at a time when the world economy is slowing.
Source: Company filings
My number of followers has recently jumped (at least since last time I looked at the number of readers), and so some of the people reading this may have read the following one or two or fifty times. To those people, my apologies for the repetitiveness, but I must preach to the uninitiated. I wish there were an easier way. The point I’ve made repeatedly is that a great company can be a terrible investment if the stock is overpriced. Alternatively, a troubled business may be a great investment at the right price. The latter is an example of the proverbial “cigar butt” described by the father of value investing. Given the disconnect between stock prices and the business, I must spend some time writing about the stock as a distinct element.
When I look at a stock, I want to buy it at a time when the shares are inexpensive. I know. That statement sounds about as insightful as “water’s wet”, but it is worth reminding readers that we want to buy assets when they’re on sale. I judge whether or not they’re on sale in a few ways, ranging from simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value like earnings, free cash flow, etc. In particular, I want to ensure that the stock is trading near the low end of the company’s range. On that basis, the shares seem to be trading near the low end of their price to book value range (note that I’m not looking at earnings, as I think book value is a more relevant value measure for this business).
In my view, history may not repeat, but it certainly rhymes. With that in mind, I’d point out that the last time the shares traded at current valuations, they went on to do very well. Thus, now is a relatively low risk time to buy, in my estimation.
Options to the Rescue
Just because I consider this to be a great time to buy doesn’t make it so. I can certainly understand why people who are relatively shell shocked may not be interested in buying aggressively until shares fall further in price. For those people, I recommend an alternative to the tedium of waiting for the shares to drop. In particular, I recommend selling put options to generate premia today while agreeing to buy this company at a much more attractive price. These offer investors a “win-win” trade in my view because if the shares remain above the strike price, the investor simply pockets the premium. If the shares fall, the investor will be obliged to buy, but will do so at a price that they already determined is a great entry point.
At the moment, my preferred options are the September puts with a strike of $35. These are currently bid-asked at $2.20-$3.20. If the investor simply takes the bid with these, and is subsequently exercised, they’ll be obliged to buy Essential Utilities Inc. at a net price ~20% below the current level. Ceteris paribus, that price represents a dividend yield just under 3% and a PE multiple of about 22.4 times. Obviously if the shares rise from current levels and remain elevated, the investor simply pockets the premia. In my view, either outcome is quite acceptable.
I think Essential Utilities is a good buy at current prices. The yield is well covered, and the growth through acquisition strategy seems to be going well. Additionally, this strategy should continue to serve the company well for years, given the fragmented nature of the industry it serves. Also, the shares are very reasonably priced in my view, and the last time they traded at these levels, they went on to do well.
Finally, the feeling I have when waiting for share prices to drop to reasonable levels is uniquely off-putting. The only time I’ve experienced anything similar is when I saw Beckett’s “Waiting for Godot” at the Abbey Theatre in Dublin. The interminable waiting, the hope that someday the price may come down to the “right” price is almost enough to put me off investing. It makes me wonder how many fortunes have been squandered because, after years of watching overpriced shares rise ever higher, people lost patience and decided to buy, and then watched shares drop in price. I think selling put options is a great way to overcome this problem. Investors either pocket premia and/or buy shares at prices that they consider to be great, long-term entry points. For my part, I’m comfortable both buying shares at the moment and selling the puts described above. I think this company represents excellent, long-term value, and I think investors who buy at these prices will be glad they did.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in WTRG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In addition to buying shares, I’ll be selling the puts described in this article.