American Water Works Co. Inc (AWK) — Q1 2015 Earnings Call Transcript

Thank you, Allison. Good morning, everyone, and thank you for joining us for today's call. As usual, we'll keep our call to about an hour. At the end of our prepared remarks, we'll have time for questions. Now before we begin, I'd like to remind everyone that during the course of this conference call, both in our prepared remarks and in answers to your questions, we may make statements related to future performance. Our statements represent our most reasonable estimates. However, since these estimates deal with future events, they're subject to numerous risks, uncertainties and other factors that may cause the actual performance of American Water to be materially different than the performance indicated or implied by such statements. Such risk factors are set forth in the company's SEC filings. I encourage you to read our 10-Q on file with the SEC for a more detailed analysis of our financials. We will be happy to answer any questions or provide further clarification, if needed, during our question-and-answer session. All statements in this call related to earnings per share refer to diluted earnings per share. And now I'd like to turn the call over to American Water's President and CEO, Susan Story.

Thanks, Durgesh. Good morning, everyone, and thanks for joining us. With me today are Linda Sullivan, our CFO, who will go over the first quarter financial results; and Walter Lynch, our COO and President of Regulated Operations, who will give us updates on our Regulated Business. Once again, we delivered solid results for the first quarter of 2015 despite challenging winter weather in some of our states. This is a direct result of our employees, who are out there every day working for our customers to make these financial results happen. Turning to Slide 5. Our quarter-over-quarter revenues increased 2.8% to $698 million. Earnings from continuing operations were $0.44 per diluted share. This is a 7.3% increase over the 2014 adjusted EPS of $0.41, excluding the $0.02 cost impact from the Freedom Industries chemical spill in the first quarter of 2014. Turning now to Slide 6. You see our growth triangle and highlights of the progress we're making on delivering on our strategy. Our foundational base for earnings growth continues to be the capital investments that we're making in our Regulated operation in order to provide clean, safe and reliable service to our customers. Through March 31, 2015, we've made about $167 million in infrastructure investments. We plan to invest $1.1 billion in our Regulated Business this year in order to improve our water and wastewater systems, with another $100 million budgeted for acquisitions and strategic investments. Since the start of 2015, we have received rate case approvals and infrastructure surcharges in several of our states. We also filed general rate case requests in 3 states, and we have a pending settlement in Maryland. We're able to make needed infrastructure investments that are good for our customers and which minimize their bill impact through both our continued focus on controlling O&M costs as well as the constructive regulatory mechanisms, which are in many of our states. As we've previously discussed, we increased our 5-year capital spending plan by an additional $200 million to $6 billion total. Walter and Linda will discuss capital investments and O&M efficiency results more fully. Moving to Regulated acquisitions. The agreements we made in 2014 continue to move toward approval and closing. We recently received regulatory approval for the purchase of the wastewater system in Arnold, Missouri. And we're on track for the closing of this and other pending acquisitions by the end of this year. We also announced last week the proposed purchase of Environmental Disposal Corporation, or EDC, adding 5,300 wastewater customers in New Jersey, subject to BPU approval. Moving to our Market-Based Businesses. We continue to deliver solid results. Our Homeowner Services business recently launched its exclusive partnership with the Orlando's Utilities Commission, offering a warranty service program to its more than 200,000 residential customers. We also announced the renewal of our exclusive contract with the City of Burlington, Iowa, and continue to grow enrollments in New York City, Nashville and other areas of the country. If you remember, we entered this business several years ago to address an unmet need that our regulated customers had with regards to the water pipes that were their responsibility, and this business has grown to leverage those competencies. Also, as we look to our Market-Based Business growth, we put special focus on those businesses like Military Services that have a regulated-like risk profile. On our nonregulated shale. There has been a lot of discussion within the oil and gas E&P sector regarding capital reductions and prioritization of the remaining capital. This could potentially provide an opportunity for us, as some of these companies recognize the value of American Water's expertise and our capabilities in developing long-term water supply solutions. While we are continuously evaluating opportunities in this space, we are disciplined in our approach, and we don't have to rely on shale to meet our EPS guidance. Slide 7 illustrates our ongoing commitment to our shareholders. The American Water Board of Directors last week raised the dividend about 10% to $0.34 per share. This is the third consecutive year of double-digit percentage increases to our dividend. Comparing the dividends paid from 2010 through 2014, we're in the top quartile of dividend growth compared to the Dow Jones Utility Average companies and to our water peers. Based on our performance year-to-date, we reaffirm our 2015 earnings guidance from continuing operations to be in the range of $2.55 to $2.65 per share. We're off to a good start this first quarter, and we remain committed to delivering on our long-term EPS growth goal of 7% to 10% through 2019, anchored from our 2013 earnings. So with that, Walter will now give us an update on our Regulated Business.

