American Water Works' Stock Is Pricey, but Its Q2 Earnings Reflect Why Investors Keep Pouring Money In

By Markets Fool.com

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American Water WorksCo. (NYSE: AWK) released second-quarter 2016 earnings last week. The largest publicly traded water and wastewater utility in the U.S. posted revenue growth of 5.8% to $827 million, while earnings per share rose 13.2% to $0.77. Earnings growth was primarily driven by continued regulated system investments and improved operational efficiency.

Analysts were looking for earnings of $0.73 per share on revenue of $832.92 million. So, American Water Works flowed past Wall Street's earnings expectations, though fell a bit short on the top line.

American Water Works stock has spouted off a total return of more than 49% over the one-year period through Aug. 10, leaving the S&P 500's 5.7% return all wet. It's also rained on the parade of the industry's second- and-third largest companies by market cap, Aqua America(NYSE: WTR) and American States Water (NYSE: AWR), whose stocks have returned about 36% and 10%, respectively, over this period.

Key quarterly numbers

Metric

Q2 2016

Q2 2015

YOY Growth

Revenue

$827 million

$782 million

5.8%

Operating income

$299 million

$278 million

7.6%

Net income

$137 million

$123 million

11.4%

Earnings per share

$0.77

$0.68

13.2%

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Data source: American Water Works. YOY = year over year.

Both operating and net income grew faster than revenue, which means that operating and profit margins expanded in the quarter.

Performance by segment

American's regulated business drove its earnings, as shown.

Segment

Q2 2016

Q2 2015

YOY Growth

Regulated Business

$0.76

$0.68

11.8%

Market-Based Business

$0.07

$0.06

16.7%

Parent

($0.06)

($0.06)

--

Total EPS

$0.77

$0.68

13.2%

Data source: American Water Works.

American Water Works operates as a regulated water and wastewater services provider in 16 U.S. states, while its companywide footprint includes 47 states plus Ontario, Canada. Net income in the regulated business was $135 million, up from $122 million for the year-ago period. The increase was primarily due to revenue growth of $29 million, or 4.2%, from rate increases driven by investment growth and acquisitions.

The market-based business reported net income of $13 million, up from $12 million in the year-ago period. Operating revenue grew to $115 million from $100 million, primarily driven by the addition of $11 million from Keystone Clearwater Solutions, whichsupplies water and related services to natural gas exploration and production companies in the Appalachian Basin.

Management said on the analyst conference call that it continues to see headwinds in American Water Enterprises Group, or AWE, for the remainder of 2016. This is primarily due to lower fixed-capital upgrades on its existing military installations because of reduced federal budgets and the "lumpy" nature of these contracts.Management also reiterated that it expects Keystone to have a neutral affect on 2016 earnings. The company remains optimistic about Keystone's prospects once the natural gas market makes further strides in its recovery.

Acquisitions keep on flowing

For the first half of 2016, $24 million of American Water's approximately $552 million of capital investments went toward regulated acquisitions. (The majority of the remainder was for regulated system improvements.)

Regulated acquisitions that closed during the first half added about 7,600 customers. Pending acquisitions expected to close this year are expected to add about 47,800 customers; these include the wastewater system assets of the Sewer Authority of the City of Scranton, Pennsylvania, and theShorelands Water Company in New Jersey.

Efficiency improves

The adjusted regulated operation and maintenance (O&M) efficiency ratio is a key non-GAAP metric for the company's owned facilitiesthat reflects how well it's controlling costs; the lower the better.

American Water's O&M ratio for the 12-month period through the end of Q2 improved to 35.2% from 35.9% for the 12-month period through the end of the year-ago period. The company'sbeen steadily lowering this ratio for the past few years, with a goal of achieving 34% by 2020. Investors should closely watch this ratio going forward.

Full-year 2016 outlook

American Water affirmed its full-year 2016 earnings guidance in the range of $2.75 to $2.85 per share. At the midpoint, this reflects year-over-year EPS growth of 6.1%. Management said the company is on track to meet its long-term goal of increasing EPS at a 7% to 10% compounded annual growth rate over the five-year period of 2016 through 2020, using 2014's earnings as a base.

A stock for the long investing voyage

While American Water Works has been performing solidly, its stock has gotten ahead of its financial performance. For instance, the stock's price-to-earnings (P/E) ratio has risen to 28.5 from 21 a year ago, while its price-to-cash flow from operations (P/CFO) ratio has increased to 10.9 from 8.5. However, its valuation metrics mostly compare favorably to Aqua America and American States Water, despite the fact that it's been performing better. For instance, Aqua America and American States sport P/E ratios of 28.2 and 26.5, respectively.

Defensive stocks, such as dividend-paying utilities, have benefited from investors' flight to safety due to economic uncertainty because of slowing growth in China, among other factors, coupled with a very low-interest-rate environment. While the rapid run-up in valuation could result in some choppy seas over the medium term, American Water's solid Q2 earnings and bright outlook demonstrate why it will likely remain a top-quality investment choice for long-term investors.

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Beth McKenna has no position in any stocks mentioned, though believes the kiddie trio pictured have the right idea during the summer heat. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.