American Water Works Co. Inc (AWK) — Q4 2017 Earnings Call Transcript

Thank you, everyone, and good morning. Thank you for joining us for today's call. As usual, we will keep the call to about an hour and at the end of our prepared remarks, we will open the call for your questions. Now during the course of this conference call, both in our prepared remarks and in answers to your questions, we may make forward-looking statements that represent our expectations regarding our future performance or other future events. These statements are predictions based upon our current expectations, estimates, and assumptions. However, since these statements deal with future events, they are subject to numerous known and unknown risks, uncertainties and other factors that may cause the actual results to be materially different from the results indicated or implied by such statements. Additional information regarding these risks, uncertainties and factors, as well as a more detailed analysis of our financials and other important information, is provided in the earnings release and in our December 31, 2017, Form 10-K, each as filed with the SEC. Reconciliations for non-GAAP financial information discussed on this conference call, including adjusted income, adjusted earnings per share, adjusted return on equity and our adjusted regulated O&M efficiency ratio can be found in our earnings release and in the appendix of the slide deck for the call. Also, this slide deck has been posted to our Investor Relations webpage. All statements in this call related to earnings and earnings per share refer to diluted earnings and earnings per share. And with that, I'll now turn the call over to American Water's President and CEO, Susan Story.

Thanks, Ed. Good morning, everyone, and thanks for joining us. After my opening comments today, our CFO, Linda Sullivan, will cover our fourth quarter and year-end 2017 results, tax reform impacts, and our 2018 guidance and long-term outlook. Our COO, Walter Lynch, will then give key updates on our regulated operations. While there is continuous volatility in the market, our fundamental story remains the same. The vast majority of our business is regulated and our capital plan is critical to addressing ongoing infrastructure challenges. There are lots of national conversations about the urgent need to invest in water and wastewater in the U.S., a topic emphasized in the administration's recently released infrastructure plans. Every year, our country loses about 2 trillion gallons of treated water through more than 240,000 main breaks, with an economic cost in the billions of dollars, and about 900 billion gallons of untreated sewage is discharged into our rivers and streams every year, further stressing our environment and water quality in communities. Addressing these infrastructure issues is compounded by a fragmented industry with approximately 53,000 water and 17,000 wastewater systems, the majority of which are run by small to medium-sized municipalities with multiple competing critical needs for their investment dollars. American Water will invest $8 billion to $8.6 billion over the next five years, with more than $7.2 billion spent to improve our existing systems. Additionally, the lower federal tax rate, which Linda will cover in more detail means we can make these capital investments without increasing customers' bills as much. We will always make needed investments to ensure safe and reliable water services, which are critical to human life and healthy communities, but we are constantly mindful of what our customers must pay for their services. Our portfolio of market-based businesses provides strong growth by leveraging our core competencies, using little to no capital and generating healthy cash flows. The successful execution of our strategies has enabled us to achieve a five-year total shareholder return of 275%, with a 29% TSR in 2017. Today, we are affirming our 7% to 10% long-term EPS growth and our 2018 EPS guidance range of $3.22 to $3.32 per share, the same that we provided to you in December. Our conservative financial approach has resulted in our current A credit rating and strong balance sheet, providing us optionality going forward under tax reform. We continue to pursue efficiencies in O&M and capital deployment to further ensure that our decades of investment needs are affordable for our customers. From a capital project risk perspective, we differ from most utilities focused on just a few large projects per year for the majority of their capital spend. Our annual capital is spent on around 500 discrete investment projects per year along with 2,500 smaller and more routine capital efforts. In 2018, this spend is projected to be $1.4 billion to $1.5 billion. These investment projects are planned for multiple years out, so if it is right and a project might cause delays, we simply move that project into a future year and push forward other projects which are already in the queue. Given our size and scale as the nation's largest water utility, we've benefited from our geographic diversity, reducing both regulatory and weather risk to earnings. This is further enhanced by our small but important portfolio of market-based businesses. All of our efforts are driven by our commitment to our customers, communities, and those who invest in us. For the fifth year in a row, our board of directors approved a quarterly dividend increase that is at the top end of our 7% to 10% EPS compound annual growth rate. None of our results would matter if we do not operate in the right way. For us, the house is just as important as the watch. We know this matters to you too, because companies do well by also doing good. Our efforts in environmental, social responsibility, and governance arenas are recognized, most recently by Barron's, which named us 36th out of their 100 most sustainable companies. Of course, none of our achievements would be possible without the 6,800 people who are American Water. When sustained subzero temperatures in late December and early January resulted in over 1,000 main breaks in the Midwest and Northeast, our folks were working 24 hours a day to ensure that our customers have the precious resource of water, as well as critical fire protection and sanitation services. We've been in business for 132 years and we want to be in business for at least that many more years. We have succeeded through world wars, market ups and downs, company ownership changes, technology disruptions, and the full continuum of political and regulatory policy experiences. That's why we are confident in our business and growth for the future. With that, I'll turn it over to Linda.

