Middlesex Water: This Dividend Aristocrat Is Seriously Overvalued (NASDAQ: MSEX)

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Middlesex Water (NASDAQ:MSEX) is a New Jersey-based water and wastewater utility company. After years of fairly unremarkable performance, stocks began to soar in 2016 and have remained surprisingly strong until today.

Over the past decade, MSEX the stock rose 376%. This might lead investors to believe that this water company has a special formula that leads it to these tremendous returns. Unfortunately, however, much of the gain simply comes from a higher valuation multiple, and therefore leaves the stock vulnerable to a significant downside in the future.

This is arguably most evident when looking at the company’s price-to-sales ratio. Normally people might not use P/S for utilities. However, I find it interesting because utilities tend to be regulated and generate stable returns and profit margins on their business. Revenue is a very good indicator of what a utility will be able to earn in the long term, because profit margins fluctuate very little.

In the case of Middlesex, after decades of trading at a P/S ratio of 2-3x, that figure suddenly exploded to 10.5x today:

Chart
MSEX PS Ratio data by YCharts

I find this hard to justify, given that the profit margin on water tends to be limited. A utility will struggle to create as much shareholder value beyond what it can achieve in terms of bottom line growth. And, as the chart shows, Middlesex’s valuation far exceeded the actual growth in its business.

Earnings growth is slower than it looks

A bull on the company could indicate its earnings growth, which has been much faster than its revenue in recent years. However, there is a specific factor driving this above-average earnings growth that investors should be aware of.

Here is part of Middlesex’s income statement so you can see the key factor:

MSEX income statement

MSEX income statement (Seeking Alpha)

I have highlighted the income tax expense line as it has been central to Middlesex’s profit growth in recent years. Until 2017, Middlesex paid around a third of its pre-tax profit (“EBT”) in income tax. In 2018, however, Middlesex had almost no tax liability, and since 2019 it has received a net tax benefit.

Middlesex still owes normal statutory tax; in 2021, he paid $6.5 million in tax at the statutory rate. He paid an additional $1.5 million in state taxes. However, Middlesex received tax benefits of $12.3 million for repairs to tangible property and another benefit of $1.3 million for repairs to utility installations. On the net, Middlesex received a significant tax rebate rather than having an expense. There is significant discussion in the Middlesex 10-K about the regulatory treatment and IRS handling of accounting relating to these tangible assets.

I am not a tax expert and cannot speak to the specifics of this situation. I’d just like to note that it’s not particularly common for US companies to have negative effective tax rates for this long and investors may want to double-check their research before assuming the company will benefit indefinitely such a favorable net tax rate.

Why is this tax rate change important? Between 2012 and 2021, Middlesex Water increased its profit from continuing operations by $14 million to $36 million. Sounds good, that’s an increase of over 150%.

However, earnings from continuing operations during this period only increased from $28 million to $35 million. This is an increase of nearly 30% in the real pre-tax profits of Middlesex’s business. That’s still decent, decent growth, but it’s a lot less than you’d think just by looking at the company’s reported earnings per share.

Total returns likely minimal going forward

Let’s put this math together. Realistically, what kind of return could an investor expect from MSEX stocks over the next five years?

Middlesex has grown revenue at a compound rate of 3.4% over the past decade, and earnings growth was of the same order of magnitude when taking into account the change in the company’s tax rate.

Middlesex also pays a dividend yield of 1.3%, and investors can also expect small annual increases in this dividend in the future. Combine 3% revenue growth with the dividend and we could expect total returns in the 5% annualized range if the stock’s valuation stays where it is today.

This is where the other problem comes in, though. The company’s P/E ratio has now climbed to nearly 40, from much lower averages in the past:

Chart
MSEX PE Ratio Data by YCharts

Prior to 2015, Middlesex tended to have a P/E ratio of around 20. From 2016, the company’s P/E ratio reset to around a median of 30. Now it is pushing 40.

If we estimate earnings to move from a projected $2.52 this year to $3.00 over the next five years, that would be respectable growth in line with the company’s past performance. However, if MSEX stock returns to a 30x P/E ratio, the stock would trade at just $90 in 2027, offering virtually no upside from the current price of $89. And if Middlesex returns to a 20x P/E ratio, as it traded for much of 2008-2014, that would put the stock at $60 in 2027, which would be a significant loss even including the company’s dividend.

Is Middlesex Water Stock a good candidate for short selling?

If MSEX stock is significantly overvalued relative to its own past history and the valuations of other water utilities, does that make MSEX stock a good short position?

Sure, some people think so. As of this writing, over 4% of MSEX stock float has been sold short. That’s a pretty high number for a sleepy utility company like this.

I imagine some managers use Middlesex Water as funding shorts. That is, they probably own other utility stocks at more attractive prices and are hedging their bets by taking a short position in Middlesex. Sounds like a reasonable strategy.

But he’s not a short slam dunk candidate. As Middlesex only has 17 million shares outstanding, the price can move quite quickly on any positive catalyst.

One such example occurred in July 2021, when the S&P 600 SmallCap Index added Middlesex to its holdings. In doing so, it forced a ton of passive funds to buy MSEX stocks. The shares went from $80 to $110 in the space of a month, mainly thanks to this index inclusion event.

On the other hand, there have been rumors of potential consolidation in the water industry. There aren’t many listed companies available, so Middlesex could rally if water deal rumors break out.

Overall, I would expect a short sale of Middlesex Water shares to perform reasonably well in a broader long/short equity portfolio. However, I would also say that it’s not as simple as saying it’s a slam dunk short because it’s a 30-second high P/E water serve. The valuation seems too high, I agree. But without an obvious catalyst to correct it, these types of low volatility stocks can remain disconnected from underlying fundamentals for some time. Especially in a bear market, these types of low-beta defensive stocks can outperform for longer than expected.

Verdict on MSEX stocks

I generally hesitate to use the word sell when it comes to dividend aristocrats. It’s admirable when a company pulls off the feat of increasing its dividend for so many consecutive years and is a testament to the cautious nature of a management team and their ability to manage a business through the economic cycle. This is not at all a blow to the business strategy or the leadership of the company.

I just don’t see how the math works even over a five year period from here. Assuming the company grows its core business in line with its historical results, Middlesex would have to trade with a P/E ratio of nearly 30x in 2027 for shareholders to simply break even from today’s starting price. today.

For a holder with a sufficiently long time horizon, it may still be justified to hold the stock. Water utilities are somewhat of a fixed income alternative, as they typically offer a stable cash flow from irreplaceable assets with regulated returns on equity. It’s an equation that boils down to getting a good night’s sleep. In the case of Middlesex, I would say that cash flow is significantly overstated. But, it’s still something you can own and have great confidence that it will produce steady dividends a decade from now.

So for very long-term investors or people who have capital gains tax issues, stocks are perhaps a hold. For most people, however, the prospect of low or zero total returns through 2027 on this stock should be reason enough to consider redeploying capital to other more attractive opportunities.

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