Research firm Spruce Point has conducted a detailed analysis of Essential Utilities and, as with the high-profile Hindenburg Research report on Adani Group, has serious concerns about the accuracy of financial reporting, the business model and the company's ability to meet its financial obligations. In a report that is 91 pages long, Spruce Point believes that there is approximately 35-50% (to a price of US$20-28) downside risk to the company's shares. Let's take a look at the key points from the report.
What does Essential Utilities do?
Essential Utilities is a US holding company that provides water, wastewater and gas services in the United States. The company was founded in 1886 as Bryn Mawr Corporation and changed its name to Aqua America in 2007. In 2020. Aqua America changed its name to Essential Utilities to better reflect its business, which has expanded to serve gas customers. The company serves customers in 10 states, including Pennsylvania, Ohio, Illinois, New York, New Jersey and Virginia. The company designs, builds and operates water, wastewater and gas infrastructure, and also provides water and wastewater quality monitoring and waste-to-energy recycling and recovery services. In 2018, the company acquired US natural gas supplier Peoples Natural Gas (hereafter Peoples) for a largely borrowed sum of almost $4.3bn.
Accusations concerning the water company
Spruce Point cautions investors to be wary of companies that frequently change their names and corporate branding, as it may be a tactic to hide a problematic history. Essential Utilities, Inc. which went through a debt-financed acquisition of Peoples Natural Gas, thereby changing from a water and wastewater company to a water and gas company. Spruce Point's research suggests that this transaction was done out of necessity and masks mounting financial pressures, with negative cash flow and record leverage (debt-to-equity ratio of 1.19 against a sector average of 0.13). The company has a history of failed expansion efforts and negative customer feedback. According to the research firm, there is evidence that customer water supply revenues and return on equity and earnings per share were declining prior to the deal with Peoples Natural Gas. Although Essential Utilities benefited from increased water usage during the pandemic period, performance trends now appear to be normalising.
The company presented weaker growth targets for 2023, no longer committing to a minimum rate base growth from the acquisition. The company has also slightly lowered its estimated organic growth rate. Spruce Point believes that the company's investors will experience further disappointment in future results.
"The acquisition of Peoples Natural Gas is already being assessed for impairment."
The article discusses Essential Utilities' acquisition of a gas company in 2018 for $4.275 billion. This was to expand the company's regulated natural gas business. However, there are concerns about Peoples' financial performance, and a recent audit by the Pennsylvania Utility Commission found that the company needs significant improvements in financial management, cost allocation, governance and gas operations. There are also long-term pressures on the natural gas business due to declining demand, which is linked to increased equipment efficiency and environmental measures, as well as increased interest in alternative energy. The potential for growth in the customer base is a key marketing argument used by Essential Utilities, but Peoples' performance remains below expectations, with forecasts reduced by $100 million a year. The article also discusses potential financial inaccuracies in Essential Utilities' reporting on the Peoples acquisition, as well as issues related to the quality of the customer base and provisions for doubtful accounts.
"Essential Utilities' dividend policy is nonsense"
Spruce Point has carried out a financial assessment of Essential Utilities, which has positioned itself as a growth company that aims to pay regular dividends. Essential Utilities' policy is to pay a dividend of no more than 65% of net profit. However, according to Spruce Point, this dividend policy is flawed due to high investment capital expenditure and acquisition commitments. Spruce Point suggests that Essential Utilities should pay a dividend commensurate with its free cash flow after meeting its investment and acquisition commitments. The company has never been able to cover its dividend from free cash generated after meeting these commitments, and its ability to do so has deteriorated since 2018. Spruce Point warns investors that the dividend reinvestment scheme offered by Essential Utilities at a 5% discount is not a good investment proposition. The funds raised from investors through these schemes could be used to pay dividends to other investors.
Why does Spruce Point think Essential Utilities is overvalued?
The warning issued by the research firm relates to Essential Utilities and its relationship with questionable brokerage firms. Spruce Point believes that the company is overvalued and that investors should pay particular attention to independent analyst Morningstar's opinion of the company's shares as a 'sell'. The research firm is carrying out a sum-of-the-parts valuation for Essential Utilities' water and gas businesses, which are separate companies. Spruce Point believes investors should also factor in significant dilution and a larger debt issue in valuing Essential Utilities' forward share price. The authors of the alert believe that Essential Utilities' financial pressures are being ignored by analysts, who are lowering financial estimates and target prices insufficiently. Therefore, the research firm estimated that an appropriate value per Essential Utilities share is between US$20 and US$28, approximately 35-50% below the current price.
Source: Conotoxia MT5, EssentialUT, Daily
Grzegorz Dróżdż, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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