The utility industry has always been known to be a stable industry despite changing economic activities and increased market volatility. However, one sector seems to be an exception from the rest. In today’s FA Alpha, we will discover the higher uncertainty levels of the water utility sector by taking a deeper look into SJW Group, one of the biggest water utilities providers.
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Utilities are often viewed as very low credit risk entities because they have secured customers with regulated pricing, and have high visibility with their capital expenditures (Capex).
While that is true for most utilities, there’s an exception for the water utilities.
The water utility sector has a few different dynamics that change its credit risk.
The first difference is that water utilities have to keep on making sure they find more resources continuously as water tables are dropping due to usage.
Also, in places like California, there are regulations on how the water supplied by water utility companies can be used.
This situation can lead water utility companies to have higher levels of uncertainty than other utilities.
As a result of this uncertainty, water utility companies can have higher Capex and bigger issues with cost and demand.
As one of the biggest water utility companies, that’s the issue SJW Group faces right now.
The company provides water service to 140,000 connections, which serve approximately 456,000 people in 81 municipalities.
While its scale and essential positioning as a utility company give confidence to its credit investors and rating agencies, we can not unsee the company’s problem.
However, it seems like rating agencies want to ignore what is going on by giving the company a very safe credit rating like A-.
This is a very low credit risk for the SJW group, which implies around only a 1% chance of default.
We can figure out if there is a real risk for this company by leveraging the Credit Cash Flow Prime (“CCFP”) to understand the company’s obligations matched against its cash and cash flows.
In the chart below, the stacked bars represent the firm’s obligations each year for the next five years. These obligations are then compared to the firm’s cash flow (blue line) as well as the cash on hand available at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).
The CCFP chart shows that SJW Group’s cash flows are not enough to cover its obligations going forward and the company has some near-term debt maturities.
As the CCFP chart shows, SJW Group has massive capital expenditures and these expenses can increase even further due to the uncertainty that water utility companies have been facing.
Also, the company could have significant problems for the years wherein they have debt maturities.
Considering these factors, giving an investment grade rating that implies a 1% chance of default seems too optimistic for the company.
Instead, we think that this company shouldn’t be investment grade at all as it can not cover its obligations going forward.
That’s why we are giving an HY2+ rating to the company.
HY2+ rating from Valens implies around a 25% chance of default and it would be a much more reasonable credit risk assessment for SJW Group.
It is our goal to bring forward the real creditworthiness of companies, built on the back of better Uniform Accounting.
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SUMMARY and SJW Group Tearsheet
As the Uniform Accounting tearsheet for SJW Group (SJW:USA) highlights, the Uniform P/E trades at 47.2x, which is above the global corporate average of 17.8x but slightly below its historical P/E of 49.4x.
High P/Es require high EPS growth to sustain them. In the case of SJW, the company has recently shown a 51% Uniform EPS shrinkage.
Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, SJW’s Wall Street analyst-driven forecast is for a 115% and 8% EPS growth in 2022 and 2023, respectively.
Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify SJW’s $71 stock price. These are often referred to as market embedded expectations.
However, the company’s earning power in 2021 was below the long-run corporate average. Moreover, cash flows and cash on hand were below its total obligations—including debt maturities and capex maintenance. The company also has an intrinsic credit risk that is 540bps above the risk-free rate.
Overall, this signals a high credit and dividend risk.
Lastly, SJW’s Uniform earnings growth is above its peer averages and is trading above its average peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
This analysis of The SJW Group (SJW) credit outlook is the same type of analysis that powers our macro research detailed in the member-exclusive FA Alpha Pulse.