基础设施

Essential Utilities and American Water announced they reached a regulatory settlement in Pennsylvania that is critical to close their $63 billion merger on management's initial timeline in early 2027.

Why it matters: Pennsylvania represents more than 60% of Essential's water regulatory asset base, making it critical that state regulators approve the merger as proposed. Although the settlement is not unanimous, it could avert a lengthy, potentially contentious commission hearing. Kentucky, Ohio, and Virginia regulators have approved the merger. The companies have reached unanimous settlements in Texas and North Carolina that likely will receive regulatory approval. The companies must receive approval in New Jersey and Illinois, where they have no settlements. Those states represent 12% of Essential's water regulatory asset base.

The bottom line: We are reaffirming our $38 per share fair value estimate and narrow moat rating for Essential. Our fair value estimate for Essential reflects the merger's 0.305 share exchange ratio and our stand-alone fair value estimate for American Water. Essential shareholders will own 31% of the combined company. Essential's and American Water's stocks trade in line with our fair value estimates as of Sept. 9.

Big picture: Essential management's stand-alone 5%-7% annual earnings growth target through 2027 aligns with our estimate. American Water is targeting 7%-9% annual long-term earnings growth. In Pennsylvania, a political focus on affordability could complicate Essential's pending $163.2 million gas rate increase request and plans to request new water rates by year-end.

Coming up: Regulatory hearings in New Jersey related to merger approval are scheduled for Oct. 15 and Oct. 29. A proposed order in Illinois is due Friday, with a final order by Nov. 5.

Our fair value estimate is $38 per share based on the 0.305 proposed merger share exchange ratio and our stand-alone fair value estimate for American Water Works. We don't include any net synergy benefits.

Our stand-alone fair value estimate for Essential is $46 per share. We forecast 6% average annual earnings growth over the next three years on an organic, weather-normalized basis, excluding the Delcora acquisition. Our organic growth outlook is in line with management's 5%-7% annual earnings growth target.

We assume $1.5 billion of combined gas and water capital investment and municipal water acquisitions per year, on average. This includes management's estimated $450 million of PFAS-related compliance investments in 2024-28.

Municipal water acquisitions have slowed recently, but that could pick up in the coming years as its combined scale with American Water offers cost savings and access to capital for small municipal utilities.

The combination of surcharges and base rate increases across Essential's subsidiaries supports our earnings growth outlook. This includes favorable outcomes for rate reviews in several states in 2026-27.

In our discounted cash flow valuation, we use a 5.8% cost of capital based on a 7% cost of equity. This is lower than the 9% rate of return we expect investors will demand of a diversified equity portfolio, reflecting Essential's lower sensitivity to the economic cycle and lower degree of operating leverage. We assume a similar cost of capital for American Water Works.

On a stand-alone basis, 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. We don't expect this to change if the American Water Works merger closes. American Water Works also has a narrow moat rating based on its efficient scale advantages.

Essential owns a difficult-to-replicate network of water, wastewater, and natural gas distribution infrastructure that provides essential resources to customers.

In exchange for service territory monopolies, 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 and history of regulatory decisions in the states that Essential serves are mostly constructive, leading to ROICs modestly above its WACC.

In the water distribution and wastewater businesses, Essential shareholders benefit from fair market value legislation in seven of the eight states where it operates. This allows Essential to ensure its acquisitions are value-accretive by allowing it to increase its regulatory 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.

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 most of its nonutility businesses that had few competitive advantages.

Constructive regulation allows Essential to raise rates through surcharges or base rates to reduce regulatory lag and enhance cash flow available for the dividend and growth investments.

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

Essential has raised its dividend 36 times in the last 35 years, including 33 consecutive annual increases of more than 5%.

Essential Utilities paid a peak market price for Peoples, which will drag on consolidated returns for several more years.

Customer rate increases to fund Essential's large capital investment could cause regulatory pushback that would slow earnings growth.

Higher interest rates could raise financing costs for Essential and make its dividend yield less attractive for income investors.