Thank you, Susan, and good morning, everyone. Today I will cover our fourth quarter and annual results followed by a discussion of the impacts of tax reform on 2017 and on our five-year plan and conclude with 2018 and five-year earnings guidance. Let me start with our fourth quarter and full-year 2017 results on Slide 7. Excluding the impacts of tax reform, we had a very strong fourth quarter. We reported adjusted earnings of $0.69 per share, an increase of $0.12 or 21% over the fourth quarter of 2016. Our regulated businesses were up $0.11, our market-based businesses were up $0.01, and the parent was flat to the prior year. GAAP earnings, which were negative $0.01 per share, included a $0.70 charge from the re-measurement of deferred taxes to the new 21% tax rate under the Tax Cuts and Jobs Act. I will discuss the key elements of this charge in more detail in a moment. For the full year, our adjusted earnings were $3.03 per share, which is at the midpoint of our narrowed earnings guidance range set forth in both December and January. As you know, we had some challenges to overcome in 2017, including tax-related changes in several of our states and lower capital upgrades in our military services group. Despite those challenges, our teams across the company delivered, just like they have consistently done. For the year, GAAP earnings were $2.38 per share which includes adjustments for the positive insurance settlement related to the Freedom Industries chemical spill, the early debt extinguishment charge with the parent, and the impact of tax reform. Turning to Slide 8, let me walk through our adjusted quarterly earnings by business. Our regulated operations were up $0.11 per share in total. Revenue was up $0.06 from infrastructure investments and regulated acquisitions, net of lower demand or declining usage of about 1%. Weather negatively impacted the quarterly comparison by $0.01 per share as the fourth quarter of 2016 had drought conditions in the northern part of New Jersey resulting in higher bulk water sales. Also, in the fourth quarter, we had favorable O&M expense of $0.02 per share, mainly from higher O&M expenses in the fourth quarter of 2016 due to timing. Finally, higher depreciation and interest expense related to investment growth was more than offset by the approval of a new depreciation study in Illinois, which reduced full-year 2017 depreciation by $16 million. Turning to our market-based businesses, we were up $0.01 compared to the same period last year. The majority of this increase was in Homeowner Services from customer growth and price increases, offset slightly by lower capital projects in the Military Services Group. Turning to Slide 9, our full-year adjusted earnings were up $0.19 per share or a 6.7% increase over adjusted earnings in the same period last year. Our regulated operations were up $0.23 in total, driven primarily by infrastructure investment, regulated acquisitions and organic growth. Also, we had warmer and drier weather in 2016, which negatively impacted year-over-year earnings by $0.05 per share. Depreciation, interest, and taxes were higher by $0.06 per share from investment growth, partially offset by the new depreciation rates authorized in Illinois. Our market-based businesses were up two pennies, with AWE coming in $0.01 favorable to the prior year as growth in Homeowner Services exceeded the impact from lower capital upgrades in our Military Services Group. Let's now turn to the impact from tax reform on Slide 10. As you all know, there are a lot of moving parts on tax reform, both with the numerous judgments and interpretations from changes in law and how our different regulatory jurisdictions will handle the implications. We will continue to monitor the impact of additional interpretations or guidance on these judgments. For American Water, the most important takeaway from tax reform is that over the next five years, our fundamental investment strategy does not change. We continue to see a 7% to 10% long-term compound annual growth rate in EPS, and our EPS CAGR with tax reform is accretive or even stronger than our plan before tax reform. We expect to continue to invest capital of $8 billion to $8.6 billion over the next five years with a majority focus on the much-needed infrastructure investments for our customers. We expect to continue to help make our regulated customers’ bills affordable by focusing on O&M and capital efficiency. We expect to continue to grow our complementary capital efficient and cash flow positive market-based businesses. We expect to maintain our guidance to grow our dividend at the high end of our long-term EPS compound annual growth rate of 7% to 10% and we do not plan to issue additional equity under the normal operating conditions expected with this plan. So, our fundamentals stay the same. Now what changes? There are two primary items. First, we expect our customer bills to benefit from the impact of tax reform, which for us helps to make our much-needed capital investments more affordable. Second, similar to other utilities, as we return the benefit of the lower tax rate back to our customers, we expect lower cash flow. And with the loss of bonus depreciation, we expect to become cash tax payers sooner than in our prior plan, which is why Moody's put us along with 23 other utilities on negative outlook. So, you may ask, given the expectation of lower cash flow, why do we think we can execute on our five-year plan without impacting capital, dividends, or equity? The answer is, because we start from a position of strength. We have a very strong balance sheet, we are A rated by S&P and AAA by Moody's which gives us optionality. We continue to believe we will have a strong balance sheet under the plan even though we expect our FFO to debt metrics to drift lower as we return the tax rate benefits to our customers and pay cash taxes sooner. It's also important to note that we are working closely with our regulatory jurisdictions to determine the best approach for our customers, which I'll talk more about in a moment. So, all that said, the bottom line is that we are starting from a position of balance sheet strength, and net-net we believe tax reform will be good for both our customers and our shareholders. Now let me dig into the details a bit. I'll start with how tax reform impacted our 2017 income statement and balance sheet on Slide 11. As I mentioned earlier on the income statement, we had a $0.70 or $125 million charge in 2017 related to tax reform. This onetime non-cash charge was the result of re-measuring our deferred taxes from the 35% federal rate to the new 21% rate. The re-measurement was required to be recorded when the new tax law was enacted; therefore it impacted 2017 earnings. The largest portion of this adjustment was from federal net operating losses recorded at the parent company, as well as adjustments to deferred taxes for items currently not recoverable through regulated customer rates. For the balance sheet, our regulated businesses are required to normalize the impact of the change in the federal tax rate, or said another way, they are required to return the benefits to customers over the average remaining life of our assets, which are currently estimated at approximately 50 years, specific to the longer life of water and wastewater assets in our