Dividend Kings In Focus: California Water Service

California Water Service (CWT) has an amazing track record when it comes to increasing dividends to shareholders. CWT is part of the Dividend Kings, a group of stocks that have raised their payouts for at least 50 consecutive years. You can see all 45 Dividend Kings here.

Impressively, CWT has paid 310 consecutive quarterly dividends.

The Dividend Kings are the “best of the best” when it comes to rewarding shareholders with cash and this article will discuss CWT’s dividend, as well as its valuation and outlook.

Business Overview

CWT is a water stock and is the third-largest publicly-owned water utility in the United States.

CWT was founded in 1926 and has six subsidiaries that provide water to approximately 2 million people in 100 communities, primarily in California but also in Washington, New Mexico and Hawaii.

Just like the vast majority of utility companies, CWT is a slow-growth company. Utilities spend excessive amounts on the expansion and maintenance of their infrastructure and thus they accumulate high debt loads.

As a result, they rely on the regulatory authorities to approve of rate hikes every year. These rate hikes aim to help utilities service their debt but they usually result in modest growth of revenue and earnings. Regulatory authorities have incentive to offer attractive rate hikes to utilities in order to encourage them to invest in infrastructure.

On the other hand, authorities offer limited rate hikes in order to keep customers satisfied. The reliable rate hikes that utilities enjoy result in a resilient business model, which is characterized by fairly predictable cash flows and earnings growth.

This is clearly reflected in the exceptional dividend growth record of CWT. The company has raised its dividend for 54 consecutive years and has a projected payout ratio of just over 50% for 2022.

The most recent quarter was difficult for CWT and the company is expected to see earnings-per-share decline for the year.

California Water Service reported its second-quarter earnings results on July 28th, 2022. Revenue totaled $206 million during the quarter, which was a 3% year-over-year decline. Management explained the second-quarter revenue decline was primarily due to lower customer consumption.

California Water Service generated a net profit–per–share of $0.36 during the second quarter, which was below analyst expectations by $0.20 per share. 

The company is projected to earn $1.85 per share in 2022, which would be a 5.6% decrease from the prior year. 

Growth Prospects

As mentioned above, utilities rely on modest rate hikes by regulatory authorities year after year, and thus they are mostly slow-growth stocks.

CWT is not an exception, as it has grown its earnings per share at a ~4% average annual rate over the last decade.

We expect the company to grow its EPS by 5% per year over the next five years. One major driver of earnings growth will be continued rate hikes.

The chart below show that the regulated rate base of CWT is expected to grow by 9.3% per year from 2022-2025.

Source: Investor Presentation

Earnings growth in the long run should be achievable thanks to the rate hikes that are regularly approved by relevant authorities/regulators.

Regulators need to continuously encourage the company to keep investing in the expansion and maintenance of its network.

Customers are dependent on high–quality infrastructure that will remain reliable in the future, which is why future rate increases are more or less a given.

Another growth catalyst for CWT is acquisitions.

This is a common practice for companies in many industries, including utilities, to generate inorganic growth by simply acquiring new customers.

Source: Investor Presentation

As you can see, the company is currently progressing through multiple acquisitions, which will instantly add thousands of new customers.

Overall, we expect CWT to continue to grow its earnings per share at a 5% average annual rate over the next five years, which is slightly ahead of its historical growth rate.

Competitive Advantages & Recession Performance

Utilities invest enormous amounts on the maintenance and expansion of their network. These amounts result in high amounts of debt, but they also form extremely high barriers to entry to potential competitors.

It is essentially impossible for new competitors to enter the markets in which CWT operates. Overall, utilities have the widest business moat investors can hope for.

In addition, while the vast majority of companies suffer during recessions, water utilities are among the most resilient companies during such periods, as economic downturns do not affect the amount of water consumed by customers.

The resilience of CWT was evident in the Great Recession. Its earnings-per-share during the Great Recession are below:

  • 2007 earnings-per-share of $0.75
  • 2008 earnings-per-share of $0.95 (27% increase)
  • 2009 earnings-per-share of $0.97 (2% increase)
  • 2010 earnings-per-share of $0.90 (7% decrease)

Therefore, not only did CWT not incur a decrease in its earnings during the Great Recession, but it grew EPS by 20% throughout the 3-year period of 2007-2010.

The exceptional resilience of CWT was also evident in the 2020 economic downturn caused by the coronavirus pandemic. While most companies incurred a material decrease in their earnings during this period, CWT grew its earnings per share by a staggering 50% in 2020..

Put simply, CWT is one of the most resilient companies during recessions and bear markets.

Valuation & Expected Returns

CWT is expected to generate earnings-per-share of $1.85 this year. As a result, the stock is currently trading at a price-to-earnings ratio of 30.3. This is a very high valuation multiple for a utility stock. We consider 20.0 to be a fair earnings multiple for this stock.

Low interest rates are one reason for the elevated valuations of water stocks in recent years, but the Federal Reserve has increased interest rates several times already this year and is likely to do so several more times in the near term. This could put pressure on shares of utility companies.

Investors should pay attention to the valuation of slow-growth stocks, such as utilities. If investors overpay for a utility, the stock may generate years of weak returns.

In this case, the downside risk of CWT is significant whenever the company faces an unforeseen headwind, such as rising interest rates.

If CWT reverts to our assumed fair price-to-earnings ratio of 20.0 over the next five years, it would incur a -8.0% annualized drag in its returns. This could more than offset the positive returns of earnings-per-share growth and dividends.

Another negative aspect of bloated valuations is lower dividend yields. Due to its lofty price, the stock is offering just a 1.8% dividend yield. This is only barely above the average yield of the S&P 500 Index.

Through the combination of expected EPS growth, valuation changes, and dividends, we believe CWT is likely to offer a negative annual return of -1.2% over the next five years.

Final Thoughts

CWT has exhibited an exceptional dividend growth record, thanks to its reliable earnings growth, which is secured by rate hikes that are approved by regulatory authorities.

In addition, thanks to its healthy payout ratio and its solid business model, the company should easily continue raising its dividend at a mid-single-digit rate for many more years.

While CWT is a “boring” stock, it is exceptionally resilient during recessions. When most companies see their earnings collapse, CWT provides a safe haven to investors.

However, we believe the market has fully priced in future growth (and then some). The stock is likely to offer poor returns over the next five years. As a result, we currently rate CWT stock a sell.

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