Better Buy: Aqua America, Inc. vs. California Water Service Corp.

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 reality, coupled with 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,Aqua America (NYSE: WTR)andCalifornia Water Service (NYSE: CWT), to see which company 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

Far from being wet behind the ears, Aqua America has been in the water business for more than 130 years. The second-largest publicly traded water service provider by market cap, Aqua America provides water and wastewater services to about 3 million customers in eight states. It's Pennsylvania, however, that accounts for the lion's share of the company's business -- approximately 52% of operating revenue and about 74% of net income for 2016.

California Water Service, on the other hand, is a holding company which was only incorporated in 1999. Representing the third-largest publicly traded water utility, California Water Service provides water services to about 512,000 customers in four states: California, Hawaii, New Mexico, and Washington. California, as you may have guessed, is the primary source of business.

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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.

Company Market Cap FY 2016 Revenue FY 2016 Earnings Per Share FY 2016 Operating Margin Return on Equity (3-Year Average)
Aqua America $5.6 billion $820 million $1.32 39.7% 13.10%
California Water Service $1.7 billion $609 million $1.02 16.6% 7.48%

Data source: Morningstar.

Aqua America, with a commanding operating margin of 39.7%, is considerably better at converting revenue to earnings, so it seems to be swimming away with the more compelling argument for investment. But there's plenty more to consider, so let's grab our scuba gear and dive in even deeper.

The case for Aqua America

When weighing water utilities against each other, one of the most important things to consider is the companies' geographic footprints, since those with greater diversification have reduced exposure to certain environmental risks.Aqua America, for example, maintains regulated operations in eight states -- from New Jersey to Illinois to Texas -- mitigating the risk associated with adverse local weather phenomena. California Water Service, conversely, is a case and study in the perils of insufficient geographicdiversity. Even though it operates in four states, California provides the lion's share of business -- 93% of total consolidated operating revenue in fiscal 2016. So it should come as no surprise that the drought that recently plagued the Golden State also wreaked havoc with the company's bottom line.

WTR Operating Revenue (Annual) data by YCharts

The greatest illustration of how geographically diversified operations mitigate risk is American Water Works (NYSE: AWK), which maintains regulated operations in 16 states, including California. According to American Water Works' 10-K, California accounted for 7.4% of the company's operating revenue in fiscal 2016, but it has had no problem recognizing earnings growth while California has struggled with its water woes.

Aqua America's strategy of growing its enterprise through acquisitions is another factor that distinguishes it from California Water Service. In addition to further diversifying its customer base, the acquisitions position the company to grow revenue, increase the efficiency of its operations, and ensure that it's well suited to maintain dividend growth. According to its recent 10-K, over the past five years, the company has expanded its "utility operations by completing 84 acquisitions or other growth ventures." In fiscal 2017, Aqua America anticipates closing on four acquisitions that will add almost 9,000 customers. California Water Service, on the other hand, reported in its most recent 10-K that it completed "no significant acquisitions" in 2014, 2015, or 2016.

Another enticing reason for investors to go with Aqua America over California Water Service is the company's dividend, which currently has a yield of about 2.37%. California Water Service, on the other hand, offers a yield of only about 2.00%. And though there's no guarantee about what the future holds, a look in the rearview mirror suggests that Aqua America offers even more of a compelling option for dividend-minded investors. Over the past 10 years, Aqua America has grown its dividend at a compound annual growth rate (CAGR) of approximately 6.89%; however, California Water Service has grown its dividend at a CAGR of approximately 1.75% over the same time period.

The case for California Water Service

With a less attractive customer base, arguably less growth ahead of it, and a less attractive dividend, there is little to suggest that California Water Service is a better buy than Aqua America. In fact, the only real reason to consider picking up shares would be based on valuation.

WTR PS Ratio (TTM) data by YCharts

Trading at 2.76 times trailing sales, California Water Service seems inexpensive compared not just with Aqua America but also with the industry in general, which, according to Morningstar, trades at an average 3.4 times trailing sales. Further illustrating the more attractive price tag, California Water Service's stock is also cheaper than Aqua American in terms of cash from operations per share. And rounding out our look at valuation, we find that California Water Service's enterprise is less expensively valued in terms of trailing EBITDA.

Investor takeaway

Having sized up these two water utility stocks against each other, we find one thing to be crystal clear: Aqua America offers a considerably more compelling argument for investment. California Water Servicesports a far cheaper price tag, but we're looking for sound businesses here -- not merely inexpensive stocks.

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.