American States Water Company: Shares More Than Fully Priced At Present (NYSE:AWR)

Investment Thesis

While the business appears to be a safe investment, American States Water (AWR) shares appear more than fully priced at present. A wait and watch approach is appropriate. A detailed analysis of the company’s financials and its outlook appears below.

The Dividend Growth Income+ Club Approach

The logo of the DGI+ Club explained:

Total Return, Dividends, Share Price

The only way an investor can achieve a positive return on an investment in shares is through receipt of dividends and/or an increase in the share price above the buy price – the only way. For more information and background on share value assessment please visit, “Forget Irrelevant Valuations, Returns Based Investing Is A Better Approach” and “Free Cash Flows: Let’s Have A Discussion Towards A Better Understanding.”

Assets, Liabilities

The engines and the lubrication, along with human talent, drive the business. Shareholders have no legal rights to or ownership of the assets. Shareholders in a limited liability company have no legal obligations in respect of the liabilities.

“Equity Bucket

Shareholders have an equitable entitlement to their equity in the company. Equity is increased by capital raised from shareholders, and by earnings of the company. While shareholders have an equitable entitlement to their equity in the company, they have little to no say in how the equity is distributed. In some companies, management actions in respect of the shareholders’ equity do not always benefit shareholders and can be highly detrimental to shareholders. At the DGI+ Club, in addition to reviewing profitability, balance sheet strength, liquidity, and other metrics, we take the extra step of checking the “Equity Bucket” for “leaks”, i.e., effective distributions out of or other reductions in equity that do not benefit shareholders.

Below, I address:

  1. Historical And Potential Future Shareholder Returns
  2. Checking the American States Water “Equity Bucket”

American States Water: Assessing Historical And Potential Future Shareholder Returns

In this article and in most of my articles, I seek to show how targeting a desired return on an investment in shares can be facilitated by actually estimating what future returns will be, based primarily on analysts’ EPS estimates and other publicly-available data. After all, gaining a return is the primary aim of most investing.

First, I provide details of actual rates of return for American States Water shareholders investing in the company over the last four to five years.

Table 1 – American States Water Historical Shareholder Returns

For many stocks where I create a table similar to Table 1 above, I find a wide range of returns indicating a degree of volatility and risk. Table 1 above shows the results for American States Water were returns of 13.5% to 20.3% for six of eight different investors, each investing $3,000 over the last five years and holding to the present. The two remaining, and most recent investors had returns of 8.1% and negative (6.7)%, due to their higher buy prices of $75.4 and $86.64 in 2019. These rates of return, ranging from positive 20.3% to negative (6.7)%, are not just hypothetical results. They are very real results for anyone who purchased shares on the various dates and held through to July 23, 2020. In the above examples, the assumed share sale price is the same for all investors, illustrating the impact on returns of the price at which an investor buys shares.

Projecting Future Shareholder Returns

If rate of return is the basis on which we judge the performance of our investments, then surely we should be seeking to estimate future likely rates of return when we are making investments. But how do we do that? I use proprietary models to generate net income, balance sheet/funds flows, and projected rates of return going out three to five years. Much of this is automated but still involves a great deal of research and business and data analysis to back up the projections. Let us first look at the traditional approach to assessing value of a stock for investment purposes.

Assessment Based On Quant Ratings For Share Investment Decisions

Share buy price, dividends, share sale price, and duration the shares are held are the only factors affecting the return on an investment in shares. That makes potential share sale price the single most important and uncontrollable unknown when making a share buy decision. My expertise is in fundamental analysis, but I do recognize, any methodology, Quant or Elliott Waves or other techniques providing assistance in assessing possible future share price direction, can be of benefit to share investors. I find SA Quant ratings useful for both screening for stocks of interest and as a form of due diligence.

Figure 1

Quant ratings for American States Water show the company is rated particularly poorly on value, at present share price levels, and also on profitability.

Assessment Based On Analysts’ EPS Estimates

Figure 2 – Summary Of Analysts’ Adjusted Non-GAAP EPS Estimates

Some observations on contents of Fig. 2

  • The analysts’ quarterly EPS estimates for consensus, high and low, do not add to the yearly EPS estimates for consensus, high and low. This is generally the case because the analyst with the high estimate for the year is not necessarily the analyst with the highest estimate each and every quarter, ditto low, and consensus figures. To overcome this, I adjust the quarterly EPS figures in the proportion of yearly totals to quarterly totals.
  • The further out estimates are made, the less certain they become. The 2022 to 2024 estimates, due to being covered by only 3 or fewer analysts, will have additional uncertainty.
  • The range between high and low estimates is not great, suggesting reasonably quantifiable future expectations.