industry. The re-measurement resulted in a $1.5 billion net reduction to deferred taxes on the balance sheet. Looking forward, the impact of tax reform on our business is summarized on Slide 12. There are three major technical areas that impact us, and we have shown directionally how they are expected to affect earnings and cash flow, and as you can see, overall tax reform is expected to be positive to earnings over time and negative to cash flow. Let me walk briefly through each area. First, the change in the tax rate from 35% to 21%. We expect the change in tax rates to be accretive to long-term earnings and negative to cash flow. For earnings, the lower tax rate will benefit our customers, so that impact is expected to be earnings neutral. However, we do expect rate base in our regulated businesses to increase over time as a result of having lower deferred tax liabilities, which offsets rate base. There are three primary drivers of lower deferred tax liabilities. First, we will have a lower federal tax rate on new investments. Second, we will normalize or give back to customers the re-measured deferred taxes over the remaining life of the assets; and third, we are no longer eligible for bonus depreciation going forward. For our market-based businesses, the lower tax rate is expected to increase earnings; however, we do expect the majority of our military service contracts to tune up over time. Partially offsetting these increases is the impact of a lower tax shield on parent company interest expense and higher debt levels due to lower cash flow from operations through 2022. From a cash perspective, the lower tax rate will result in lower regulated revenue under cost of service rate making, although this lower revenue will be earnings neutral, it will negatively impact cash flow as we currently have a net operating loss for federal tax purposes. We will see a cash benefit from lower taxes for the market-based businesses, but this is offset by the lower tax shield on interest expense of the parent company. Next, interest expense reduction and bonus depreciation. Utilities received a carve-out that allowed us to preserve the ability to deduct interest in exchange for foregoing bonus depreciation. At the parent, we expect the majority of the interest expense to be allocable to our regulated operations and fully deductible for tax purposes. With our market-based businesses being capitalized, the allocated interest is expected to be well below the 30% limitations, and that is why we showed the interest deduction as neutral to both earnings and cash flow. As I mentioned earlier, the loss of bonus depreciation will increase rate base and earnings over time, but will decrease cash flow and is expected to accelerate when we become a full cash taxpayer from 2021 to 2022. Now let me quantify some of the major impacts I directionally discussed. Let me start with the impact on earnings on the left side of Slide 13. For the regulated businesses, rate base is expected to increase a 4-percentage point over our prior plan to a compound annual growth rate in the range of 7.5% to 8.5% post-tax reform. Because the earnings from our market-based businesses are at about the same level as the interest expense of the parent company, the increase from the lower tax rate in our market-based businesses is expected to offset the loss in the tax shield on interest at the parent. However, lower cash flow will result in additional debt and interest expense drag at the parent. In total, over time, the earnings benefit at the regulated and market-based businesses are expected to largely outpace the additional drag at the parent company. On the cash flow side, we expect lower cash flow of about $500 million over the next five years compared to our pre-tax reform plan. You can see that the estimated impact is larger in the beginning years, especially in 2020 when we become a full cash taxpayer, but that impact declines over time as we grow rate base. Now, the actual impact will be largely dependent upon the outcome of our regulatory proceedings regarding tax reform. With this lower cash flow, we expect about $500 million of additional debt at the parent to support our growth over the next five years, which could increase our long-term debt to capitalization levels to a range of about 61.5% to 62.5% in 2022 after tax reform. Moving to Slide 14, the forecast we are providing you today is based on the expectations of reasonable regulatory outcomes and customer impacts which will be determined by various regulatory proceedings. All our state commissions have opened formal proceedings or dockets related to changes in the tax law or we have open rate cases. We have begun to work with regulators to determine how best to provide the tax savings to our customers. We are currently considering several options with our various commissions that will moderate rate and cash flow impacts. Some of the discussions with regulators include the consolidation of customer rate impacts with general rate case proceedings, offsetting of capital investment needs and regulatory assets to address the customer rate impact, deferral of rate reductions, rate reductions or a combination of these items. The outcome of these proceedings would likely take some time and we have to keep in mind that each state will look at the infrastructure needs and customer builds in a different way. We are glad our regulators are trying to find a win-win in conversations with us. This is so important for our customers and the local communities we serve as we continue to invest in our infrastructure and create jobs in our local communities. Turning to Slide 15, and looking forward to 2018, we are today affirming our 2018 earnings guidance range of $3.22 to $3.32 per share. In terms of the tax reform impact on 2018 in our regulated businesses, we do not expect significant near-term changes in earnings. As the decrease in the tax rate is expected to flow back to customers and it’s earnings neutral. However, in our market-based businesses, we do expect a positive impact from the lower tax rate that will be offset by the lower tax shield in interest expense for comparison. The major variables included in our guidance range are consistent with what we've shown you before with plus or minus $0.07 of weather or what we consider to be normal weather variability being the most significant events, or variations outside of these ranges could cause our results to differ. Turning to Slide 16 in our long-term financial plan, as I mentioned earlier, we do not expect our fundamental investments strategy to change. We are affirming our 7% to 10% long-term compound annual growth rate in EPS while investing capital in the range of $8 billion to $8.6 billion, mainly for our customers. Our strong balance sheet provides flexibility to overcome challenges of tax reform and we do not see a need to issue additional equity under normal operating conditions. We've been a top leader in dividend growth for five consecutive years, with dividend growth at or above 10% and we expect to grow our dividend over the next five years at the top of our 7% to 10% EPS growth range, subject to board approval. Also, we continue to target a dividend payout ratio of 50% to 60% of earnings. With that, I'll turn the call over to Walter to talk about the regulated businesses.