Thanks, Susan, and good morning, everyone. As Susan mentioned, we're off to a great start in 2015, continuing our commitment to investing in our infrastructure while focusing on improved O&M efficiency to mitigate the rate impacts for our customers. Turning to Slide 10. In recognition of the investments we made to ensure clean, safe and reliable service for our customers, we received a rate order in California providing $5.2 million in incremental revenues effective January 1, 2015. This rate case outcome continues to demonstrate constructive regulation in California, allowing recovery of SAP costs, sharing of one-time proceeds from groundwater contamination litigation, and a forward test year approving $126 million in new investments through 2017. Susan will be speaking in more detail later on the call about California water supply challenges, but I wanted to emphasize that we're working hard in California and our other states to balance needed investments with what customers pay for service. In West Virginia, last week, we filed a rate request for $35.6 million. The primary driver in this request is the investment of approximately $105 million in system improvements made since 2012, as well as an additional $98 million that the company plans to expend on recurring and investment projects through February 2017. These capital investments include upgrades to the water distribution system, water treatment facilities, storage tanks, and pumping stations. All are necessary to maintain and improve water quality, reliability, fire protection, and customer service for approximately one-third of the state's population served by West Virginia American Water. The request also includes a reduction in operations and maintenance expenses of $1.1 million when compared to the last rate filing. In fact, the current operations and maintenance expenses are at their lowest levels since 2010. This rate case does not include the costs incurred from the Freedom Industries chemical spill. West Virginia American Water is seeking to defer the recovery of costs related to the Freedom Industries chemical spill to a separate future proceeding. We believe that by moving these spill costs to a separate proceeding, stakeholders can better focus on our ongoing provision of safe, clean, and reliable water and wastewater service to our customers. As you know, one of our goals is to pursue constructive regulatory mechanisms and legislation, and we've made some great progress on that front in Indiana. I'd like to highlight three of these bills signed into law in the last few weeks. The first is an amended DSIC bill, which increases the DSIC revenue cap from 5% to 10%, further allowing us to replace our aging infrastructure before problems occur. The other two bills signed into law include a referendum bill that provides extra time for public education during the sale of a water or wastewater system, as well as new legislative authority for the Indiana Utility Regulatory Commission to approve the recovery of a reasonable purchase price of a distressed utility. Another highlight in our Regulated operations is our 2014 water quality reports, also called consumer confidence reports. I'm proud to say that, once again, American Water scored well above industry averages for compliance with strict federal standards for water quality and more than 99% compliance with Safe Drinking Water Act standards or approximately 15 times better than the industry average for compliance with drinking water quality standards and 20 times better than the industry average for meeting all drinking water quality standards. This exceptional water quality record is directly attributable to the dedication and expertise of our people and the investments we make into our systems. Moving to slide 11. We continue to improve our O&M efficiency ratio, achieving 36.3% for the last 12 months. And as we've said previously, our stretch target is to achieve an O&M efficiency ratio of 34% or less by 2020. This translates to our disciplined approach to capital investments to help us maintain reliable service while minimizing customer bill impacts. So in closing, and it can't be said enough, our efforts to improve operating efficiencies while ensuring high-quality service and reliability delivers the best value for our customers. And now I'll turn the call over to Linda for more detail on our first quarter financial results.

