American Water Works (NYSE: AWK) released its first-quarter 2019 results earlier this month. The country's largest publicly traded water utility's revenue grew 6.8%, and earnings per share (EPS) adjusted for one-time items rose 3.4% year over year. Moreover, management reaffirmed 2019 guidance of adjusted earnings growth in the range of 7.3% to 10.3% year over year.
On the Q1 earnings call, CEO Susan Story discussed the PFAS drinking water contamination issue, which she called "one of the biggest emerging issues that will need to be addressed across the country." As both an investor and consumer, you should be aware of this crisis, as it has the potential to affect both your wealth and health.
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There are already good reasons to buy American Water stock, as I've been harping on for years. The unfolding PFAS issue provides another one, as we'll get to in a moment.
Before diving in, for context, American Water stock has returned 42.9% over the one-year period through May 22, making the S&P 500's 7% return look like a drop in the proverbial bucket. It's also swimming by shares of Aqua America and American States Water (NYSE: AWR) -- the second- and third-largest (by market cap) U.S. water utilities -- which have returned 20.6% and 27.6%, respectively, over the last 12 months. Moreover, American Water stock has also been a great performer over the long term, returning 762% over the last decade -- more than 2.5 times the S&P 500's return.
What are PFAS?
PFAS stands for "perfluoroalkyl and polyfluoroalkyl substances" (a plural, so there's no need to ever add a small "s," as in "PFASs"), with the most relevant thing to know for our purposes being that this large group of synthetic chemicals includes perfluorooctanoic acid (PFOA) and perfluorooctane sulfonate (PFOS).
This toxic duo has infiltrated the drinking water supply across the country, mostly in a localized way surrounding certain industrial sites and military bases. They're the most studied of the PFAS group because they're the ones that have been produced in the largest quantities in the United States, according to the U.S. Environmental Protection Agency (EPA).
PFOA and PFOS, which repel water and stains of various types, have been used as coatings on fabrics and leather and in the production of stain-repellent carpeting and are found in firefighting foams -- which have been used extensively on U.S. military bases for decades -- among other products. Moreover, some related polyfluoroalkyl compounds can be transformed into these chemicals in the environment, per the National Institutes of Health (NIH), with the Environmental Working Group (EWG) stating that some perfluorinated chemicals not only break down into PFOA in the environment but also can do so in the human body.
The brand names of products that contain (or contained) one of these chemicals or generate (or generated) one of them in the environment upon use and/or production are familiar: Teflon (from DuPont, now DowDuPont), Stainmaster (invented by DuPont but acquired by privately held Koch Brothers in the early 2000s), and Scotchgard (3M), to name a few. While PFOA and PFOS are no longer made in the U.S., that hardly matters in our global economy. Both are still produced internationally, which means they end up in our country via imports of consumer goods such as carpet, apparel, textiles, and paper and packaging.
Why all the concern about PFOA and PFOS?
These chemicals -- dubbed "forever chemicals" because they're persistent in the environment and the human body -- have been linked to cancer, thyroid disease, weakened immune system and liver function, low infant birth weight, and other health problems, according to many sources. Here's what the EPA has to say:
No federal regulations for PFOA and PFOS in drinking water
When it comes to drinking water from the tap in the U.S., the phrase that fits with respect to PFOA and PFOS is "caveat emptor" (buyer beware). The EPA has not regulated these chemicals.
In May 2016, the EPA established a drinking water "health advisory" of 70 parts per trillion (ppt) for the combined concentrations of PFOA and PFOS. While that was a start, there's a big difference between a health advisory and a regulation that has teeth. Moreover, many scientists consider 70 ppt too high a limit. Reportedly, the EPA -- which is under pressure from some lawmakers -- is now considering turning its 70 ppt health advisory into an official regulation.
Meanwhile, some states have stepped up to the plate to better protect their residents and visitors. In April, for instance, the New Jersey Department of Environmental Protection (DEP) proposed maximum contamination levels (MCLs) of 14 ppt for PFOA and 13 ppt for PFOS in the state's drinking water.
American Water has a "competitive advantage" stemming from PFAS in the U.S. drinking water supply
From CEO Story's remarks:
It seems likely that states will increasingly enact regulations limiting the levels of PFOA and PFOS -- and perhaps other PFAS -- in their drinking water systems, while the EPA might -- at least eventually -- turn its health advisory into an official regulation. Against this backdrop, it makes good sense that Story believes American Water's capability to lower the level of certain of these bad actors in drinking water supplies provides the company with a "competitive advantage," at least in its military services group. This business currently has 50-year "utility privatization contracts" for 14 bases across the country. American Water's competitors in this business are California-based American States Water, Suez North America -- a subsidiary of France's Suez Environnement -- and France-based Veolia Environnement, according to the company's 2018 annual report.
Story didn't explicitly say the PFAS issue also provides the company with a catalyst for growth in its core regulated business -- such a comment risks coming off as somewhat predatory -- but this seems like a no-brainer. Many municipalities across the country that own and operate their own water systems are already finding it challenging to keep up with costly required maintenance and regulations. Most are reportedly not equipped to remove PFAS from the water they treat, which means they'll need to spend big money on upgrading their systems if and when their state and/or the EPA regulates these chemicals. This should provide an impetus for more of them to put their systems up for sale, which municipalities have increasingly been doing in recent years.
American Water is not only based in New Jersey -- which is at the forefront of enacting stringent PFAS regulations -- but also has a large chunk of its regulated business in the state. In 2018, the Garden State accounted for 24.2% of American Water's regulated revenue and 21% of its total revenue. The company's big presence in the state already provides it with an advantage with respect to acquisitions since it's more cost-efficient for water utilities to expand near where they already operate. And it also has much greater financial resources than potential competitors.
So American Water is already sitting in the catbird seat when it comes to scooping up municipal-owned water utilities that go on the market in NJ -- and tough PFOA and PFOS regulations have the potential to magnify the company's competitive advantage by increasing the pool of possible acquisition targets.
This is a good thing, in my opinion, as long as the company remains responsibly run. Many municipalities are in over their heads expertise- and oversight-wise when it comes to operating water systems in this day and age, I suspect.
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