Thanks, Linda. Good morning, everyone. Our regulated businesses had a strong year all around with historic capital investments, record levels of employee safety, strategic acquisitions, and continued O&M efficiency gains that benefit our customers. Let's walk through some of the regulatory highlights starting with Pennsylvania. The Pennsylvania Public Utility Commission unanimously approved the rates settlement in December with new rates going into effect on January 1st. The settlement resulted in an increase of approximately $62 million in annual revenue driven by approximately $1.3 billion of investments made since our last rate case in 2013. Our calculated ROE for the settlement is 10%. This constructive settlement balances our customers’ interests with much needed investments, including the replacement of nearly 450 miles of aging pipe, valves, service lines, and hydrants. This substantial investment, balanced by our commitment to cost management, means the average family pays about $2 for a day's worth of cooking, feeding, cleaning, and drinking water. In New Jersey, we filed a rate case last September seeking recovery of $868 million in infrastructure upgrades, made in less than three years since our last rate adjustment in 2015. This includes the replacement of more than 200 miles of aging water mains, which is in compliance with the new replacement rate criteria of New Jersey's recently approved Water Quality Accountability Act. In fact, New Jersey American Water has had a better replacement rate than required by the new law for several years. In Missouri, we filed a rate case last June requesting an increase of $84 million in annual revenue driven by more than $490 million in investment in our systems. Settlement discussions have begun, with evidentiary hearings to begin next week. A decision could come late April or early May. In California, we filed our cost of capital application last April; it was submitted for consideration in the fall with a proposed decision issued earlier this month. The proposed decision must be on record for 30 days before the commission considers it. At that time, they may support, reject or modify it. We've reviewed the decision and intend to file comments next week. We're concerned that the proposed decision's recommendation on ROE does not reflect current market conditions like interest rates, inflation, and tax reform. It also makes an assumption that ROE is guaranteed by the water revenue adjustment mechanism, which is not accurate. This will be reflected in our comments and will keep you updated as the process moves forward. Finally, as Linda mentioned, our states are currently assessing the impact of tax reform. We're working closely with our local commissions, as each of our states have different circumstances and needs. We want to ensure we get to the right outcome for everyone. Moving to growth, we had another great year. We added 15,000 customers through organic growth in our existing service areas, the highest organic growth in many years. Through pending and closed acquisitions, we've added or will add approximately 63,000 customers in our regulated businesses. You can see here that we have 16 pending acquisitions in multiple states. This growth across our footprint really speaks to the local solutions we’re able to offer neighboring communities. In 2017, we closed 19 acquisitions in 9 states, adding about 40,000 customers. This includes our newest wastewater customers in McKeesport, Pennsylvania. We completed that acquisition last December and we're pleased to welcome 22,000 new customers, as well as the new employees who joined our Pennsylvania American Water team. This acquisition has been highlighted in several venues as a model of public and private sectors working together to address wastewater challenges. Turning to Slide 20, doing right by our customers is key to our ability to grow. This means smart investments balanced by efficient operations and capital deployment. We invested more capital in 2017 than in any other year, with $1.4 billion going into our regulated operations. This is critical to reliable service, but it's also about affordable service. As you know, we measure our operating efficiency using the O&M efficiency ratio. With tax reform, we expect that metric to increase to 34.9% in 2018 due to reduced operating revenues. For comparison purposes, we've included pre-tax reform and post-tax reform numbers. As you can see, we’ve made great progress since 2010 due to our continued commitments to our customers and our culture of continuous improvement, which is why we expect to meet our 32% O&M efficiency target by 2022. Let me give you two examples of the many initiatives we have at American Water to improve operating efficiency. We have a highly trained asset reliability team that conducts assessments at critical facilities across our footprint. Using specialized instruments, these teams predict and correct minor issues preventing major issues from occurring. Just last year, further assessments identified and corrected about 200 minor issues, resulting in $400,000 in repair costs. In New Jersey, our operations team is using acoustic monitoring to find and fix leaks before they lead to main breaks. This water-saving technology uses sound waves to locate leaks and has already provided savings up to $1.9 million in the first two years, and an estimated 1.7 million gallons of water per day. Remember, every dollar we save in expenses allows us to invest $8 in capital with no impact to customer bills, driving our commitment to our O&M target. Additionally, we reinforced our operational efficiency efforts by also focusing on capital efficiency, leveraging technology, and using our scale and size to achieve savings through our supply chain. We understand that driving capital efficiency allows us to do more with the same amount of money. In summary, it was a great year of growth, smart investments, and engaged employees driving efficiencies and quality results that also benefited our customers. With that, I'll now turn the call back over to Susan.