Thank you, Walter, and good morning, everyone. I will start on Slide 13, which is our new format intended to expand the transparency of our disclosures by showing the contribution to earnings per share by each business segment. On the left side of the page, we show our consolidated first-quarter results. Adjusted EPS from continuing operations was $0.44 per share, up 7.3% over the same period last year, after adjusting for the 2014 costs associated with the Freedom Industries spill. The Regulated segment continues to be our largest contributor towards earnings in the first quarter at $0.45 per share. Our Market-Based Business contributed $0.04 per share. And our parent company drag, which is primarily interest expense on parent debt from the RWE period, was $0.05 per share. These solid results increased our consolidated adjusted return on equity for the 12 months ended March 31, 2015, by 40 basis points to 8.88%. Now let me discuss the different components of our first quarter adjusted EPS growth from continuing operations on Slide 14. Our starting point is first-quarter 2014 EPS from continuing operations of $0.41 per share, which is adjusted for the Freedom Industries chemical spill. We reported first quarter 2015 results of $0.44 per share or $0.03 above 2014 adjusted EPS. The major drivers of this increase were, first, $0.02 from higher incremental regulated revenue from rate increases and infrastructure surcharges for a number of our operating companies, partially offset by decreased demand from declining usage. Next, Regulated O&M was lower by $0.02 due to lower production costs mainly from lower fuel and natural gas prices as well as the positive impacts of the California rate case settlement, which allowed recovery of certain SAP implementation costs previously incurred. Partially offsetting these decreases were higher employee-related costs due to higher pension expense as well as higher uncollectible expense. Depreciation, taxes, and other was higher by about $0.01 per share principally from growth associated with our capital investment programs in the Regulated Business. I would also like to note that the operating income of our Market-Based Business was relatively flat in the first quarter compared to last year as the revenue growth was offset by the timing of expenses and higher claims in the Homeowner Services segment due to harsh winter weather. Also due to weather, we experienced delays in some construction projects within the Military business segment, but expect that to pick up in pace in the balance of the year as the backlog of approved projects is currently at approximately $120 million. In the appendix of the slide deck, we have included our revenue and expense bridge slides to provide more details to the variances I just discussed. Now let me cover regulatory highlights on Slide 15, which shows rate cases and infrastructure filings awaiting final order and new rates that became effective since April 1, 2014. In terms of pending rate cases, we are awaiting orders for general rate cases in three states, with the largest being New Jersey and West Virginia, for a combined total rate request of $101.9 million. As Walter mentioned, these rate cases demonstrate our disciplined approach to investing. In fact, our two large rate cases request recovery of over $975 million in much-needed capital infrastructure investments while reducing requested operating costs by $20 million combined. Also, we continue to await a proposed decision in our Maryland rate case settlement for an additional $0.5 million in revenues, and several of our operating subsidiaries filed for additional annualized revenues from infrastructure investment charges for a total of $4.4 million. For rates that became effective since April 1, 2014, through today, we received a total of $55.4 million in additional annualized revenues from general rate cases, step increases, and infrastructure surcharges. These are the highlights of these cases, and we advise you to review the footnotes in the appendix for a fuller understanding of particular cases. Turning to Page 16. I am pleased to announce that in late April, Moody's Investors Service changed American Water's outlook to positive. This highlights our value offering as a geographically diversified regulated utility and our commitment to managing the overall financial strength of the company while maintaining our disciplined approach to investing. And we're really proud of that. Slide 17 is a summary dashboard of our performance in the first quarter. During the first three months of 2015, we made capital investments of approximately $167 million to improve infrastructure in our Regulated Business. For the full year of 2015, we continue to estimate our total capital plan to be $1.2 billion, most of which will be in our Regulated Business. The decrease in cash flow from operations during the quarter reflects changes in working capital. A significant portion of the change was related to higher cash collections in the first quarter of last year as we delayed some 2013 billings into the first quarter of 2014 when we implemented our new customer information system in late 2013. In terms of our dividend increase, we increased the dividend by about 10%, which is in line with 2014 EPS growth. This annualized increase puts our payout ratio at 52% when compared with the midpoint of our 2015 earnings guidance range or at the lower end of our target payout ratio of 50% to 60%. And building on the 7.3% increase in earnings per share this quarter, we are reaffirming our 2015 earnings guidance from continuing operations to be in the range of $2.55 to $2.65 per share. With that, I'll turn it back over to Susan.

