NEW YORK--(BUSINESS WIRE)--Spruce Point Capital Management, LLC (“Spruce Point” or “we” or “us”), a New York-based investment management firm that focuses on forensic research and short-selling, today issued a detailed report entitled, “A Non-Essential Stock Holding,” that outlines why we believe shares of Essential Utilities, Inc. (NYSE: WTRG) (“WTRG” or “Essential” or the "Company") face up to 35% to 50% downside risk, or approximately $20.00 – $28.00 per share. Download or view the report by visiting www.SprucePointCap.com and follow us on Twitter @SprucePointCap for additional information and important updates.
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Spruce Point Report Overview
Based in Bryn Mawr, PA, Essential Utilities, Inc. (formerly Aqua America and Philadelphia Suburban Corp.) is a regulated utility providing water, wastewater, or natural gas services to residential and commercial customers predominately in the Northeast United States. After an unsuccessful strategy to grow by acquisition through state expansion and by joint venture, the Company is now facing long-term pressures both from declining water use and from the challenges stemming from its $4.3 billion acquisition of Peoples Natural Gas Co (Peoples), a levered transaction intended to drive the Company’s expansion into natural gas distribution.
Key findings from our report include:
- Essential is an aggressive roll-up hitting a wall that draws public outrage. Since embarking on an aggressive roll-up acquisition strategy of water and wastewater municipal assets in the early 1990s, it has made over 350 acquisitions spending approximately $4.5 billion in cash. Favorable regulation and the perception that infrastructure assets are safe provided the Company an opportunity to borrow large amounts of money and pass-through higher prices to consumers. The Company is simultaneously pushing the narrative that it is investing money to improve aging infrastructure to deliver reliable water services. However, like most roll-ups, as they grow and mature, size ultimately becomes an inhibitor to continued growth. Essential has already failed at multiple state and joint venture expansions, and we believe it is now at the declining phase of its growth story as its aggressive price increases and numerous snafus in billing, service and water quality have created an environment of public outrage against it. Meanwhile, growing pools of capital dedicated to infrastructure investing, the emergence of NextEra Energy as a major player in the space, and changes in legislation towards “fair market value” that enable municipalities to command more for their assets have markedly increased Essential’s competitive field in completing new investments. To illustrate this further, in a recent auction in Essential’s home state of Pennsylvania, over 100 bidders emerged on an asset that ultimately sold at a 113% premium to Essential’s offer price. Through multiple Freedom of Information Act (FOIA) requests, we also see how Essential has pursued other deals of questionable economic value. The Company recently cut its acquisition pipeline from 430,000 to 400,000 (-7%) between January and February 2023 and subtly lowered its organic water rate base growth outlook.
- Evidence shows that Essential’s recent $4.3 billion levered acquisition of Peoples was a defensive deal and is struggling. In 2018, the Company announced the acquisition of Peoples, a provider of natural gas distribution services to residents in the Northeast U.S. Peoples formed through various acquisitions by SteelRiver Infrastructure Partners from 2010 to 2017. In Spruce Point’s experience, when public companies buy assets from private equity owners, it rarely ends well for shareholders. Essential has been touting the many benefits of the transaction, including diversification into natural gas. However, based on our primary research and discussions with former employees with knowledge of Essential’s finances, we learned that the transaction was defensive, and concerns were raised about Essential’s ability to meet investor targets absent the transaction. We also found evidence that, leading up to the transaction, three of Essential’s key water segments (residential, commercial and wastewater) were experiencing declining revenue per customer growth, while the Company’s consolidated return on equity and EPS were both in decline. After conducting a close forensic examination of the transaction, we found evidence that Peoples is not only falling behind its rate base growth plan but also that its customers are experiencing increasing difficulty paying bills. As further evidence, Peoples’ allowance for bad debts as a percentage of gross receivables skyrocketed from approximately 6.4% pre-deal to more than 29% in 2021. Furthermore, we estimate that Peoples’ EBITDA margins have contracted by 540bps (pre-deal to 2022) and 1,130bps (Q1 2020 to 2022). In addition, Spruce Point finds alarming evidence that Essential’s operating cash flow margin is in perpetual decline, falling from 48.2% to 38.3% (2017-2019, pre-deal) and contracting even further to 23.9% in 2022. Not only are Essential’s water volumes declining annually, but it is now also facing declining natural gas usage among its Peoples customer base. As seen by recent abnormally high temperatures in its local region, global warming and climate change are other factors working against Peoples. In a sign of its financial stress, Essential reports “book overdrafts,” which we analytically reclassify from financing to operating cash flows because they are considered current liabilities and form part of working capital movements. Interestingly, a recent audit by the Pennsylvania Public Utility Commission (PUC) revealed further alarming insights into the status of the combined company. Within this audit, Essential/Peoples received a mark that it “Meets Expected Performance Levels” in only five out of 22 categories (27%) scored by the audit. Drilling down deeper, we find evidence of wide-ranging issues encompassing accounting systems that lack documented flow charts, internal control and cost allocation issues, along with manual processes and a lack of formal budgeting policies in what the report called a “Complex Organization.”
