Utilities aren't the most exciting, but one stock is surging thanks to growth and ESG momentum

Published Tue, Oct 27 20203:00 PM EDTUpdated Tue, Oct 27 20205:09 PM EDT

(This story is for CNBC PRO subscribers only.) The utilities sector isn't exactly known for exciting investors. These companies aren't going to see their shares shoot up in a heartbeat, like some names in the high-flying technology sector. Nor are they household names that consumers know and love. But the sector is, of course, instrumental in our daily lives. As such, these stocks are typically referred to as "defensive" since they provide consistent earnings no matter the broader economic backdrop. Not all utilities are created equal, however, and as the world transitions to renewable energy sources, some electric utilities may be at risk. Water, on the other hand, isn't going anywhere, meaning water utility companies offer an attractive long-term bet for investors. And within the space one name stands out: American Water Works . This point is not lost on the Street: shares of the company have gained 25% this year through Monday's close, while the S & P 500 utilities group is flat. With a market cap north of $27.9 billion, the company is by far the largest player focused exclusively on water, in what's a heavily fragmented market undergoing consolidation. "American Water Works is totally unique," said Tim Porter, chief investment officer at Reaves Asset Management. "No other water utility is growing as quickly. No other water utility is a pure-play water utility. No one has their credentials as far as ESG or their performance track record." Key player American Water Works is the U.S.' largest and most geographically diverse public water and wastewater utility company, in terms of both operating revenue and customers served. The lion's share of the company's business is as a regulated utility serving 16 states with over 3.4 million active customers. This portion of the company's business, which is concentrated in New Jersey and Pennsylvania, accounts for roughly 90% of the company's revenue. American Water Works also has market-based businesses, which includes providing water and wastewater for military bases as well as homeowner services. The company is actively seeking to expand this channel and in September was awarded another military contract — its seventeenth — worth $771 million. The combined units span 46 states, providing services for roughly 15 million people. Earnings growth The company continues to grow earnings and revenue as it expands its footprint through strategic acquisitions, all while utilizing a conservative spending approach. In 2019 the company's regulated businesses earned $3.09 billion, up from $2.98 billion and $2.95 billion in 2018 and 2017, respectively. The regulated operations also fell to 86% of total revenue in 2019, down from 88% in 2017, as the company expanded its market-based business. For 2020, American Water Works expects to earn between $3.79 and $3.89 per share, up from $3.43 in 2019. The range is, however, below prior guidance of $3.85 to $3.95, due to potential impacts from Covid-19. Still, at a time when some companies have cut their dividend, American Water Works continues to pay shareholders. The company currently yields around 1.4%, which Aureus Asset Management chairman and CEO Karen Firestone noted isn't high but is still twice the rate of a 10-year treasury. Utilities are seen as a proxy for bonds, and with interest rates at historic lows, they look more attractive than Treasurys. Firestone, who has owned the stock for years, added that the company has a solid balance sheet, and carries about the same amount of risk as a government bond. "They run a really tight ship," said Porter, whose firm holds shares of the company through mutual funds. "It's literally the only game in town if you want institutional exposure to water as a theme, which makes it that much more valuable." Water as 'poster child' for ESG Part of American Water Works' performance this year has been driven by the momentum behind ESG, or when a company's environmental, social and governance factors are evaluated when making an investment decision. During the second quarter, global assets under management in socially responsible funds topped $1 trillion for the first time on record, according to data from Morningstar. ESG is a catch-all term and there are a number of ways in which this strategy can be implemented. That includes negative screens, which is avoiding a certain type of company — such as those involved in hydrocarbon production — entirely. For large investors who want to own the utilities sector while avoiding companies with exposure to oil and gas, American Water Works is the only game in town. It's more than double the size of competitors like American States Water and Essential Utilities, which have market values of $2.8 billion and $10.8 billion, respectively, according to FactSet. The latter is also involved in natural gas. "You can't beat water as a poster child for ESG," noted Firestone. "AWK is the only liquid, pure play water utility option for mid- and large-cap investors, including those