Stock story: Essential Utilities

Providing high-quality water across eight US states and decent returns for investors.

Stock story: Essential Utilities

Headquartered in Pennsylvania, Essential Utilities has become one of the fastest-growing utility holding companies in North America. Through its holdings, Essential Utilities is one of the largest regulated US water and wastewater utilities as it serves more than three million people across eight states (Illinois, Indiana, New Jersey, North Carolina, Ohio, Pennsylvania, Texas and Virginia). The company also owns a market-based business that provides related services to its utility customers.

Essential Utilities more recently grew by more than 50% after buying Peoples Natural Gas Company, a regulated natural-gas-distribution company that serves nearly 750,000 customers in Pennsylvania, West Virginia and Kentucky. Combined, the company derives about 97% of total earnings from regulated assets on a rate base that amounts to US$7.3 billion.

As an investment, Essential Utilities fits well within Magellan's Core Infrastructure strategy. The company offers its shareholders a highly dependable stream of cash flows, which are underscored by the nature of its critical services as well as the supportive regulatory environment it operates within. The latter is particularly important given it protects Essential Utilities’ earnings from volume (via revenue decoupling) and commodity-price risk (cost pass-through). Moreover, the various state regulators afford the company the ability to immediately earn and recover capital investments (via rate surcharges) from customers.

Adding to the company's regulatory environment are some of the most attractive allowed returns conferred by US regulators.  Pennsylvania – which regulates more than 66% of Essential Utilities’ water utility earnings – recently awarded the utility an authorised return on equity range of 10% to 10.5%. This underpins Essential Utilities' allowed return on equities of about 10.25% for its regulated water assets, and 10.3% to 10.4% for its regulated gas distribution business.

By virtue of its business, Essential Utilities invests considerable amounts of capital into projects each year that often require access to funding. For Essential Utilities, this hasn't been an issue with its constructive regulatory jurisdictions and its well-managed balance sheet. As at November 2020, the company enjoyed a 1.6-times interest-cover ratio; a 54% debt-to-total-capitalisation ratio; and is highly rated by the major credit rating agencies (A- by Standard & Poor’s; Baa2 by Moody’s). Essential Utilities enjoys a sound liquidity position.

On sustainability, Essential Utilities’ day-to-day practices are guided by the environmental, social and governance initiatives to which the company committed some time ago. These include a pledge to maintaining the highest-water-quality standards in the industry (the company outperformed the national average on drinking water quality by seven times in 2019) and, longer term, a leadership role in addressing harmful chemicals in drinking water. 

To some extent, ESG will be a key driver in Essential Utilities' long-term growth plans. Specifically, the company is well placed to benefit from thousands of miles of water and gas pipelines that need replacement as a result of either age or safety concerns. This means decades of replacement work and about US$1 billion in annual regulated capital expenditures – all just to bring the company’s assets to modern standards.  Growth is also expected to come from the vast opportunities to acquire municipal water systems, which most local governments can no longer afford to maintain or upgrade

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