I incorporate the above analysts’ EPS estimates from SA Premium into my rate of return projections utilizing my proprietary 1View∞Scenarios DashboardsTM further below. As for Quant ratings, EPS and EPS growth estimates do not quantify the rate of return that can be expected for the stock in question.

Figure 3 – Non-GAAP P/E Ratios, Historical And Future Estimates

Figure 3 is primarily designed to determine an appropriate range of non-GAAP P/E ratios for determining estimated future share price levels for American States Water. This is necessary for quantifying estimated future rates of return. Figure 3 also informs us of past non-GAAP EPS growth rates compared to forward estimates of EPS growth based on analysts’ consensus estimates. Analysts’ consensus estimate of EPS for 2020 is estimated to be up 7% on 2019 suggesting little expected impact from the COVID-19 pandemic in 2020. Analysts’ consensus estimates for 2021 to 2024 EPS growth range from 5.7% to 7.8% YoY. These rates of EPS growth compare to quite variable historical growth rates for 2017 to 2019, ranging from negative (1.1)% to positive 21.6%. It should be understood, in quantifying the estimated rates of return below, I’m relying on the soundness of analysts’ consensus estimates of EPS. The other important factor is determining appropriate future P/E ratios, which is fraught with difficulty. P/E ratios are impacted by issues both at the macro and micro level. I don’t believe I will have any arguments against the notion current P/E ratios are influenced by expectations of future EPS growth rates. Below, I quantify potential rates of return under various scenarios utilizing my proprietary 1View∞Scenarios Dashboards.

Assessment Based On Quantification Of Potential Rates Of Return

My forward-looking analyses bring another dimension – the quantification of potential returns utilizing various pieces of financial information already available.

Table 2.1 – 1View∞Scenarios Dashboard

Table 2.1 shows buying at the current share price would provide indicative rates of return through end of 2022 of 8.5% for the consensus case, 9.0% for the high case, and 7.9% for the low case. These rates of return assume EPS results in accordance with analysts’ consensus, high and low estimates and a constant adjusted non-GAAP P/E ratio of 37.66 (same as current TTM P/E ratio). This P/E ratio of 37.66 is above the historical median of 34.64 per Fig. 3 above. American States Water P/E ratio compares to peers as follows, per this peer comparison from SA Premium.

Figure 4

Table 2.2 – 1View∞Scenarios Dashboard

Table 2.2 uses similar assumptions to those in Table 2.1 above, except for a lower 34.64 P/E ratio, in line with the historical median per Fig. 3 above. At the lower P/E ratio 2022 consensus case rate of return reduces from 8.5% per Table 2.1 to 5.0%, with similar reductions for high and low cases.

Table 2.3 – 1View∞Scenarios Dashboard – Stress Testing

Table 2.3 uses the same assumptions as in Table 2.2 above, except for a decline in the P/E ratio by around 26% from the historical median of 34.64 to 25.72. The 25.72 is still a little higher than American States Water’s historical low P/E ratio of 24.57 per Fig. 3 above. At the assumed lower P/E ratio, indicative returns through end of 2022 are negative (6.5)% for consensus, negative (6.1)% for high case, and negative (7.1)% for low case. By holding on until 2024, continuing EPS growth effect on share price, and receipt of dividends eventually enables the average yearly return to turn positive. In Table 2.4 below, I show the result of holding off buying to wait for a possible lower share price.

Table 2.4 – 1View∞Scenarios Dashboard Projected Rates Of Return – Allowing For A Lower Share Buy price

Table 2.4 assumptions are similar to Table 2.2, except I have assumed a P/E ratio 10% below the historical median, and an 11.6% fall in share price in 2020 occurs before buying. At the assumed lower P/E ratio of 31.17 and the buy price of $71.90, indicative returns through end of 2022 are 6.0% for consensus, 6.5% for high and 5.3% for low cases. It should be noted the American States Water share price reached a 2020 high of $95.67 on February 18, 2020, before the impact of the COVID-19 pandemic caused a market-wide downturn. The share price fell to a low of $65.11 on March 16, before recovering to the current closing price of $81.34 on July 23.