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Multiple signs of rising financial stress, problematic financial reporting and potential asset impairment are looming. Negative trends open the door for Essential to potentially get more aggressive and/or opaque with financial reporting. Essential lays out plans to spend $3.3 billion through 2025 on capital expenditures (“capex”) (a recent increase in guidance from $3.0 billion), while also carrying a burden to maintain (and grow) $303 million per year in dividends. There are also approximately $380 million of acquisitions currently pending to close with “active” opportunities in the pipeline. The Company guides investors to EPS that will compound 5% – 7% through 2025. Yet, even though it pitches itself as having stability by being an essential utility, it does not provide cash flow guidance. Spruce Point has identified many indicators that the Company’s cash flow is being pressured, including:
- Omission of Operating Cash Flow Discussion: Essential does not provide a quarterly discussion of its operating cash flow in the MD&A section of its 10-Q. Given its negative working capital and dependence on external capital, we believe this information is material to investors.
- Rising Bad Debt Allowance: Essential’s allowance for bad debts as a percentage of gross receivables has skyrocketed from approximately 6% prior to the acquisition of Peoples to 23.7% through year-end 2022. The peer industry average is 7.2%.
- Growing Divergence Between Net Income and Operating Cash Flow: Spruce Point frequently evaluates the ratio of operating cash flow to net income in assessing the “earnings quality” of a company’s financial reporting. We see a clear trend that Essential’s ratio has been in decline since the closing of the Peoples acquisition in Q1 2020. The ratio made a two-year low in the most recent Q4 2022 quarter.
- Increasing Short-Term Debt Dependence and Debt Modification: Earnings are typically weighted towards Q1 and Q4, so it is not surprising to see more strain in Q3. However, if we compare the Q3 2022 to Q3 2020 results post-closing of Peoples, we find a significant increase in short-term debt. In June 2022, Peoples amended its 364-day revolving credit agreement primarily to increase the amount of the facility from $100 to $300 million.
- Divesting A Recently Acquired Underperforming Asset: On January 3, 2023, the Company announced it would sell its West Virginia gas utility assets, which were acquired through the Peoples acquisition. Based on our primary research, we found that the asset was an underperforming business, so the divestiture is of little surprise.
- Goodwill Testing Methodology and Accounting Principle Change: In 2021, Essential changed goodwill testing methodologies – more specifically, we observed that it switched from a “quantitative” to a “qualitative” approach for its Regulated Water and Aqua Resources unit. It changed from using a DCF approach to a “market and income approach” to evaluate the Regulated Natural Gas segment. In Q4 2022, Essential made an accounting principle change to goodwill and claimed it was for better alignment with long-term planning and forecasting but made no fiscal year reporting period change. As an additional concern, it says testing requires significant judgment and assumes margins will “generally” increase in the future, despite the fact that margins have consistently declined for three years post-acquisition.