Thank you, Walter. Before I turn the call over for questions, I do want to speak just a couple of minutes about the administration's infrastructure proposals which were recently released. We're encouraged that the administration and Congress are working to address the pressing need to upgrade our nation's infrastructure, including the systems that provide critical water and wastewater services. Companies like American Water play an important role working together with the public sector, as the needs are too great for any one sector to tackle alone. We are very pleased that the proposal seeks to level the playing field for private and public providers of these critical services. There are several positive proposals in the plan including the removal of caps on tax-exempt private activity bonds, as well as making clean water state revolving fund loans available to private wastewater utilities. The plan encourages partnerships between private and public providers with incentives for smarter ways of investing in critical upgrades. While this infrastructure plan is just a proposal, the fact is that the Tax Cuts and Jobs Reform Act is actually an infrastructure package for us. It doesn’t change our strategy or operating plans, but we will be able to invest more with less impact to our bills, and that's good news for our customers and our regulators. American Water looks forward to continuing to be part of the infrastructure conversations and working with the administration and Congress as they address the nation's infrastructure challenges. With that, we're happy to take your questions.

So just two questions. First, there has obviously been a lot of analysis on tax reform, and so much of the focus is centered on cash flow metrics like FFO to debt. In light of you guys not needing any equity and looking at debt to sort of offset the near-term cash drag from tax reform, can we talk a little bit about what other metrics the agencies could be looking at, especially as we think about the water industry? I have to imagine that looking at cash flow metrics in isolation sort of misses the bigger picture, especially in this industry?

Yeah. Shah, this is Linda, and you're right, there has been a real heavy focus on the FFO to debt metric for utilities due to the lower cash flow from the loss of bonus depreciation, the passing back of the tax benefits to customers and especially for those that are in a federal net operating loss position like us. You're right; FFO to debt is an important element of our rating. It represents 12.5% of our rating under Moody's methodology, but it is also important to note that the largest component of our ratings is based on our business risk profile, which generally represents about half of our rating. The business risk profile is based on more qualitative risk specific to the water industry and to the unique size and scale of American Water. For example, the types of things that are looked at include items such as the absolute essential service of providing water, the smooth deployment of our small capital projects like Susan discussed earlier, and the regulatory environments across our diverse 14 jurisdictions that really support our ability to grow, to invest, and to generate cash flow going forward. This strong business risk profile is not changing with tax reform. The other thing that's really important to note is that the business risk profile of the water industry and American Water is unique to us. So, our FFO to debt metrics generally will fall in a broader range than what you see with other utilities, so a strict comparison of the numbers of FFO to debt with other utilities is not a good comparison. As I mentioned in my comments, with tax reform, we do expect our FFO to debt metrics to drift lower, and we carefully reviewed the right mix of capital investment needed for our customers, dividends for our shareholders, and we believe we will be able to carry the tax reform impact without issuing additional equity. The tradeoff is a lower FFO to debt ratio, and our starting point, as I mentioned, is a very strong balance sheet that provides us with that optionality as we work through the appropriate mix.

Got it. That’s super helpful. And then I want to touch a little bit on your growth rate. You have no dilution obviously from incremental equity, you have very minimal regulatory or structural lag and what seems to be fairly perpetual growth opportunities and a very healthy step up in rate base. So how are you sort of thinking about where growth should fall kind of within these raises, especially as the benefit of tax reform sort of lands within your outlook, mainly focused on your 5% to 7% regulated growth outlook?

So, in our growth triangle, we continue to see that the bottom part of that triangle that’s 5% to 7% for rate base growth. We also see 1% to 2% for regulated acquisitions, and both of those together translate to what we showed on our rate base growth chart.

