Stock of artesian resources: valuation does not provide a margin of safety (NASDAQ: ARTNA)

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Investment thesis

The Artesian Resource Corporation (NASDAQ: ARTNA) is one of the few publicly traded water utilities. Water has long been considered a safe, long-term investment in companies with strong balance sheets. In recent decades, water companies have been characterized by their slow and steady growth. ARTNA is no exception. The company is posting low single-digit growth and paying a stable dividend. However, ARTNA has been challenged by high CapEx in recent years and negative free cash flow. Despite this, the stock has performed relatively well and has tripled since 2009. In terms of valuation, ARTNA is one of the cheapest water utilities on most relative metrics. However, from an absolute perspective, ARTNA is expensive, trading at over 5x LTM revenue for a company with limited growth prospects.

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Company presentation

Incorporated in 1927, Artesian Resources Corporation is a Delaware corporation that operates as a holding company for eight wholly-owned subsidiaries providing water, wastewater and other services in Delaware, Maryland and Pennsylvania. Artesian Resources operates as the parent company of five regulated utilities: Artesian Water Company, Inc., Artesian Water Pennsylvania, Inc., Artesian Water Maryland, Inc., Artesian Wastewater Management, Inc., and Artesian Wastewater Maryland, Inc.; and three unregulated subsidiaries: Artesian Utility Development, Inc., Artesian Development Corporation, and Artesian Storm Water Services, Inc.

The main subsidiary, Artesian Water Company, Inc., is the oldest and largest investor-owned water utility on the Delmarva Peninsula and has been providing water services since 1905. This company distributes and sells water. water to residential, commercial, industrial, municipal, and utility customers. Additionally, ARTNA provides remediation services to Delaware customers.

Market opportunity

Americans use more water per person than almost anywhere else in the world – more than triple China and 15 times more than Denmark. Domestic water use has been incredibly high in the driest western states. For example, residents of Arizona consume 147 gallons per day compared to 51 gallons in Wisconsin. In the latest American Water Works Association (AWWA) survey, 54% of water professionals say their utility’s access to capital is as good or better than at any time in the past. last five years. Fare increases are their primary source of funding, and the greatest need is for infrastructure upgrades. Key remaining concerns for the water industry include replacing aging infrastructure, securing funding for capital improvements, and the availability of long-term water supplies due to drought, variability climate and extreme weather events.

Water has long been considered a safe, long-term investment in companies with strong balance sheets. In recent decades, water companies have been characterized by their slow and steady growth. However, today’s global water market is still expected to only expand. The total market size is estimated at $100 billion in the United States and $500 billion worldwide. Major segments of the water industry include water utilities, water treatment technologies, water infrastructure, water efficiency improvement and water monitoring . Water utilities represent 40-50% of the $100 billion US water market. Most are small municipal systems serving less than 3,000 people. Large water utilities have long been essential investments because of their stability and the fact that they enjoy a virtual monopoly in the regions where they operate. They do well in good times and bad because people need to use more or less the same amount of water regardless of economic conditions. Rich, steadily rising dividends even out price swings and play an important role in total stock returns.

Company overview

In a previous article, I analyzed the Middlesex Water Company (NASDAQ:MSEX), which shares similar business characteristics. Both companies fit well within the definition of the typical water utility. ARTNA is characterized by low revenue growth and stable dividend payments. FY15 to FY20 average annual revenue growth rate is approximately 2.8%, while operating cash flow average growth rate over the same period is -4.2% per year. Interestingly, while revenue grew moderately during this period, cash flow from operations actually declined.

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Refinitiv Eikon

Additionally, ARTNA has a very volatile operating cash flow pattern. For example, its cash flow from operations decreased by around 19% year-on-year in FY18 and around 35% year-on-year in FY19, before increasing by around 8 % YoY in FY20. In my opinion, the fluctuation in operating cash flow over the past few years adds some uncertainty to an investment that the market perceives as very sound.

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Refinitiv Eikon

Another red flag is the company’s inability to generate positive free cash flow in recent years. From fiscal year 2015 to fiscal year 20, ARTNA posted a cumulative free cash flow of approximately -52 million dollars and this trend seems to persist as the company recorded a free cash flow of approximately -13 million dollars. dollars on LTM. ARTNA is in the middle of its capital expenditure cycle, which consists primarily of a program to rehabilitate transmission and distribution facilities by replacing aging or deteriorated pipelines, upgrading existing processing facilities, and replacing wells and equipment. aging pumps. Since January 2015, ARTNA has spent approximately $244 million in capital expenditures and generated only approximately $181 million in operating cash flow. Due to this cash asymmetry, ARTNA had to resort to debt to finance its CapEx program. Total debt has increased by more than 49% since the fourth quarter of fiscal 2015. The D/E ratio now stands at ~1 and the net debt/EBITDA is 4.3, which is above the level T4 FY15 or T2 FY17.

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Additionally, ARTNA has been a market darling for its stable dividend over the years. However, I think there is a risk that ARTNA, like other US water utilities, will ultimately prove to be a dividend trap. Based on the last five years and taking into account the negative free cash flow, the payment of the dividend was financed by the proceeds of new debt issued by the company. In my opinion, this is a misguided capital allocation strategy, especially when you are at this part of the CapEx cycle and inflation, which is likely to drive up your CapEx costs, is sticky. Additionally, ARTNA’s dividend yield is at an all-time low of around 1% and does not provide any margin of safety to the dividend investor at the current level, nor does it in my view provide sufficient compensation for risks involved.

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Evaluation

In this part, I used a relative valuation approach to value the company. I compared ARTNA to a basket of stocks including American Water Works Company (NYSE:AWK), American States Water Company (NYSE:AWR), SJW Group (NYSE:SJW), York Water Company (NASDAQ:YORW) and MSEX . When we look at price to sales (P/S), enterprise value to EBITDA (EV/EBITDA), price to cash flow (P/CF) and price to book (P/B ), it is quite obvious that ARTNA is overvalued from an absolute point of view. However, on a relative basis, ARTNA seems to be one of the cheapest water utilities right now, along with SJW. All in all, I think it makes no sense to pay more than 5x LTM revenue for a business that is likely to grow at low single digit rates in the future.

Refinitiv Eikon

Refinitiv Eikon

Key points to remember

In summary, ARTNA operates as a monopoly with very little competition, which provides a clear moat for the business. Over time, this led to a stable revenue stream and the business grew in low single digits. However, the company is facing fundamental headwinds which should put pressure on the valuation. For example, ARTNA spends more than it earns in CapEx and has primarily used debt to fund its expenses, which has resulted in an increase in leverage compared to five years ago. At the same time and despite negative free cash flow, the company increased its dividend, which is mostly funded by new debt at this point. I don’t think this is a prudent capital allocation strategy, and dividend investors should pay particular attention to this trend. In terms of rating, ARTNA is one of the cheapest water utilities in my opinion. However, this does not necessarily make it attractive from an absolute point of view. Overall, I think you are probably paying too much for ARNTA if you buy the stock at the current level.

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