• Over the past three years, AWK stock price has had an average increase of about 26%.
• From 2015 until 2019, operational revenue had a CAGR of 3.4% while its operation and maintenance expense grew at 2.4%, demonstrating economies of scale.
• As a result of global industry growth of 3.68%, my belief that the company is experiencing economies of scale and is reducing its retention rate, I estimated a target price.

I have always wanted to invest in a utility directly, but for some reason, I have never invested in one. Occasionally I would glance at a water and wastewater company with the idea that demand for water is increasing while its supply is decreasing. With that thought in mind, I imagined that this industry would be able to provide at least a six percent dividend yield. I found out that it doesn't.

Since water is an essential resource, it would be easy to assume that the stocks of these companies would be high fliers. Demand from the industrial, agricultural and residential markets is expanding and the supply of potable water is shrinking. Big earnings and share-price gains have not been the case, here, however. The industry is subject to regulation, which can raise service costs, while limiting rates and return on investment.

I remember reading a text pretty similar to the above text in one of my finance courses. Because of the information similar to the one above, I imagined that the only way I could get a decent return on my investment was to find a utility company that had a dividend yield of 6% or more.

American Water - Past Decade

American Water did not take the same finance course as I. Over the past three years, AWK's stock price has had an average increase of about 26%. During the same period, the company's average dividend yield was 2%. The company began paying dividends during the second half of 2008 and has increased its yearly dividend every year. From 2010 until 2019, AWK's dividend CAGR was 9.8%.

Figure 1 - Net Margin (2010 to 1Q20)

Source: Macrotrends

As seen in figure 1, AWK's net margin has increased by 7.4% over the past ten years. During the financial crisis of 2008 and 2009, the company had a negative net margin (not shown in Figure). The company's net margin stayed around 15% from 2015 until 2016. In 2017, the company's net margin suffered due to the normalization of deferred income tax.

The enactment of the TCJA required a re-measurement of our deferred income taxes that materially impacted our 2017 results of operations and financial position. (Source: Page 27 of 2017 Annual Report)

After 2018, the company's net margin began to normalize between 16.5% to 17.2% thanks to the reduction of the corporate tax rate.

Figure 2 - Retention Rate

Source: Company's Financials

Over the past five years, the company has had an average retention rate of 42%. Not taking into consideration 2017, the AWK seems to be slowly reducing its retention rate. Currently, AWK's forward dividend yield is 1.66%, while its peer average is 1.84%.

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