Thanks, Linda. In closing, we're going to highlight American Water's leadership in delivering innovative solutions to address the two key water issues facing our nation today: water supply and aging infrastructure. These are very real issues that will affect our economy, our standard of living and other basic life functions into the future if we don't plan well and execute the right actions now. Unlike electricity, where you can build a plant to create more, if you have reduced surface water or groundwater supply and you've optimized conservation, your remaining options are pretty much desalination and water reuse. American Water is leading in all of these supply options as well as in conservation efforts. California offers us the opportunity to utilize this wide array of expertise. As many of you know, with the drought worsening, the Governor of California issued a 25% mandatory reduction of water usage. Our Monterey Peninsula Water Supply Project is a critical part of addressing the ongoing drought there while reducing our dependency on the Carmel River for supply. This project includes a total investment of about $300 million, which includes a desalination plant, which will be owned and operated by California American Water, as well as 30 miles of pipeline, two booster stations, and a reservoir. This energy can be up to 55% of the cost of operating a seawater desal plant. We will employ energy recovery devices to lower the plant's power use, and we hope to purchase half of the power needed from an adjacent landfill site. The plant will also include an innovative subsurface intake system, which uses slant well technology that draws seawater underneath the sand near the shoreline and avoids the harming of marine life posed by traditional open-ocean intakes. Lastly, we're adding two additional Aquifer Storage and Recovery wells to capture excess winter flows from the Carmel River, which can be used during the dry summer months. Conservation is also critical in California, and we've been a leader for years in educating our customers, offering rebates for water-efficient appliances and fixtures, and providing incentives for drought-tolerant landscaping. Our customers have already reduced their water usage significantly statewide and as much as 17% in Sacramento since 2013. In addition to further promoting and educating customers on our current conservation programs and efforts, we are piloting a unique program in Monterey using advanced water meter technology that will enable customers to more proactively manage their water use. They will be able to download individual daily water consumption information to monitor their use, set up text or email alerts to let them know if a leak is detected or let them know when they are about to enter a new price tier or exceed a self-determined budget amount. All of these efforts are supported by constructive regulation that balances the long-term sustainability of the water supply and the utilities that treat and deliver that water. We realize that as the nation's largest investor in water and wastewater utility, we have to take the lead in solving our country's water and wastewater challenges. Our 6,400 employees take that responsibility very seriously, and we will ensure that our customers have the water services they need every day to live safely and comfortably. And with that, we're happy to take any questions you may have.

Just looking at Slide 11, you guys are showing kind of progression toward your stretch target on the efficiency ratio. Is 34% feeling like a stretch given the fact that you've got four years to get there? Or is that number going to keep pushing lower, and you're going to surprise us again?

Well, the 34% is our stretch target. And as you know, as you get closer to that, it gets a little bit more difficult. So we still see that as achievable. But it's also a stretch target, so we're working towards that.

So we should anticipate that the rate of improvement will slow down compared to what we've experienced in the past few years.

Yes, I'd agree with that.

Okay. On Slide 33 in the back, where you show the acquisitions completed last year and what is currently in process this year, can you remind us how much money was spent on acquisitions in 2014? Additionally, what is the total amount you plan to invest in 2015 to finalize the ongoing deals?

We incurred about $8.4 million in 2014 for the completed acquisitions. Currently, we have set aside approximately $100 million for strategic and regulatory acquisitions for the full year, including these acquisitions and others that are pending.

So Linda, you're going to have to find some more deals than what's on here to get to the $100 million dollars. Is that right?

Yes. And remember, Dan, we also have some flexibility in terms of the capital spend to deal with some timing issues there as well.

Okay. One last question on the nonregulated side. Revenues have increased significantly this quarter, but expenses have also risen correspondingly. Did you pre-fund some of the military work in the first quarter to allow for more ongoing profit? Or can you explain why those two factors have moved at the same rate?

