Description

We believe that the common equity of American Water Works Company (NYSE: AWK), the largest investor-owned water utility in the U.S., offers a compelling risk/reward at its current price level.  AWK’s stock recently sold off due to its announcement of a secondary stock offering, in our opinion.  AWK trades a significant discount to its water utility peers despite a healthy pipeline of pending tariff increases and potential acquisitions.  We feel that the largest overhang on the stock has been the majority ownership of German utility RWE.  RWE is actively reducing its position, however.  Furthermore, AWK pays a healthy 3.7% dividend.

We are currently long AWK, but may change our position at any time.  We make no guarantees regarding the accuracy of the information contained herein.

Company Description

American Water Works Company is the largest investor-owned water utility in U.S., serving over 15 million people in 32 states in the U.S. and Canada.  Roughly 88% of revenue is from its regulated utility business, and its unregulated operations and maintenance businesses accounting for the remainder. 

AWK began trading on the NYSE April 2008 when it was spun out of German utility giant RWE.  RWE sold roughly 40% of its ownership of AWK to the public via IPO, and announced that it intended to sell its remaining 60% over time.  AWK has traded at a discount its peers since the IPO, due in large part to investor concern over selling pressure stemming from RWE’s eventual liquidation of its remaining shares, in our opinion.

Secondary Offering

AWK announced on 12/18/08 it would sell an additional $600 million in common equity in Q1 2009, half of which would be primary shares and half coming from RWE. The stock fell 5% the day of the announcement.  Successful completion of the sale will lower RWE’s ownership from 60% to roughly 45%. 

Regulatory Decisions and Outlook

In the period preceding AWK’s spinout from RWE, the company made limited requests for tariff increases.  The Public Utility Commission (“PUC”) for each state in which AWK operates had to approve the spinout, and the company delayed tariff increase requests in hopes of maximizing goodwill with various PUCs.  Once the necessary approvals were obtained, however, the company began pursuing tariff increases and acquisitions more aggressively.

AWK recently received $106 million in combined annual rate increases in NJ and MO with permitted ROEs of 10.3% and 10.5%, respectively.  This represents a roughly 4.7% increase over 2007 company revenues.  The company has an additional 7 rate cases pending totaling over $100 million in annual revenues, representing an approximate 4.2% increase over our 2008 revenue estimate.

Valuation

We forecast AWK to achieve high single digit annual revenue growth for the next several years given their rate case pipeline.  Furthermore, we believe the multiple discount to its peers will disappear as RWE decreases its ownership stake.  Adjusted historical financials and our forecast are below ($ in millions, ex per share data):

                                    2006                        2007                        2008E                        2009E

Revenue                        2,093                        2415                        2353                        2570

Growth rate                                                    5.8%                        6.3%                        9.2%

EBITDA                          723                        791                           847                          933

Net income- GAAP       -162                        -343                         -547                           231

Net income- Adj.               92                        188                           181                           240

EPS- Adj.                       0.57                        1.17                         1.13                          1.39

(Net income and EPS adjustments were made for one-time items)

We assign a price target of $27.80, based on a P/E of 20.0x and our 2009 EPS estimate of $1.39, representing a 32% upside versus the current price.  While we believe a premium multiple is warranted given the significantly AWK’s significantly larger market cap and liquidity versus the bulk of its peer group, our target price still assumes a discounted P/E of 20.0x:

                                                Market Cap            EV/EBITDA              Price/Tang BV            P/E

American Water Works            $3.4 bln               10.8x                           1.6x                             18.0x

Aqua America   (WTR)            $2.9 bln               14.2x                           3.3x                             31.5x

California Water (CWT)            $0.7 bln              11.6x                           2.0x                             22.5x

American States (AWR)            $0.6 bln              10.3x                           2.2x                             25.6x

Risks

The primary risk to our thesis is that AWK doesn’t receive the tariff increases we anticipate, thereby achieving lower revenue and EPS growth, and is consequently assigned a lower multiple by the market.

Catalyst