Fair market value laws in several states support Essential’s water business acquisition strategy.

Business Strategy & Outlook

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 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. Essential’s gas and water utility earnings are mostly rate regulated. The management prioritizes infrastructure investments and paying a robust dividend, like most other utilities. The Essential’s earnings to grow 8% annually during the next five years due to its water system acquisition opportunities. This is among the highest growth rates in the U.S. utilities sector. Although efficiency savings have reduced retail water use for several decades, Essential has been able to grow earnings and the dividend by replacing and upgrading infrastructure that is decades old. The Essential to grow by acquiring small, typically municipal-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.

Similarly, they expect little natural gas usage growth at Peoples Gas, which had been owned by a private equity group. But the gas business still should produce steady earnings growth as Essential replaces and upgrades the system infrastructure. Fair market value laws in several states support Essential’s water business acquisition strategy. These laws require Essential to pay municipalities at least the assessed value of the system it acquires and allow Essential 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. Recent FMV legislation in Kentucky and West Virginia opens acquisition opportunities near areas Essential already serves.

Financial Strengths

Essential maintains a capital structure in line with its regulatory allowed capital structure for ratemaking purposes and leverage metrics in line with high investment-grade credit ratings. One cannot expect that to change. The Essential to issue new debt to fund growth investments and acquisitions in the coming years. One cannot expect any material new equity needs after the company raised $300 million in 2021. With constructive regulation, The Essential will be able to use its cash flow to fund most of its equity investment needs during the next five years. Essential has paid an annual dividend since 1945 and increased it at least 5% for each of the last 25 years. The Essential will be able to continue growing the dividend at this rate or higher for the foreseeable future while staying below management’s 65% maximum payout ratio threshold.

Bulls Say

Constructive regulation allows Essential to raise rates through surcharges or rate cases to reduce regulatory lag and enhance cash flow available to pay the dividend and invest in growth projects.

Fair market valuation state laws allow Essential to make municipal water utility acquisitions immediately value-accretive for shareholders.

Essential has raised its dividend 31 times in the last 30 years, including 29 consecutive increases of more than 5%.

Company Description

Essential Utilities is a Pennsylvania-based holding company for U.S. water, wastewater, and natural gas distribution utilities. The company’s water business serves 3 million people in eight states. Nearly three fourths of its water earnings come from Pennsylvania, primarily suburban Philadelphia. It also has a small market-based water business that provides water and water services to third parties, notably natural gas producers. Its $4.3 billion Peoples Gas acquisition that closed in March 2020 adds 750,000 gas distribution customers in Pennsylvania, West Virginia, and Kentucky.

(Source: Morningstar)

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