Checking The American States Water “Equity Bucket”

Table 3.1 American States Water Balance Sheet – Summary Format

Period January 1, 2017 to March 31, 2020 (3.25 years)

Table 3.1 shows American States Water has increased net assets used in operations by $212 million over the last 3.25 years. The increase was funded by $110 million in equity and $102 million in net debt. The $110 million increase in shareholders’ equity over the last 3.25 years is analyzed in Table 3.2 below.

Table 3.2 American States Water Balance Sheet – Equity Section

I often find with companies, while they produce earnings that increase shareholders’ equity, significant amounts of distributions out of, or other reductions in equity, do not benefit shareholders. Hence the term “leaky equity bucket.” This is happening to some extent with American States Water as explained below.

Explanatory comments on Table 3.2 for the period January 1, 2017, to March 31, 2020:

  • Reported net income (non-GAAP) over the 3.25-year period totals to $220.4 million, equivalent to diluted net income per share of $5.97.
  • The company shows some net income and EPS growth over the period.
  • The non-GAAP net income excludes $10.8 million of income regarded as unusual or of a non-recurring nature, in order to better show the underlying profitability of American States Water. These adjustments decrease reported non-GAAP EPS over the 3.25-year period by $0.27 per share.
  • Other comprehensive income includes such things as foreign exchange translation adjustments in respect to buildings, plant, and other facilities located overseas and changes in valuation of assets in the pension fund – these are not passed through net income as they fluctuate without affecting operations and can easily reverse in a following period. Nevertheless, they do impact on the value of shareholders’ equity at any point in time. For American States Water, these items were $1.2 million positive and increased EPS by $0.03 over the 3.25-year period.
  • There were share issues to employees, and these were a significant expense item. The amounts recorded in the income statement and in shareholders’ equity, for equity awards to staff, totaled $7.7 million ($0.21 EPS effect) over the 3.25-year period. However, the market value of these shares is estimated to be higher by $14.4 million ($0.39 EPS effect) than the amount recorded for stock compensation expense purposes over the 3.25-year period. This understatement of expense is equivalent to ~6.5% of reported non-GAAP EPS over the 3.25 years, so in accounting terms, it is a material understatement of the real cost of stock compensation. This is not a matter unique to American States Water. This Ernst & Young publication on Returning capital to shareholders, expresses a similar concern –

Companies seek to offset executive compensation dilution. Buybacks can replace the shares or fund the options that companies award as compensation. A director recently cautioned that this practice could cause companies to inadvertently increase the cost of executive compensation plans: “If we are using hard dollars to offset stock dilution, we should treat those hard dollars as a compensation expense. Otherwise we are not recognizing what we are actually spending to compensate our people.”

  • By the time we take the above-mentioned items into account, we find, over the 3.25-year period, the reported non-GAAP EPS of $5.97 ($220.4 million) has decreased to $5.89 ($217.5 million) net income from operations, added to funds available for distribution to shareholders.
  • There were no share repurchases to offset issues to staff.
  • In the period under review, net debt as a percentage of net debt + equity has increased from 41.8% at end of 2017 to 45.9% at end of Q1-2020.

American States Water: Summary And Conclusions

Based on current high P/E multiple, the stock appears overpriced at present. But this is a highly subjective assessment. If investors in general are prepared to continue accepting these high multiples in the long term, then the shares will continue to trade at relatively high prices. At a constant multiple, share price growth will move in line with EPS growth. This is true whether the constant P/E ratio is 15 or 34. The only time P/E ratio affects returns is when there is a change in the P/E ratio.

Investors chasing yield will look for a reliable dividend payer with a dividend yield above the treasury yield – that is what pushes up P/E multiples to new highs as treasury yields fall. The risks of large capital losses are greatly magnified at high P/E multiples. Those risks could be realized if there is a change in investor sentiment brought on by an increase in interest rates or a general market downturn for any number of reasons. On the other hand, if recessionary effects are greater than expected, the share price could benefit from a flight to safety.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor and/or a tax advisor as to the suitability of such investments for their specific situation. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer, or a recommendation to buy, sell, or dispose of any investment, or to provide any investment advice or service. An opinion in this article can change at any time without notice.

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