SJW Group: Water Stocks Are In Favor

Massive storm brings flooding rains and damaging winds to California.

Investment Thesis

On Nov. 23, 2021, with the share price at $70.84, I published the article, “SJW Group: Not At This Price.” Again on Feb. 9, 2022, with the share price at $65.82, I published the article, “SJW Group Is Overvalued And Risky“. And again on May 19, 2022, with the share price at $60.13, I published article, “SJW Group Stock: Still Not A Buy At This Price (NYSE:SJW)“. Since then, the share price of SJW Group (NYSE:NYSE:SJW) decreased further to $55.74 by mid-June 2022, followed by a period of fluctuating prices before the recent run up to the current stock price of $80.03. I believe the current SJW Group stock price might reflect a belief by investors that through SJW they are investing in water as a valuable and increasingly scarce commodity. And investing in a valuable and increasingly scarce commodity will naturally result in outsized gains as the market price of the increasingly scarce commodity inevitably increases. I believe this ignores the fact SJW Group is a regulated utility with profitability governed and limited by financial formulae, set by government instrumentalities. In this regard, water utilities are similar to power utilities, and yet the P/E multiples and other relevant statistics for each are at very different levels. The effect of a share price growing at a faster rate than the dividend can be seen in Fig. 1 below.

Figure 1

Over the last 8 years, dividend yield has decreased from close to 3% to below 2%, primarily due to the faster growing share price. Figure 2 below shows the relationship between share price and P/E ratio.

Figure 2

Figure 2 shows it is an increasing P/E multiple, and not earnings growth that is driving the SJW Group share price higher. This is not just a flight to the safety of utility stocks, as evidenced by comparative data for electric utility ALLETE (ALE) in Fig. 3 below.

Figure 3

The share prices of both SJW Group and ALLETE have shown considerable volatility. But ALLETE P/E multiple is around half of SJW Group current multiple and not much different to 8 years ago. SJW Group multiple has increased from under 15 to over 40 over the last 8 years. I believe this is likely due to sentiment towards water and an incorrect perception SJW Group will benefit from water scarcity beyond the normal earnings attributable to a regulated utility. The long period of drought in California has likely contributed to this sentiment. The drought has now broken and that might have consequences, although the increased water availability might be viewed favorably as far as the SJW Group stock is concerned. Mind you, the increasing share price has been good for long-term investors in SJW Group as illustrated in Table 1 below.

Table 1

The effect of buying 7 to 8 years ago at low multiples is clearly shown in Table 1. Investors A and B have double digit returns driven mostly by share price increases, but also with healthy dividend yields on costs of over 3%. Buying at a recent high SJW Group share price, Investor I has share price losses exceeding a much reduced dividend yield on cost of 1.89%. I believe potential investors should be wary about buying SJW Group stock at current elevated prices.

Additional analysis and comment follow.

Looking for share market mispricing of stocks

What I’m primarily looking for here are instances of share market mispricing of stocks due to distortions to many of the usual statistics used for screening stocks for buy/hold/sell decisions. The usual metrics do not work when the “E” in P/E is distorted by the impact of COVID-19. And, if the P/E ratio is suspect, so too, then, is the PEG ratio similarly affected.

I believe the answer is to start with data at the end of 2019, early 2020, pre-COVID-19, and compare projections out to the end of 2022 or later, when hopefully the impacts of COVID-19 will have largely dissipated. Summarized in Tables 1 and 2 below are the results of compiling and analyzing the data on this basis.

Table 2 – Detailed Financial History And Projections

Table 2 shows SJW Group projected EPS for 2022 is $2.39, which is below 2016 EPS of $2.57. Despite this SJW Group share price at end of 2022 of $81.19 is up around 50% on share price of $55.84 at end of 2016. This is primarily due to an increase in the P/E multiple from 21.73 at end of 2016 to 33.97 at end of 2022. The share price growth has undoubtedly been supported by dividend per share growth from $0.81 at end of 2016 to $1.44 at end of 2022. But this dividend growth is not supported by corresponding EPS growth, and has been primarily achieved by an increase in the payout ratio from 31.5% at end of 2016 to 60.3% at end of 2022.