Shah, this is Susan. We cannot be a company that gets too far ahead of ourselves. What we want to see is, let's give time for everything to settle in, and before we start looking at changing anything, we want to feel confident and comfortable that our plan, which we have presented as 7% to 10%, is still the best guess we have in terms of the best estimates and projections for the next five years. So, what you won't see is us going back and forth based on the type of swings or initial analysis, but the points you brought up are good; we will continue to evaluate all market trends and will continue to weigh our balance sheet and our growth opportunities to determine the best projections for our five-year plan.

So, I wanted to follow up a little bit on Shah's questions, two-fold on the tax reform question. First, on the regulatory front, what are you embedding in the context of your slide? You showed some CFO impacts. Can you touch on some of the regulatory operations in key states, say Pennsylvania, New Jersey, Missouri for instance, just on what the game plan is there vis-à-vis returning the funds to customers or otherwise seeking accelerated investment depreciation?

Yes, and we are working as we have 14 regulatory jurisdictions, we are working through with those regulators in terms of how to best pass the benefits back to customers and to continue to invest in the much-needed infrastructure. We currently have three open rate case proceedings in New Jersey, California and Missouri, so we are having discussions in those proceedings. We're also working across our jurisdictions where everyone is really open to some sort of tax proceeding, and we're working to determine the best approach and I went through some of those strategies on the call. I don’t know if Walter wants to add more to the specific state.

Again, as Linda said, we are in rate proceedings obviously in New Jersey and California and Missouri and we’re incorporating these discussions in those rate case proceedings. It's a great discussion, and we're very happy that the commissions are open to addressing these issues as part of the rate filings. As Linda said, in the other proceedings, we're working through with the commissions to say we want to mitigate the impact on customers, give back what we can, but as we invest, we want to make sure that it's smoothing out. So, I think we're having good discussions across our footprint.

With those discussions, Julian, we put forward on slide 13 the cash flow impacts that are expected using reasonable judgments. So we looked at what we think are reasonable judgments from a regulatory perspective, and we also considered some cash flow strategies that we can deploy across the company. We wanted to be very transparent and put it there by year.

Julian, interestingly each of our states are in a little bit different situation. For example, I mentioned we actually had about 1,400 main breaks in the frigid temperatures in late December and January, so that goes into our investment planning. We've had flooding, where we have natural disasters; we’re putting a lot of focus on our critical assets and resiliency planning. When you look at Indiana, for example, in Gary, Indiana, there are a lot of lower-income customers on-lit service lines. Each state has some similarities, but each state also has its own issues in terms of investment needs as well as the ability to continue to keep rates affordable while we increase investments. Every state president and each state staff work very closely to determine what that specific state need is and find a way forward that works for everybody.

Can you provide more details on your FFO to debt situation, specifically how it aligns with what the agencies expect, and give a general overview of your position in relation to the plan?

Yeah, Joe, so our cash flow from operations remains robust. Moody's just issued their report and published an FFO to debt metric of 17% covering the 12-months ended in September and we believe the FFO to debt metric will continue to remain strong throughout the remainder of 2017.

Through the remainder of 2017, you said?

Yeah. Yes.

Hi, thanks for taking my question. Could we just cut back to California, the cost capital proposal? And then maybe John, what we saw with other types of utilities and their cost capital of California, what do you think that means going forward to water utilities in California? And then do you think that there's a spillover or is this a precedent in other jurisdictions? And then I have a follow-up question, please.

Yeah, absolutely. So, the decision was an administrative law judge proposed decisions are not a final decision. We have, as Walter mentioned, 30 days before the commission considers it and at that time, they may support, reject, or modify, we will be filing comments next week. We are concerned that the ROE does not reflect the current market conditions like interest rates, company’s risk profile, etc. Reasonable jurisdictions across the country are understanding the need to have capital attract to invest in the much-needed water and wastewater infrastructure across the nation.

I have a follow-up question regarding the infrastructure plan that has been discussed. Could you share one or two key points that are important for the water utility industry, even though I realize it’s still early and things are changing?

Yeah. So, this is Susan, Ben. We were actually a little bit surprised just how much focus there actually was on water and wastewater. And a few things, so, PricewaterhouseCoopers actually came out with a report about six months ago that said that $60 billion to $80 billion of additional private investment could be released if a few things happened. Interestingly, they listed five things; two of those five I mentioned in my comments, which is one thing people may not understand. It’s state revolving funds that tend to have the least expensive financing costs. We're able to take advantage of those in several of our states, but only for drinking water. The Clean Water Act's state revolving fund, which is wastewater, would not allow private. This particular proposal now would allow us to access the state revolving funds, which have a lower financing cost. That’s one. The WIFA, the Water Infrastructure and Finance Act, also allows for private firms to pay for financing debt tied to the treasury yield without an upcharge. A couple of things too that we're seeing that will be part of this: half of the $200 billion debt the administration says is going to leverage the $1.5 trillion; over half of that is for projects and only 20% of the project cost can come from federal, so local areas, private companies or municipalities will have to find funding for the other 80% of that. We think that's very positive as well as the issue of workforce development and looking at things like permitting reform to allow projects to go forward more quickly; we think those are all positive things that will benefit not just the entire industry but specifically American Water.