with ESG mandates," added Wells Fargo, which has a neutral-equivalent rating on the stock. Consolidation in the space Much of the U.S. water system is in desperate need of an upgrade. At present, more than 40% of pipeline infrastructure is currently classified as poor, very poor or life elapsed, and many municipalities don't have the money to replace systems — especially in the wake of Covid-19 — which is where American Water Works can step in. The company has steadily expanded its reach, and in the highly fragmented water and wastewater sphere its status as the largest player makes acquisitions easier. And there's a lot of opportunity for purchases. There are around 53,000 community water systems across the country, according to estimates from the Environmental Protection Agency. Across the industry just 16% of water utilities are investor-owned, with that number dropping to 2% for wastewater operations. This year through the end of July, American Water Works made 13 acquisitions across six states, adding 10,800 customer connections. Another 28 acquisitions are under agreement, and the company has identified opportunities to add another 800,000 customer connections. The industry is highly regulated meaning much depends on federal, state and local legislature. But recognizing the benefits of outsourcing water operations, some states have adopted legislation that incentivizes local municipalities to sell or bring in a professional manager for water systems. Key infrastructure spending As a regulated utilities company, American Water Works has to consistently spend money upgrading its infrastructure in order to gain approval to increase rates. During the first half of the year the company invested $930 million in its operations, and over the next decade is targeting between $20 billion and $22 billion in capital investments. But this spending has immediate returns. "The more a utility spends, the more it earns," summarized Porter. Utilities are essentially monopolies that are paid to run a system. The value of that system grows based on the amount of spending, and the company then earns a return on the equity that it puts into the system. Stretched valuation? After American Water Works' rapid rise this year some believe the stock has gotten ahead of itself. According to data from FactSet shares trade at 40 times forward earnings, making it more expensive than other utility companies. Equity analysts at Guggenheim noted recently that while the company is "a top tier growth platform built to last," it's "difficult to justify the [multiple] expansion versus electrics." The firm has a neutral rating on shares. Earlier in October, research firm Janney downgraded the stock from buy to neutral based on valuation, saying investors might look elsewhere for cheaper names. Regulatory issues is another potential headwind. While the business is secular in nature, meaning it performs no matter the broader economic backdrop, the stock isn't immune to the whims of the market. Between March 6 and March 23 of this year, for example, the stock dropped 31% — from $141 to $97 — as the coronavirus pandemic roiled markets. The stock has since recovered those losses and then some. Shares currently trade around $153, which is above the average Street price target of $145, according to estimates compiled by FactSet. But even if American Water Works' stock has gotten a little bit ahead of itself, it offers solid upside for the long-term. The steady dividend, low-risk business and growth opportunity combined with a best-in-class management team should drive upside into the future. - CNBC's Michael Bloom contributed reporting.

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(This story is for CNBC PRO subscribers only.)

The utilities sector isn't exactly known for exciting investors. These companies aren't going to see their shares shoot up in a heartbeat, like some names in the high-flying technology sector. Nor are they household names that consumers know and love.

But the sector is, of course, instrumental in our daily lives. As such, these stocks are typically referred to as "defensive" since they provide consistent earnings no matter the broader economic backdrop.

Not all utilities are created equal, however, and as the world transitions to renewable energy sources, some electric utilities may be at risk. Water, on the other hand, isn't going anywhere, meaning water utility companies offer an attractive long-term bet for investors. And within the space one name stands out: American Water Works.

This point is not lost on the Street: shares of the company have gained 25% this year through Monday's close, while the S&P 500 utilities group is flat. With a market cap north of $27.9 billion, the company is by far the largest player focused exclusively on water, in what's a heavily fragmented market undergoing consolidation.

"American Water Works is totally unique," said Tim Porter, chief investment officer at Reaves Asset Management. "No other water utility is growing as quickly. No other water utility is a pure-play water utility. No one has their credentials as far as ESG or their performance track record."