Water Acquisitions Take Back Seat to Gas in Essential Utilities' Growth Plan

Strategist

Travis Miller

For more than 50 years, Essential Utilities—formerly Aqua America—was one of the few pure-play water utilities in the United States. But its $4.3 billion acquisition of Peoples Natural Gas in March 2020 made the company nearly 50% larger and diversified its earnings mix.

The gas business contributes about one third of earnings on a normalized basis. Its asset base is growing faster than that of the water business due to infrastructure upgrades. As municipal water acquisitions have slowed in the near term, the gas business has become a critical source of growth.

Although water conservation has reduced demand for several decades, Essential has increased earnings and the dividend by replacing and upgrading old infrastructure. Similarly, Peoples should produce steady earnings growth as it replaces and upgrades system infrastructure, even though we expect little usage growth.

Essential also grows by acquiring small, typically municipally owned water systems. In the U.S., 85% of the population is served by a municipal water utility, offering a long runway of acquisition growth opportunities. Tighter environmental standards could raise costs for municipalities, spurring more acquisition opportunities.

We expect 6% annual earnings growth during the next three years, in line with management's target. Growth could trend higher if Essential can close the pending $276.5 million Delcora acquisition and increase water acquisitions. Long term, we assume an average $200 million of water acquisitions annually. Essential likely will fall short of that in 2024, excluding Delcora.

State fair market value laws require Essential to pay municipalities at least the assessed value of the system it acquires and allow the company to add these assets to rate base at the assessed value rather than historical cost. The municipalities benefit by ensuring they get fair prices, and Essential shareholders benefit by ensuring the company doesn't overpay for growth. In many cases, these deals are immediately value-accretive.

Business Strategy & Outlook

We have greater than 50% confidence that Essential can generate economic profits on a consolidated basis for at least the next 10 years based on its efficient scale competitive advantage for its water, wastewater, and natural gas distribution businesses. We have strong confidence that Essential’s returns on invested capital will remain at a healthy spread over its weighted average cost of capital during this period, leading us to assign the company a narrow moat rating.

Essential owns a difficult-to-replicate network of water, wastewater, and natural gas distribution infrastructure that provides essential energy sources to customers. In exchange for a service territory monopoly, state and federal regulators set rates for Essential’s water distribution, wastewater, and natural gas distribution utilities at levels that aim to keep customer costs low while providing adequate returns for capital providers. This implicit contract between regulators and the utilities should, in the long run, allow Essential to earn a consistent spread over its cost of capital. Rate-setting mechanisms in the states that Essential serves are mostly constructive, leading to ROICs modestly above its WACC.

In the water distribution and wastewater businesses, Essential enjoys fair market value legislation in seven of the eight states where it operates. This allows Essential to ensure its growth acquisitions are value-accretive by allowing it to increase its regulated earning asset base to reflect the deal value based on a third-party valuation rather than historical cost. This effectively eliminates the drag on returns created by goodwill and the risk of cost overruns for organic growth investment.

Essential made 57 water system acquisitions between 2015 and 2019, and goodwill represented only 1% of its net asset base before the Peoples acquisition. Thus, Essential’s earned ROICs tend to track very closely its regulatory allowed ROICs, the foundation of an economic moat for regulated utilities.

As with all regulated utilities, we think regulatory caps on revenue and returns preclude Essential from establishing a wide economic moat.

Essential has exited its nonutility businesses that had few competitive advantages, particularly its water, wastewater, and energy services businesses.

Narrow

Economic Moat

Essential Utilities

Essential Utilities, Inc. is a holding company, which engages in providing water, wastewater and natural gas services through its subsidiaries. It operates through the Regulated Water and Regulated Natural Gas segments. The Regulated Water segment includes water and wastewater regulated utility companies. The Regulated Natural Gas segment consists of natural gas utility companies, which provides natural gas distribution services. The company was founded in 1968 and is headquartered in Bryn Mawr, PA.

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Essential Utilities, Inc. is a holding company, which engages in providing water, wastewater, and natural gas services through its subsidiaries. It operates through the Regulated Water and Regulated Natural Gas segments. The Regulated Water segment includes water and wastewater regulated utility companies. The Regulated Natural Gas segment refers to natural gas utility companies, which provide natural gas distribution services. The company was founded in 1968 and is headquartered in Bryn Mawr, PA.

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