I wanted to mention that while the tax reform is an important issue, it appears there is less focus this quarter on the acquisition municipal M&A pipeline. I would like to receive an update on the pipeline, particularly in key states like Pennsylvania where you've had significant success in recent years. I am interested in a more detailed update on the deal environment and the cadence of encore activity as well.

The opportunities are robust throughout our pipeline. We spend a lot of time on working on legislation to enable the acquisitions, and our teams are focused on it. The municipal sector, many of them are having a lot of issues monetizing the assets which would really solve their situation. So, we're in discussions and we have, as I said before, about 330,000 customer opportunities in our pipeline across our footprint, and that’s up from 145,000 this time last year. We have a robust pipeline and feel confident we're going to get there.

I understand you can't provide details on specific deals, but can you share any general themes from the discussions? Are there recurring issues that are hindering progress in several cases, or is it more about individual circumstances? Are there any common factors that influence whether those discussions advance or stall?

No overall themes; it's really case-by-case basis. Again, we feel very good about our pipeline and about the size of the deals. Our focus has been on 3 to 30,000 customers and we feel like we're going to execute on that very favorably over the next five years.

Ryan, this is an area where our geographical diversity also helps. I mean you mentioned about Pennsylvania, but the fact is we've got numerous states where we have opportunities, and that's part of this significant pipeline we have, which is we're in 16 states with 14 regulatory jurisdictions. It's much easier to grow from a grassroots perspective where we are in the communities we serve. We think that's a very big positive.

And then just to revisit this, I don’t want to beat a dead horse, so to speak, but on the tax impacts, there are various PCs looking at how to address that issue and then opening discussions on that. Just to be clear from a modeling standpoint, obviously the earnings impact is neutral to positive, but from a revenue standpoint, I mean just to be clear, logically we’re talking about a potential revenue requirement reduction at least in some cases, correct?

Yes, it is. That's correct.

Thank you. I'm sorry to go back to the tax question. So when you show us the projections of the likely degradation of the operating cash flow, I mean how does it compare to what the credit agencies saw back in January when they put you in the negative credit watch? Because at least versus in our expectation, it seems like the reductions and FFO were a bit lower. I mean, do you think the reduction is lower than we have expected?

Yeah, when Moody's put us on the negative outlook, as you know, they put us on with 23 other companies. We didn't really do a deep dive into our financials; that was really more about us being in a net operating loss position. We are having meetings with our rating agencies, and we continue to work through this, but today we’re not kind of reviewing all of these details as part of that particular analysis. We’ll continue to work with them, and what we wanted to do here is really be transparent that from our prior plans to this plan with tax reform, this is our estimate of the potential tax impacts on cash flow over that five-year period, with the key being that you can see us higher in the earlier years, and then as the rate base continues to grow, it lessens.

Okay. Given that the earnings mix significantly influences your credit ratings, are you reconsidering the growth in market-based operations due to this tax reform? This might involve managing some of the duration and the FFO to debt by possibly altering the earnings mix.

Yeah. So, when we look at the earnings mix going forward, remember that under tax reform, the regulated business is growing and the market-based business is growing. That’s being offset somewhat by the additional drag as the parent company. The earnings mix is still roughly $90.10.

Yeah. And Angie, we have no plans at this point to change strategically our outlook for regulated versus market based.

Okay. Then my last question. So, the infrastructure plan. As you, Susan, pointed out yourself, it actually did cover quite a bit of water-related investments. So, are the municipalities basically even more hopeful that they will some help from the federal government and as such, that could further delay any municipal M&A?

One thing that was missing from the infrastructure proposal is the absence of significant amounts of free federal funding. Essentially, there's $200 billion intended to leverage $1.5 trillion, and aside from roughly $50 billion allocated for rural infrastructure block grants, which now also includes broadband, the bulk of that $200 billion means that $100 billion represents only 20% of a project, requiring municipalities to finance 80% themselves. Additionally, there are block grants that cover broadband, transportation, and water totaling $50 billion. The federal loan programs are available, but municipalities must have the bonding capacity to utilize them. Furthermore, about 7% to 10% is earmarked for what the administration describes as transformative projects like Elon Musk's Hyperloop in transportation. Therefore, there aren't large amounts of free federal funding available for access.

I have a quick question about Keystone. On the last call, it seemed like American was projecting rather flat earnings growth there in 2018. However, I noted that since American acquired Keystone, the customer base has more than doubled according to the filings. The rig count has increased by about 10 rigs in the past 10 months, and many energy companies I used to follow are indicating that Marcellus is becoming more active. Just yesterday, one company mentioned they expect a significant rise in shipments to the Marcellus, which indicates a much higher demand for frac sand, resulting in increased water needs for cleaning and delivery. I'm curious if you could provide an update on Keystone for 2018 because it currently appears that it will be much stronger than what American indicated just a few months ago.