Yes, we have noticed an increase in costs related to military contracts that aligns with the revenue we reported. Additionally, we encountered some timing issues in the HOS business due to marketing and start-up expenses associated with Orlando and other contracts. Furthermore, as we continue to enhance the Contract Services business, we made some one-time adjustments last year.

So if I were to think about normalizing out kind of the Orlando upfront and some of those contract adjustments, how much extra cost was that in the quarter? Just to try and get our variance right.

I don’t have those numbers at hand, Dan. However, we believe that we’ve incorporated all of those costs into our reaffirmed earnings guidance.

So the delay that I think we mentioned in the prepared remarks for the military contracts, was that more administrative? Or maybe just a little bit of color there.

It was actually more weather-driven.

Okay, got it, got it. That's helpful. On the E&P business, I think this has sort of been highlighted as a potential opportunity for some time. Are we sort of still in the early phases? Or are we kind of getting to the point where we'll see some inflection points?

This is Susan. There are many changes occurring in the E&P space. Interestingly, we have noticed that as many E&P companies cut back on their capital expenditures, they tend to focus more on their core businesses. For ancillary services, we have observed a greater willingness from companies to engage in discussions. The primary challenge is establishing partnerships that are beneficial for both parties. As we’ve mentioned before, we are not interested in high-risk ventures for these opportunities. Any new engagement would need to ensure a quick return on any capital we invest, and we are currently in talks with various groups. The progression depends on the specific deal, and we want to ensure that any partnerships build on our core strengths in the water business without straying too far from that. We continue these conversations, and whether we are close to an agreement depends on the deal and how the year unfolds. One thing we do know is that for our regulated sector in shale, the outlook for 2015 appears favorable, as even though fewer wells are being opened, the existing ones are proving to be more productive. We see some movement in the regulated side while maintaining a disciplined approach in the unregulated sector.

Got it, got it. That's very helpful. And then just top level, pretty good growth in the nonregulated business. Is this sort of a refreshed viewpoint on how large you sort of want this business to be as a percentage of consolidated results?

Currently, the revenues from the Market-Based Business account for about 10% to 11%. Our goal is for revenues, and possibly net income, not to exceed 15% to 20%. We would only feel comfortable with revenues surpassing 15% if that increase comes from Military Services and heavily regulated parts of the market. We continuously assess the overall risk profile of the company to ensure we maintain our current standing.

I wanted to ask a broad question about the national regulatory environment, particularly in relation to awarded returns on equity, which have been declining over the past several years. I would like your perspective on the outlook for ROEs, especially if you believe that an improving economy and potential rise in interest rates might lead to a recovery in awarded returns in the next year.

So if we look out from ROEs, they are largely driven by changes in interest rates. And so if interest rates go up, we would expect to see some increase in ROEs as well. In terms of recent decisions, we have had our cost of capital decision in California, extended at 9.99% through the end of 2016. We did have our Indiana rate case approved with an increase from 9.7% to 9.75%. So we are seeing just slight movements in the ROE.

That's encouraging. My next question concerns the situation in California. We're trying to understand how the decoupling mechanism may be affected by the recent conservation declines. In theory, decoupling should make any decline in consumption a non-issue. However, the extent of these declines appears to exceed what the Public Utilities Commission may have anticipated when the system was designed. Will this complicate the implementation of the decoupling mechanism as these significant consumption declines are processed? Specifically, could the Water Revenue Adjustment Mechanism balances become so large that the Public Utilities Commission might decide to extend the collection period to prevent rate shock?

Right, Ryan. And we're looking at that very carefully in California as to what would be the cash impact and the recovery period for any delays in collections under the WRAM mechanisms. The WRAM mechanisms now, with the California rate case, are in virtually all of our areas. In California, they've been now approved. This has been a mechanism that California has supported for quite some time. And it really does drive the alignment of the utility companies and the customer to conserve and to work through the drought-related issues.

