Connecticut Water Service – A Stable Business With A Twist
Summary The company is primarily a water utility business. While the utility business is highly profitable, the return on equity is capped at around 10%. The Services and Rentals could generate significant value in the future. Connecticut Water Service (NASDAQ: CTWS ) is a utility company that focuses on water distribution. As a water utility company, the company does not have to worry about commodity fluctuations, unlike a natural gas utility company . Unfortunately, the company was not able to escape the pessimism in the market. Despite on the way to post another year of growth, the stock barely budged in 2015, fluctuating around $36. In the chart above, we can see that over the long-term, the stock tracks the company’s top-line growth. This makes a lot of sense because the company primarily runs a regulated business, so margins will be fairly consistent from year to year. More recently, the company seems to have benefited from economy of scale, as the operating margin climbed along with the growth in revenue. For any other company, this track record would suggest an extremely well-run business with the potential to generate a lot of profit. Unfortunately for investors (and fortunately for citizens), the utility business is regulated for this exact reason. The company’s two main water subsidiaries in Connecticut and Maine have a rate cap (return on equity) of 9.75% and 9.5%, respectively As you can see, ROE has fluctuated around the 10%, reflecting this cap. What this means is that the maximum growth equity investors can expect from the company’s regulated business over the long-run is around 10%. Because the company provides a critical service, I have no doubt that the company will achieve this rate of return over the long term. Of course, the company can try to apply for rate increases, but I wouldn’t count them since there is no way to know in advance whether they will be approved. While most of the revenue comes from the regulated water utility business (~90%), the company does have some non-regulated operations. On the non-regulated side, the main segment is Services and Rentals. The segment’s operation is quite diverse, ranging from typical repairs to providing emergency drinking water. While small, the company is highly profitable. Year to date, the segment’s net profit margin was 24%. This is pretty much on par with the margin of the water business (25%)! However, it would seem that the management has trouble growing it. Quarter on quarter, revenue only increased by 5%. That being said, the segment could generate significant value if the management figures out a way to scale it. While I am not seeing any promises right now, it nevertheless has good option value, after all, the segment’s services do go hand in hand with the water business. Conclusion If you are satisfied with the rate of return (~10%) over the long-term, then I think Connecticut Water Service represents a good opportunity. Due to the nature of water utility (a critical service), the company should be able to reach the rate cap over the long-run. While the non-regulated side of the business is still small, I believe that once the management finds a way to convince more water business customers to use the company’s maintenance services, there could be significant upside. Overall, I believe that the company will continue to deliver stable profits from its water business, and the non-regulated activities are an added bonus for investors.