Table 3 below provides scenarios projecting potential returns based on select historical P/E ratios and analysts’ consensus, low, and high EPS estimates per Seeking Alpha Premium through end of 2024.

Table 3 – Summary of relevant projections SJW Group

Table 3 provides comparative data for buying at closing share price on Jan. 13, 2023 and holding through the end of years 2023 through 2025. There’s a total of nine valuation scenarios for each year, comprised of three EPS estimates (SA Premium analysts’ consensus, low and high) across three different P/E ratio estimates, based on historical data. Table 3 shows potential returns from an investment in shares of the company at a range of historical and assumed P/E ratio levels. This analysis, from hereon, assumes an investor buying SJW Group shares today would be prepared to hold through the end of 2024, if necessary, to achieve their return objectives. Comments on contents of Table 3, for the period to 2024 column follow.

Consensus, low, and high EPS estimates

All EPS estimates are based on analysts’ consensus, low and high estimates per SA Premium. This is designed to provide a range of valuation estimates ranging from low to most likely, to high based on analysts’ assessments. I could generate my own estimates, but these would likely fall within the same range and would not add to the value of the exercise. This is particularly so in respect of well-established businesses such as SJW Group. I believe the “low” estimates should be considered important. It’s prudent to manage risk by knowing the potential worst-case scenarios from whatever cause.

Alternative P/E ratios utilized in scenarios

1. The actual P/E ratios at share buy date based on actual non-GAAP EPS for FY-2020.
2. A modified average P/E ratio of 31.42 based on 26 quarter-end P/E ratios from Q4 2016 to Q4 2022 plus current P/E ratio in Q1 2023. The average of these P/E ratios has been modified to exclude the three highest and three lowest P/E ratios to remove outliers that might otherwise distort the result.
3. A median P/E ratio is calculated using the same data set used for calculating the modified average P/E ratio. Of course, the median is the same whether or not the three highest and lowest P/E ratios are excluded. In the case of SJW Group I have chosen to use an assumed P/E ratio of 25.0 in place of the historical median of 31.34 (similar to the average). I have done this to provide an idea of the impact on returns of the multiple decreasing from present level.
4. The actual P/E ratio at Feb. 21, 2020, share price, based on 2019 non-GAAP EPS. The logic here is the market peaked around February 21, 2020, before any significant impact from COVID-19 became apparent. This makes the P/E ratios at Feb. 21, 2020, reflective of most recent data before distortion of P/E ratios by the impact of the coronavirus pandemic. This does not work for SJW Group due to the very poor EPS result for 2019. I have replaced with historical low P/E ratio of 20.99, to show the possible impact of a prior lower multiple on returns.

Reliability of EPS estimates (line 17)

Line 17 shows the range between high and low EPS estimates. The wider the range, the greater disagreement there is between the most optimistic and the most pessimistic analysts, which tends to suggest greater uncertainty in the estimates. There are five analysts covering SJW Group through the end of 2024. In my experience, a range of 0.7 percentage points difference in EPS growth estimates among analysts is low, suggesting a degree of certainty, and thus reliability.

Projected returns (lines 18 to 39)

Lines 25, 32 and 39 show, at a range of historical P/E ratio levels, SJW Group is conservatively indicated to show negative returns between (12.3)% and (13.5)% average per year through the end of 2024. The (13.5)% return is based on analysts’ low EPS estimates and the (12.3)% on their high EPS estimates, with an (13.1)% negative return based on consensus estimates. Those are the lowest of the returns under the consensus, low and high EPS scenarios, and assume a P/E ratio of 20.99 in 2024. At the high end of the projected returns for SJW Group, the indicative returns range from 5.3% to 6.8%, with consensus 5.8%. These returns assume a P/E ratio of 31.42 in 2024, based on the current P/E ratio of 33.55 reducing slightly to the historical average of 31.42 by end of 2024.

