Infrastructure

Essential Utilities May Be the Last Cheap Stock for Water Investors

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If any sector is both defensive and a must-own for all investors, utilities comes to mind. In particular, water is about as defensive as it gets. Investors have known for more than a decade that they should have some exposure to water in their portfolios.

Water is the source of life. People can endure days without food, but trying to go more than a few days without water will result in paying the ultimate price. Almost every business and aspect of government also requires water in some form. Investors have caught on to this and have ridden most companies with water exposure much higher. There is just one problem for investors looking to capitalize on the future of water: all the water utilities have high valuations, and the stocks now look incredibly expensive compared with relative sectors.

A recent evaluation of the water-related theme showed only a few companies still have much implied upside. Those are of course based on the current share prices having appreciated, but one water utility that still may have plenty of implied upside is Essential Utilities Inc. (NYSE: WTRG).

Many investors do not know of Essential Utilities by name. This is the country’s second-largest regulated water utility, with a market cap of more than $10 billion. It was called Aqua America in the past, and the new name is the result of its acquisition of and merger with the natural gas distribution company Peoples. That was an all-cash transaction with an enterprise value of $4.275 billion, after it assumed roughly $1.1 billion of debt.

Investors are willing to pay up handily for water, but combining water and gas and enduring a name change may have made it harder for investors to want to step up to the plate here. There is also an issue with anything to do with climate change to consider. That said, Essential Utilities may be the last cheap stock for investors who want to own a major water utility stock. That is at least part of the take from Janney’s Michael Gaugler.

With shares closer to $44.50, Janney has an Outperform rating and a $70 price target. Investors should be aware of two things here before delving into the reasons for such strong upside. First and foremost, investors should never use a single research report as their sole reason for buying (or selling) a stock. The second issue is that Gaugler’s fair value estimate is the so-called street high target price.

Gaugler sees Essential Utilities posting higher earnings, and he raised his estimates to adjusted $0.28 a share from $0.23 for the coming quarter. This is based on favorable weather patterns for both its water and natural gas segments during the April through June period. The full-year adjusted earnings guidance is currently $1.53 to $1.58, but Gaugler sees that range potentially tighten or increase if the favorable weather patterns continue to go in its favor.


As for why weather is a boost, the month of April was colder than expected in Pennsylvania, and its Peoples Gas segment results should have benefitted. Pennsylvania was noted as 14% colder than normal in April, and that was followed by May being 23% colder than normal. As for the summer of 2020, it has been hot and dry through June and July. All this and the current heatwave should work in the utility’s favor.

Wedbush does acknowledge that the firm was already at the high end of the company’s annual guidance before its latest earnings target hike. The report also indicates that the firm lowered its forecasts for the fourth quarter to remain within the company’s own guidance range for the full year. One thing that may help is if fourth quarter of 2020 is colder than normal. That would set up the company to come in above its prior guidance.

With the closing of its Peoples Gas transaction earlier this year, Gaugler’s view is that there is still plenty of potential upside in the stock. Essential’s 2.1% dividend yield is the highest among the major water utilities and is about 150 basis points above the reference 10-year Treasury yield.

To prove that the water utility sector is valued at a major premium to the market, note that the $70 fair value estimate implies that Essential Utilities is valued at 42 times Wedbush’s 2021 earnings estimate of $1.67 per share. That also would imply a 1.5% dividend yield in 2030 that assumes a 7.5% dividend constant growth rate.

The Refinitiv consensus analyst targets are earnings of $1.48 per share in 2020 and $1.66 per share in 2021. And to show how much higher this is than other peer analyst calls, note that Refinitiv has a $47.91 consensus target price.

With such a high price target, it’s important to consider what is being said by other analysts for some balance. Not all analysts agree with this mega-bullish view. Barclays started Essential Utilities with an Equal Weight rating and a mere $45 price target on July 15. UBS reiterated its Neutral rating on June 5, and the firm’s prior $43 target price was bumped up to $45 at that time. Seaport Global Securities issued a new Neutral rating on May 20.

One firm that shares a bullish stance here is RBC Capital Markets. The firm initiated coverage with an Outperform rating in late April. Instead of a massive price target, it only pegged it at $49. Back in February, before the COVID-19 pandemic battered utilities and the market as a whole, Robert W. Baird reiterated its Outperform rating and raised its target to $50 from $44.

One issue that stumped most utility investors is that the sector did not act defensively at all during March’s panic selling. Essential Utilities even traded below $35, after having been at nearly $55 earlier. On top of massive layoffs and skyrocketing unemployment hurting the customers, business failures and weak conditions pushed demand for all utility outputs lower. Many utilities issued alerts that they would work with customers and would not cease services for nonpayment. Some even issued statements that they would turn services back on for those who already had been cut off for nonpayment ahead of the recession.

Essential Utilities cannot be viewed solely as a water utility due to the Peoples natural gas services from its recent merger. This also may be harder for investors to adequately model their future expectations, now that it is a gas and water utility combined. That said, this may be the last water-related stock that seems cheap and undervalued against peers, based on its share price and its history.

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