American Water Works

American Water and Essential Utilities filed with Pennsylvania regulators a settlement with key counterparties supporting the proposed combination.

Why it matters: Pennsylvania represents more than 30% of the combined American Water and Essential regulatory asset base, making the state a key regulatory hurdle to closing the proposed $63 billion merger by early 2027. Five states still need to approve the merger, but we view those outcomes as less contentious than obtaining Pennsylvania approval. Approvals have been received in Virginia, Kentucky, and Ohio. Although the settlement is not unanimous, it could avert a lengthy, potentially contentious commission hearing. We previously viewed Pennsylvania approval as being the most challenging to achieve.

The bottom line: We reaffirm our $131 fair value estimate and Narrow Morningstar Economic Moat Rating for American Water. American Water's stock trades at a slight premium to our fair value estimate as of Sept. 17, compared with our view that the US utilities sector is 5% undervalued on a median basis.

Big picture: American Water is targeting 7%-9% annual long-term earnings growth, which we view as achievable at the low end after combining Essential's slower-growing utilities. Essential management expects to grow earnings 5%-7% annually on a stand-alone basis through 2027. The combined company will look for strategic options for Essential's natural gas business to focus on regulated water and wastewater utilities. We consider this focus as in shareholders' best interests.

Coming up: Regulatory hearings in New Jersey related to merger approval are scheduled for Oct. 15 and Oct. 29. A final order in Illinois is due by Nov. 5. A settlement has been reached in principle in Texas. We expect the transaction to receive all regulatory approvals.

Our fair value estimate is $131 per share after incorporating year-to-date financial and regulatory updates.

On a stand-alone basis, management's planned infrastructure investment and acquisitions in the company's regulated segment support our five-year average annual earnings per share growth estimate at the midpoint of management's 7%-9% range.

We expect earnings growth to extend beyond the next five years, given the investment and acquisition opportunities in the water utilities industry. We expect consistent regulatory treatment in all the company's jurisdictions.

We also expect the company to invest $20 billion over the next five years, including acquisitions, in line with management's plan.

For the proposed merger with Essential Utilities, we assume the deal clears the numerous state and federal approvals. The share exchange ratio that implies a discount to our stand-alone fair value estimate for Essential Utilities increases our American Water fair value estimate by $2 per share, all else equal.

In our discounted cash flow valuation, we use a 5.7% cost of capital based on a 7% cost of equity. This is lower than the rate of return we expect investors will demand for a diversified equity portfolio, reflecting American Water Works' lower sensitivity to the economic cycle and lower degree of operating leverage.

We assign American Water Works a Narrow Morningstar Economic Moat Rating.

Utility regulation recognizes the need for capital providers--lenders and shareholders--to earn a return on their investments while ensuring that utilities do not take advantage of their service area monopolies by gouging customers.

American Water Works' returns on invested capital should remain at a healthy spread over its cost of capital for the foreseeable future. American Water Works owns a difficult-to-replicate network of water utilities that meet essential needs for customers. In exchange for a service territory monopoly, state and federal regulators set rates for American Water Works' water 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 American Water Works to earn a consistent spread over its cost of capital. Rate-setting mechanisms in the states that American Water Works serves are mostly constructive, leading to ROICs modestly above its weighted average cost of capital.

American Water Works enjoys fair market value legislation in many of the states where it operates. This allows the company to ensure that its growth acquisitions are value-accretive by allowing it to adjust its regulated earning asset base to reflect the deal value based on a third-party valuation. This effectively eliminates the drag on returns created by goodwill and the risk of cost overruns for organic growth investment. The diversity of American Water Works' regional footprint means that weaker returns experienced in the short term at any one subsidiary will have only a minor impact on consolidated returns.

The company's only nonregulated business is the company's military service group, which produces regulated-like earnings with long-term government contracts. We think the unit supports American Water Works' narrow moat.

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

We don't expect the proposed acquisition of Essential Utilities to alter our view of American Water's narrow moat. Narrow-moat Essential operates water and natural gas utilities with similar efficient-scale competitive advantages.

The company operates in constructive regulatory environments that support recovery of prudent costs and support growth investments.

American Water Works' size should be an advantage in pursuing new customers and acquisitions in the coming years. Tuck-ins to existing systems are a cheap source of growth.

Much of America's water infrastructure is old and will require significant investment over the coming decades, allowing the company to increase its rate base and earnings for many years to come.

American Water Works' sizable plans for infrastructure replacement and upgrades could run into some pushback from rising rates for water that has traditionally been cheap.

Conservation is biting into weather-adjusted usage across the company's territories, requiring higher rates to maintain returns.

Acquisitions of regulated utilities can be difficult and time-consuming and sometimes end in lost shareholder value.