Checking SJW Group’s “Equity Bucket”

Table 4.1 SJW Group Balance Sheet – Summary Format

Over the 5.75 years end of 2016 to end of Q3-2022, SJW Group has increased Net Assets Used In Operations by $1,830 million. The increase was funded by increases of $628 million in shareholders’ equity, and $1,203 million in debt net of cash. Net debt as a percentage of net debt plus equity increased from 51.1% at end of 2016 to 61.0% at end of Q3-2022, due to the mix of equity and debt used to fund increases in net operating assets. Outstanding shares increased by 9.8 million from 20.5 million to 30.3 million, of which 9.3 million shares were to raise additional equity capital, with the balance issued for employee compensation. The $628 million increase in shareholders’ equity over the last 5.25 years is analyzed in Table 4.2 below. The slide below from a SJW Group presentation published on Seeking Alpha indicates the importance of ongoing asset investment for the company.

Slide 1

The key thing here is additional investments, “eligible for infrastructure recovery mechanisms”. A further slide from the same presentation shows the formula for assessing returns allowed on investments.

Slide 2

Slide 2 gives an indication why SJW Group are increasing debt levels, as shown in Table 3.1. Based on 10.3% return on equity and 5.48% cost of debt, with a capital structure of 55% equity and 45% debt equates to a weighted average cost of capital (“WACC”) of 8.13%. Apply that to the planned investment of $1.3 billion per Slide 1 and annual infrastructure recovery potentially increases by $106 million. But finance that $1.3 billion with 60% debt and 40% equity and the actual WACC reduces to 7.4%, resulting in a recovery of ~$10 million above the actual cost of capital for SJW Group. Of course SJW Group and its shareholders carry the added risk of the higher debt levels. At current high share price, it might be opportune for SJW Group to raise more equity which would temper the effect of future borrowings on debt to equity levels.

Table 4.2 SJW Group Balance Sheet – Equity Section

I often find companies report earnings that should flow into and increase shareholders’ equity. But often the increase in shareholders’ equity does not materialize. Also, there can be distributions out of equity that do not benefit shareholders. Hence, the term “leaky equity bucket.” This is happening to some extent with SJW Group in relation to share compensation, but not to a material extent.

Explanatory comments on Table 4.2 for the period end FY-2016 to end Q3-2022:

• Reported net income (non-GAAP) over the 5.75-year period totals to $283 million, equivalent to diluted net income per share of $10.99.
• Net income growth has fluctuated widely by year but ended up virtually flat between 2017 and 2021.
• Amount taken up in equity to account for shares issued to staff over the 5.75 years is $27 million. This compares to an estimated market value of $30 million at the time of issue of these shares. The effect is a reduction of $3 million (EPS effect $0.21) compared to reported income.
• Taking the above-mentioned items into account, we find, over the 5.75-year period, the reported non-GAAP EPS of $10.99 ($283 million) is reduced to $10.81 ($281 million), added to funds from operations available for distribution to shareholders.
• Dividends of $188 million were adequately covered by $281 million generated from operations, resulting in an increase of $93 million in equity.
• This net $93 million increase in equity from operations, together with the $30 million capital raised through share issues to staff, and $505 million raised through equity issues resulted in the $628 million net increase in shareholders’ funds per Table 3.1 above.

Summary and Conclusions

The level of gains earned by longer term shareholders of SJW Group over the last several years have been driven mainly by multiple expansion, and this is unlikely to be repeated, at least to the same degree, over the next several years. Although I have explained the strong sentiment towards water utilities might be misplaced to some extent, that strong sentiment could hold multiples at current levels. If that is the case, returns in the mid-single digits are possible mainly driven by an increasing dividend per share. The balance sheet analysis above indicates the dividend is safe despite anticipated significant capital expenditures over the next 5 years (it would be wrong to assume heavy capital investment funded by new debt and equity would impact on the ability to pay increasing dividends). If sentiment wanes to some extent and multiples contract then share price losses could considerably exceed dividend receipts, resulting in net total losses over the period ahead.