And also, one thing that's interesting is there's a national discussion about the price of water. And there are those who would say that out west, where you are having the scarcity, you're starting to see more appropriate value placed on water. And so as we look at this, we compare it to where we've been in the past. It will be interesting to see where this goes in the future, though, especially as in 50 states in the U.S., 40 water managers say that parts of their state, they believe, will be in drought in the next 10 years. So I think the wider discussion about the value of water and what we do in terms of putting a price on water is pretty important, and we may see that in California. We already are seeing that in California.

Yes. And Ryan, to both your point on ROE as well as California, we do operate in 16 regulated states. So we do have a diversified portfolio here, and California represents just slightly less than 8% of our total revenue.

Okay. Just a quick question. While I understand you can't disclose specific content, has the PUC engaged you and other peers to discuss these issues and begin framing the regulatory response? Or is it currently unclear?

I wouldn't say it's a black hole. I will tell you that our team at California American is always looking for ways to work with our customers, find ways that we can work to ensure that the regulatory process operates as they're intended to operate. And so we sit down at the table and open forums. Our President, Rob MacLean, participates in a lot of the water forums and water conferences. So we're engaged in the dialogue throughout the State of California.

Okay, great. Just one final quick question for me: regarding the increase in claims on the Service Line Protection, I assume that cold weather was a factor. Was there anything else we should know about in that regard?

An increase in the number of contracts as well as cold weather.

Just a couple of quick ones here from me. First one, I want to ask about the New Jersey rate case. That $66.2 million of revenue asked, is that inclusive of amounts that are already being recovered via the DSIC?

No, that's outside the DSIC mechanisms. They'll be included as part of the rate case in the end. But the $66 million is for other things, investment. As you know, if you've been following closely, we reduced our costs by $19 million since the last rate case. We invested $775 million in the infrastructure, and that's more than we've ever spent in New Jersey. And so asking for 9.9%, we think, is a big win considering it was three years since our last rate filing.

Yes, absolutely very helpful. And also, sticking with the New Jersey DSIC, we'd gotten on a pretty good semiannual cycle there. With the rate case in progress now, is it safe to assume that we may have a bit of a stay-out from the DSIC asks? Or would those be totally separate items there?

No, we timed the DSIC with the rate case. So we filed in early January. Typically, it takes 9 to 12 months for the rate case to make its way through the BPU to get an order. We're right in line with that. And again, we timed the investment in DSIC with the timing of the rate case so that we can continue to invest up to the cap.

Okay, perfect. From a broader perspective, have you noticed any impacts from the California drought discussions affecting other regions? Specifically, I was surprised to see a 6% decline in residential volumes across the firm. Is this primarily due to California, or are you observing any other decreases in usage in areas not affected by drought?

Yes, if you look at Slide 27, it shows our billed volumes for this quarter compared to last quarter. There's a lot of variability in those billed volumes due to the implementation of our customer information system in late 2013. As a result of that implementation, we held some of our bills to ensure a thorough review and verification of their accuracy. Consequently, we had higher bills that were sent out in the first quarter of 2014, which is what led to that difference. The actual revenue differences are reflected in the unbilled revenue line item. The year-over-year decline in usage was actually $3.3 million.

From a broader perspective, people are closely observing California. I believe Texas is the next state likely to face similar water supply challenges. However, in several states, particularly around the Mississippi, we are experiencing more typical rainfall levels. The situation is quite localized. During national conferences, while discussions often turn to California, other states aren't necessarily implementing the same strategies; they are primarily ensuring they maintain sufficient water supplies. This situation can actually support our efforts to replace outdated infrastructure, as the country loses approximately 25% of all treated water annually due to aging pipes and leaks. Therefore, as we approach a period that may see reduced water availability, it becomes critical to minimize water loss through leaks.

Thank you so much. So before we conclude our call, I want to remind everyone that our second quarter earnings call will take place on Thursday, August 6, at 9:00 a.m. Eastern Time. We also would like for you to save the date for our 2015 Analysts Day, which will be held on December 15 in New York City. We'll provide you more information about this as we get closer. We appreciate your interest in American Water, and we commit to continue to be responsible stewards of your investment and the confidence that you place in us. We look forward to speaking with you all again soon. Thanks.