SJW Group (SJW): One of the Best Dividend Kings in the Utility Sector

Dividend kings, those rarest of companies with 50+ years of consecutive dividend growth, can be a great place to start looking for relatively safe income investments.

 

That’s because most companies that not only survive for 50 years but thrive enough to reward investors with rising dividends often have solid fundamental characteristics, including an advantaged business model, a conservative management team, and a shareholder-friendly corporate culture.

 

Let’s take a look at SJW Corp (SJW), which is one of America’s newest dividend kings with 50 consecutive years of payout growth.

 

Unlike most companies in this group of large and popular blue chip stocks, this fast-growing water utility has a market cap below $2 billion and is not as well known.

 

Business Overview

Founded in 1866 as the San Jose Water Company, SJW has today become a regulated water utility that serves customers in two rapidly expanding markets: Silicon Valley, California, and San Antonio, Texas.

 

 

Note the Texas Water Alliance was sold for $31 million in February of 2016.

 

The company’s two primary business units are San Jose Water and SJWTX, which owns the Canyon Lake Water Service Company.

 

San Jose Water’s 111 wells, 2,400 miles of water mains, and two water treatment plants service 229,000 connections and provide water to approximately 1 million people (about 33% of the population) in 138 square miles of Silicon Valley, with a total capacity of 283 million gallons of water per day.

 

 

 

Meanwhile, Canyon Lake Water’s 42 wells, 599 miles of water mains, and three treatment facilities provide up to 9 million gallons a day to 13,000 connections (serving 39,000 people) across 240 square miles of central Texas, located just north of San Antonio.

 

 

The company also has a real estate arm, which owns undeveloped commercial acreages as well as residential and warehouse properties in California and Tennessee, which it uses to help fund its core water utility business.

 

 

In 2016, 98% of SJW’s revenue came from its regulated water businesses, with $6.7 million generated by its land business subsidiary.

 

Business Analysis

SJW Group enjoys a wide moat as a regulated water utility, courtesy of its government-sanctioned monopoly, which grants it stable and predictable profitability and returns on shareholder capital.

 

 

For example, in 2016 the California Public Utilities Commission granted San Jose Water a 9.43% return on equity as part of an 8.6% increase in water rates for 2016, with inflation-indexed rate increases in 2017 and 2018.

 

This encourages SJW to continue investing in large infrastructure projects to provide dependable water service in its growing territories, which have minimal to no competition due to the nature of the industry.

 

Unlike most water utilities, which enjoy stable but slow growth over time, SJW, thanks to the rapid growth rates of its water markets, has enjoyed some of the industry’s fastest revenue and earnings growth rates.

 

 

While SJW lacks the economies of scale that its larger peers such as American Water Works (AWK) and Aqua America (WTR) enjoy, management has been able to make good progress at improving its overall profitability to the point where it is now nearly matching or even exceeding the industry average margins and returns on capital.

 

Trailing 12-Month Profitability

 

Of course, one of the reasons why investors are attracted to water utilities in the first place is that this is an inherently defensive (i.e. recession resistant) business, one that will require massive amounts of infrastructure investment in the coming decades.

 

 

 

Given that Silicon Valley and Central Texas are experiencing particularly strong population growth, regulators are more prone to allow SJW to rapidly increase capital spending into its water infrastructure to meet the needs of its rapidly growing population base.

 

In fact, San Antonio’s (consisting of Kendall, Comal, and Hays Counties) population grew by 3% annually between 2007 and 2016, and that growth rate has actually accelerated in recent years to become the second fastest in the U.S.

 

 

That’s resulted in SJWTX’s customer base growing 90% since SJW acquired it in 2006. That’s thanks in part to SJW continuing to make bolt-on acquisitions of small, municipal water systems (10 since 2006) and resulting in 700 to 800 new connections per year.

 

Best of all, with 25 remaining water systems in its area of operations and another 25 in the surrounding area (potential expansion regions), SJW’s Texas water business continues to have a very long growth runway.

 

Meanwhile, regulators are becoming increasingly willing to authorize larger capital spending on water infrastructure, especially since the majority of it is well over 50 years old and in desperate need of replacement and upgrades.

 

 

Those costs are then passed onto customers in the form of higher water rates, which provides SJW with revenue and earnings growth from which to secure and steadily grow its dividend.

 

 

This impressive dedication to dividend growth has served SJW investors well, with annual total returns (including dividend reinvestment) exceeding the S&P 500 by more than 5% annually over the past 22 years.

 

The bottom line is that SJW represents one of America’s smallest but fastest-growing water utilities with exposure concentrated in two of the most appealing regions.

 

The company’s fast-growing markets and the immense need for additional infrastructure investment could help SJW to not only retain its historically strong top and bottom line growth, but potentially accelerate it in the coming years, which could result in faster dividend growth as well.

 

Key Risks

As a small water utility, there are two main risks for investors to keep in mind.

 

First, like any water utility, SJW must deal with regulatory risk.

 

For example, while San Jose Water received an 8.6% rate increase for 2016, along with inflation adjustment authorization in 2017 and 2018 (recent inflation has been 1.7%), the company asked for 12.2%, 3.1%, and 5.4% increases in 2016, 2017, and 2018, respectively.

 

Meanwhile, the Public Utilities Commission of Texas only authorized 2.3%, 1.8%, and 1.8% rate increases in 2016, 2017, and 2018, respectively.