One of the things we did cover is that year-over-year Keystone was a penny up from 2016, so we were very encouraged to see that, and it didn't show up in the fourth quarter because the markets were picking up in the fourth quarter of '16. However, you are correct; we currently have about 300 employees, and we're looking to hire another 100. The margins are a little less than they were before the market went down, but we're still continuing to grow our share of the market. There are a lot of big projects underway this year and we feel great about the business this year. We think it is going to be a strong business this year.

I have one more question regarding the military group and the contracts related to tax reform. I understand the concept of price re-determination, but I'm curious about economic price adjustments. Essentially, if a water utility overspends, they bear that cost. However, wouldn't they also benefit from tax reform? Everything I’ve heard suggests that it will remain advantageous for them, yet I’m unclear on how you perceive these improvements.

Sure. So, Rich, when you understand price re-determination, the positive side and this helps to make it regulated: there are three instances that the Department of Defense will true up your original bid, and you are right, if you make a bad O&M bid that doesn’t fall into these categories, you live with the results. One of those is if there is a law change; for example, a change that requires more environmental monitoring, then we can charge for that. We also look at inflation, and the O&M contracts could adjust for inflation. The third component is if we put another capital project; for example, if we build another wastewater facility, the operation costs go up or down. It gets trued up. What you have now is that the DLA and the DOD have not come in and said where they see the tax reform falling in, so yes, we are very conservative. One way you can review and interpret what that price re-determination definition is that tax reform was a law; we would give back that money over a period of time, just as likely we would gain if there was a law passed that increased our costs. So that's been our position. I know that not everyone shares that; we're not sure, what they have not basically given that the days of DOD has not given guidance. The way we're modeling it is in the most conservative nature. If they come back and say we are going to let you keep a portion or this, then it would just be upside for us. However, we feel more comfortable modeling it the way we have it, based on our interpretation of the caveats in the price re-determination.

Just curious how you're thinking about larger scale M&A in a world where tax reform maybe impacts you less than some of your peers, in a world where you're trading at a mid-20s PE multiple and at a time when you've got one of the best balance sheets in the business?

Well, thank you, Michael. I wish we had used some of your words in our call. In terms of how we look at it, when we look at our growth triangle, we don't consume any large acquisitions. So that 1% to 2% of acquisitions are the tuck-ins, the ones in our state; they're very grassroots-based. However, we also do have a corporate strategy group, and we are always looking at the landscape; we're always looking at other water companies, and we're always looking at municipalities, large municipalities. We have mentioned to our investors before that as we look at whether we grow in our existing states or new states, we look at three factors: the business climate, the regulatory climate, and whether we see a way to get to 50,000 customers in five years. Otherwise, our efficiency model doesn't work, and we can't ensure that we have affordable value-added rates for our customers that we can leverage our size, scope, and scale. So, the answer is we are always looking; however, we are also very disciplined in how we look, and we don't believe that you get too in love with any type of deal or chase a deal that could be to the detriment of the overall long-term performance of the company. So, we'll continue to look and monitor where we see opportunities and pursue them.

And do you see the opportunity set as being changed at all via tax reform?

That's a really interesting question. I think that the water space is so limited, and you look at that and I'm not sure; I don't think any of us understand now how all of this is going to shake out in the next one, two, three years. In terms of municipalities, I don’t think it makes a difference. The bigger difference in terms of things like the age of water systems, wastewater systems, the amount of investment needed, growing pension liabilities, the amount of roads that need paving, the amount of schools. For us, I think it's more in the municipal market and it will be left to be seen what happens with the entire water and wastewater infrastructure in this country and how we approach that because it is getting to a critical stage and, in the next few years, decisions are going to have to be made because these systems can't hold up forever if they are not being invested in. Even more importantly, one thing we really like about the administration's plan is that in the past sometimes you had pools of money, and it only went to a capital project, but there was no requirement for the nourishment of these systems ongoing. The interesting thing about this administration is that 50% of the $200 billion that funds the 20% of those funds also requires a predictable revenue stream that will help with operations, maintenance, and upkeep. We're not seeing that before. So, the recognition of lifecycle costs for these infrastructure investments is something that I think is a real positive. You have to step back, and look at what you're going to do for the next 50 years. As Linda mentioned, in the water industry, our assets we're looking at 50 years, we're not looking at 20 or 30 years. They're 50 sometimes 70-year assets. Based on what happens with this proposal and the overall philosophy about infrastructure investments could lead to more opportunities than any type of impact from tax reform on individual product companies.

Hey, Susan. Thanks, I appreciate you taking it though.

It's great. So, we thank all of you for participating in our call today. We value you as our investor owners and as financial analysts who research our company for the benefit of your clients and their financial futures. We will always be open and transparent in all of our discussions and dealings with you so you can have confidence in your decisions around our company and your investments in our stock. If we haven't been able to address all the questions or you think about something later, please call Ed or Ralph, and they will be happy to help you. We look forward to talking to you at our 2018 first quarter earnings call on May 3, and our Annual Shareholders Meeting will take place on Friday, May 11. Thanks again, and we hope you all have a great week.