Better Buy: American Water Works vs. Connecticut Water Service

By Scott Levine Markets Fool.com

According to theAmerican Water Works Association, approximately $1 trillion is necessary to maintain and expand water serviceto meet demand over the next 25 years. This, in addition to the fact that infrastructure has been on the lips of pundits and politicians recently, suggests that examining water utility stocks is a worthy endeavor.

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So let's consider two of the leaders in the industry, American Water Worksand Connecticut Water Service,to see which affords investors the best choice in terms of getting their feet wet (or wetter) with a water utility investment.

Image source: Getty Images.

Getting to know you

The largest publicly traded water service provider by market cap, American Water Works maintains a massive geographic footprint, providing services to about 15 million customers in 47 states and Ontario, Canada. In addition to regulated operations, American Water Works has exposure to market-based businesses through contracts with the United States Military and energy industry. On the other end of the spectrum, Connecticut Water Service serves approximately 129,000 customers in two states: Connecticut and Maine.

The most decisive factor in choosing an investment, however, is hardly which business has the most customers, so let's compare the companies on some important metrics to gain better insight.

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Company Market Cap FY 2016 Revenue FY 2016 Earnings per Share FY 2016 Operating Margin Return on Equity (3-Year Avg.)
American Water Works (NYSE: AWK) $13.6B $3.3B $2.62 32.7% 9.15%
Connecticut Water Service (NASDAQ: CTWS) $608M $99M $2.08 31.2% 10.39%

Data source: Morningstar.

This brief look suggests there's no runaway winner. Benefiting from economies of scale, American Water Works -- with an operating margin of 32.7% -- appears to be the better operator. Connecticut Water, however, seems more adept at turning shareholders' investments into profits. So let's grab our scuba gear and dive in even deeper.

The All-American opportunity

Size may not be everything, but in the world of water utilities it's certainly an advantage. And in the case of American Water Works, it's a noteworthy competitive advantage. The company's geographic diversity -- regulated operations in 16 states -- mitigates the risk associated with adverse local weather phenomenon. Connecticut Water, on the other hand, reported that approximately 95% of its net income in fiscal 2016 was attributable to its regulated operations in Connecticut and Maine. Further demonstrating the advantage, American Water Works has increased opportunities to acquire utilities in proximity to areas where it already maintains a presence. In its recent 10-K, management states that these acquisitions help the company "to achieve operational efficiencies and prioritize capital investment needs." In 2016, for example, American Water Works completed 15 acquisitions, adding more than 42,000 customers; Connecticut Water reported none. Currently, American Water Works has 17 pending acquisitions totaling approximately 40,000 customers; Connecticut Water has two pending acquisitions totaling 9,500 water and 3,000 wastewater customers.

Although the company's past performance is not a guarantee of its future performance, it's worth recognizing the company's recent success. Over the past three years, American Water Works reported both operating revenue growth and net income growth that outpaced that of Connecticut Water.

AWK Operating Revenue (Annual) data by YCharts

The company is optimistic that the tide of growth won't turn anytime in the near future. During its last earnings call, management forecast a five-year EPS compound annual growth rate of 7% to 10%, anchored by EPS of $2.64 in fiscal 2015. But it's not just the projected bottom-line growth that suggests American Water Works is a better opportunity. Arguably, it's the company's dividend that's the more significant factor.

Whereas Connecticut Water has increased its dividend 18% over the past five years, according to Morningstar, American Water Works has raised its dividend approximately 63%. And management assures investors that the dividend growth will continue in the years to come, stating that future dividend increases will track the company's EPS growth. Connecticut Water, on the other hand, has provided no earnings or dividend forecasts; moreover, there's little to suggest that large dividend increases are on the horizon.

An investment in New England

With a yield of 2.09%, Connecticut Water represents a better option at the moment than American Water Works, with its 1.97% dividend yield. And even though American Water Works has a stronger record of dividend growth, Connecticut Water could increase the amount of cash it returns to shareholders without jeopardizing its financial health. At 53.7%, the company maintains a lower payout ratio than American Water Works, whose payout ratio is 55.8%.

Even though American Water Works has the edge when it comes to the operating margin -- 32.7% vs. 31.2% -- Connecticut Water comes out on top in other ways when considering profitability. For one, the company seems better at making the most of shareholders' capital; its three-year average return on equity of 10.39% beats the 9.15% of American Water Works. Evidently, it's better at converting invested capital into profits as well. Over the past three years, the company's average return-on-invested-capital ratio is 7.08% -- higher than the 5.15% average of American Water Works.

Moving away from profitability, we find that Connecticut Water represents a more attractive option for conservative-minded investors. The company's current debt-to-equity ratio of 0.83 is notably lower than the 1.10 ratio of American Water Works.

And the winner is...

Stacking American Water Works up against Connecticut Water, we find there's no runaway winner -- both companies offer compelling arguments for investment. So let's look at how the companies are currently valued to see if it tips the scales in either direction.

AWK EV to EBITDA (TTM) data by YCharts

When considering the price tags, American Water Works certainly seems like the more enticing opportunity. For one, Connecticut Water seems richly valued in terms of its enterprise value-to-EBITDA ratio. And even though American Water Works trades at a slightly higher multiple in terms of earnings, it seems acceptable, considering how inexpensive it is in terms of cash from operations per share compared to Connecticut Water.

Moving forward, investors should confirm that American Water Works is continuing to execute its growth-through-acquisition strategy in addition to maintaining dividend growth -- two things that, of course, must be met with responsible management of its debt.

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Scott Levine has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.