 

We also can’t forget that the key growth driver for water utilities is capex, or expanding its infrastructure so that it can recoup the costs (plus a guaranteed return on capital) and boost earnings.

 

While there has been much talk in Sacramento about the need to expand California’s water supplies, the fact remains that to actually do so involves running a gauntlet of numerous overlapping regulatory bodies, including the California Department of Conservation, Integrated Waste Management Board, the California EPA, Department of Water Resources, and the California Public Utilities Commission.

 

Which means that for San Jose Water to expand its infrastructure in the way that will be necessary in the coming decades, it could require multiple, multi-year environmental impact studies for each agency SJW must deal with. That in turn can result in profit-sapping delays and cost overruns, which regulators may or may not allow to be passed onto consumers.

 

And let’s not forget that, while the California drought may be over for now, the past few years haven’t been easy for San Jose Water. For example, in recent years state-mandated conservation efforts (for residential customers) resulted in 20% reduction in residential demand for San Jose Water (relative to 2013 levels).

 

Given that 90% of the San Jose Water’s customers are residential, this shows that future droughts (potentially also in Texas) could have significant negative growth effects on SJW Group over the short-term.

 

Essentially, like most other small cap stocks, SJW’s business is not very well diversified. Since almost all of its earnings are dependent on water services in just two cities, the company’s fate depends much more on conditions (e.g. droughts, unfavorable regulatory rulings) in those markets.

 

SJW’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

SJW has a Dividend Safety Score of 70, indicating a safe and dependable payout, which is to be expected for a dividend king that has paid an uninterrupted quarterly dividend for a remarkable 74 straight years.

 

 

Note that the apparent 1993 dividend reduction was due to a special one time payout.

 

There are three main keys to SJW’s solid dividend safety.

 

First, the underlying business model is about as stable as you can find on Wall Street, since everyone needs to drink, bathe, and wash dishes, no matter the economic climate. In fact, SJW’s sales dipped by just 2% in fiscal year 2009, and its stock outperformed the S&P 500 by 25% in 2008.

 

Second, management has remained highly disciplined about growing the dividend slowly enough to maintain a very safe EPS payout ratio, ensuring a strong safety buffer during times of company hardship such as the recent drought.

 

 

The final protective factor is the company’s very strong balance sheet, which helps ensure that management can prioritize future growth while still protecting the current dividend and continuing to increase it slowly but surely each year.

 

 

At first glance, SJW’s $431 million in debt may seem like a lot for such a small company. However, it’s important to keep in mind that the regulated water utility industry is highly capital intensive, so we need to keep these metrics in context.

 

When we take a look at SJW’s balance sheet relative to its peers, we can truly get a sense for how strong it is financially.

 

 

 

For example, SJW’s leverage ratio (debt/EBITDA) is not only significantly lower, but the current ratio (short-term assets/short-term liabilities) is nearly double the industry average. Meanwhile, the interest coverage ratio of over 7 is exemplary given that most utilities have a ratio of three to four.

 

This is why SJW has a very solid investment-grade credit rating that allows it borrow cheaply to invest in future growth, while still maintaining a highly secure and steadily growing dividend.

 

SJW’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

SJW’s Dividend Growth Score of 40 indicates slightly below average future payout growth potential. That’s not too surprising given that, as a water utility, SJW has never been known for its fast dividend growth.

 

 

The good news is that, due to its fast earnings growth rate (for a water utility) and because its current 32% payout ratio is about much lower than its historical norm, SJW can afford to grow its dividend slightly faster than the 4.5% EPS growth rate that analysts are expecting over the next decade.

 

However, that’s not to say that SJW is going to ever turn into a double-digit dividend growth stock. Rather, 4% to 5% annual dividend growth seems most likely for investors to expect over the long-term.

 

Valuation

Over the past year, SJW’s stock has about doubled the S&P 500’s total return. Unfortunately, this world-class water utility is now looking priced for perfection.

 

For example, SJW’s forward P/E ratio of 22.9 is above its historical norm of 21.0 and greatly exceeds that of the S&P 500’s 17.4, as well as the industry median of 17.6.

 

Meanwhile, SJW’s dividend yield looks even worse relative to history. Specifically, SJW’s 1.5% yield is not only lower than the S&P 500’s 1.9%, but it is also far below its 13-year median of 2.6% and the 3.1% industry median yield.

 

In fact, SJW’s current yield is tied with 2007 for its all-time low, indicating that the stock could be more likely to underperform going forward. Investors seeking greater current income, especially from stable utility stocks, should review some of the best high dividend stocks here instead.

 

Long-term shareholders can likely only expect 5.5% to 6.5% annual total returns (1.5% dividend yield plus 4% to 5% annual earnings growth).

 

That’s about half what SJW has delivered in the past two decades and also about half that of what many dividend aristocrats and kings are likely to be able to generate, even with the market at historically overvalued levels.

 

A price in the mid-$40s or below (SJW currently trades near $57 per share) would make this high quality dividend stock start to look more interesting, in my opinion.

 

Conclusion

Regulated water utilities are the epitome of boring but beautiful, wide moat businesses; the kind that can generate secure and growing dividends for well over half a century.

 

As far as water utilities go, there aren’t many better than SJW, with its industry-leading growth rate, constructive relationships with regulators, strong balance sheet, and proven management team.

 

That being said, given SJW’s very strong rally over the past year, its current valuation does not seem to this dividend king a timely choice for a diversified dividend growth portfolio, especially if you’re looking to live off dividends in retirement.