- Essential’s dividend policy is problematic as payments are effectively made from external capital sources. The Company positions itself as an infrastructure utility providing “essential” services and offers investors a dividend that is not unusual among companies in its industry. Over the years, Essential has heavily promoted its ability to consistently grow the dividend, claiming that the dividend enhances shareholder value and referencing itself as a “dividend achiever” with a policy to target a payout ratio no higher than 65% of net income. However, Spruce Point believes the Company’s dividend policy is flawed because net income is not a proxy for free cash flow available to service the dividend given its large capital expenditure requirements and commitments to acquisitions. We believe the appropriate policy is to pay a dividend commensurate with its free cash flow after both capex and acquisition obligations have been satisfied. The problem is that Essential has no surplus capital to pay dividends. In fact, by reviewing more than 30 years of financial performance data starting in 1990, Spruce Point found that the Company has paid cumulative dividends of $2.6 billion. Over this period, it generated cumulative cash from operations of $7.4 billion but spent $9.4 billion on capex, leaving a deficit of ~$2.0 billion. This doesn’t even tell the entire story since acquisitions are a core part of the Company’s growth strategy and it has spent approximately $4.5 billion on acquisitions. In aggregate, the Company has had a capital deficit of approximately $9.1 billion that has needed to be filled through external capital raising. Focusing on the dividend, Spruce Point warns investors that Essential’s dividend reinvestment and direct stock purchase program, which offers a 5% discount, is not a great investment proposition. In fact, shareholders may slowly be figuring this out on their own. Over time, the participation rate of the reinvestment program has dramatically declined from 15.4% in 2010 to just 5.1% recently. Essential attempts to circumvent the issue by claiming that reinvestment proceeds are used to “invest in our operating subsidiaries, repay short-term debt, and for general corporate purposes.” More pointedly, we believe that because it cannot cover its dividend with free cash flow, money raised from investors through these programs could essentially be used to pay back the same and other investors' dividends, or ‘taking from Peter, to pay Peter and Paul.’
- There are multiple areas of concern regarding Essential’s Board and governance. We believe investors should not place undue confidence in the assumption that the Company’s management team and the Board will act in their best interest. Spruce Point observes that insiders own a minuscule 0.17% of shares outstanding. We believe Essential’s Board is poorly constructed and alarmingly underqualified. Essential has failed to implement public recommendations made by an independent audit from New Jersey to recruit more directors with water industry experience. Instead, none of its last three Board appointees have had any public work experience in the water or gas industries. Even more concerning are prior allegations from a former Board member who referenced actions of the board, including both current Chairman and CEO Christopher Franklin and current Board member Ellen Ruff as “disingenuous.” More specifically, we have grave concerns about Essential’s management team reaping excessive bonus compensation tied to unaudited and dubious “weather-normalized” earnings adjustments. We also question the fitness of Audit Chairman Lee C. Stewart and Director David A. Ciesinski who was appointed “Financial Expert,” despite having no prior audit committee experience and a 20-year food marketing background. Mr. Stewart’s biography also fails to state that he was on the advisory board of Fletcher Asset Management (“FAM”). While there is no time frame as to when he became associated with FAM, it is notable because FAM eventually filed for insolvency. The bankruptcy trustee described FAM as a “fraud” and having “many characteristics of a Ponzi scheme.”
- Essential has alarming historical connections to disreputable stock promoters, and we estimate a 35%-50% downside risk to Essential’s share price. Spruce Point warns that Essential has previously been associated with analysts and brokerage firms of dubious merit. In fact, we find that Essential’s stock was promoted by Stanford Group Company (part of Stanford Financial Group), which was a notorious Ponzi scheme run by Allen Stanford who is now serving a 110-year federal prison sentence. In addition, the Company’s stock was also promoted by Jesup & Lamont, a brokerage that was ordered to cease operations by FINRA. Fast forward to today and Essential is covered by fewer analysts than in the past, yet its roster still includes a mix of low-tier stock promoters with a resounding “Buy” opinion that collectively see 32% upside. We have a markedly different view and identify a range of negative headwinds that are likely to pressure Essential’s ability to meet its financial targets. We separately value its regulated water and natural gas business and estimate the fair value of Essential’s stock price to be $20.00 - $28.00 per share (35% - 50% downside).
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Please note that the items summarized in this press release are expanded upon and supported with data, public filings and records, and images in Spruce Point’s full report. As a reminder, our full report, along with its investment disclaimers, can be downloaded and viewed at www.SprucePointCap.com.
As disclosed, Spruce Point has a short position in Essential Utilities, Inc. and owns derivative securities that stand to net benefit if its share price falls.
About Spruce Point
Spruce Point Capital Management, LLC is a forensic fundamentally-oriented investment manager that focuses on short-selling, value and special situation investment opportunities. Spruce Point Capital Management, LLC is a member of the Financial Industry Regulatory Authority, CRD number 288248.