American Water Works Co. Inc (AWK) — Q1 2018 Earnings Call Transcript

Thank you, Brian, and good morning, everyone, and 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 be opening the call for your questions. 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 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 Form 10-Q filed with the SEC. Reconciliations for non-GAAP financial information discussed on this conference call, including 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 this call. Also, this slide deck has been posted to our Investor Relations page of our website. All statements in this call related to earnings and earnings per share refer to diluted earnings and earnings per share. I would like to turn the call over to American Water's President and CEO, Susan Story.

Thanks, Ed. Good morning, everyone, and thanks for joining us. Today, our CFO, Linda Sullivan, will cover our first quarter financial results, and COO, Walter Lynch, will give key updates on our operations. The employees of American Water delivered strong results in the first quarter of 2018. Our earnings per share were up 13.5% compared to the first quarter of 2017. This includes excellent growth in both our regulated business and Market-Based Business. March 20, our Board of Directors approved a 9.6% increase in our quarterly dividend to $0.455 per share. This marks the sixth year in a row that our dividend increase was at or above the top of our long-term EPS CAGR of 7% to 10%. We believe that long-term financial success depends on effectively executing the fundamentals of our business every day. These fundamentals include engaging our employees to provide excellent service to our customers; building constructive and transparent regulatory relationships; growing our business and becoming even more efficient in our operations to ensure affordability and value for our customers. The foundation for our earnings growth continues to be the capital investment we make in our regulated operations to provide clean, safe, and reliable service to our customers. We invested $343 million this quarter, with $302 million of that for our regulated infrastructure. We minimized the customer bill impacts of these investments through a continued focus on controlling O&M costs, optimizing capital spend through both value engineering and value procurement, and through constructive regulatory mechanisms. Our regulated business closed several acquisitions during the quarter for a total of 3,700 new customer connections. We also added about 1,500 more customers through organic growth in our footprint. We have an additional 47,000 customer connections under agreement, including the recently announced Alton Waste Water System. This one agreement will add 23,000 new wastewater customers in Illinois. We have served water in this great city for over 140 years, and our employees live, work and play there. So this acquisition is very special to us. Walter will discuss this as well as our strong pipeline and potential regulated acquisitions in a few minutes. Earnings were also up in our Market-Based Businesses. This was due in large part to an increase in results from our homeowner services organization, where we saw growth in customer contracts along with benefits from cost management efforts. We recently announced our agreement to acquire Pivotal Home Solutions, which will nearly double our home warranty business. Pivotal is highly complementary to our homeowner services group. We have been in this business for 16 years, and we're excited to welcome the great many women of Pivotal to the American Water family upon closing of the transaction, which we expect in the second quarter. With this strong start to 2018 and our continued execution of strategies, we are affirming today our 2018 guidance of $3.22 to $3.32 per share. Given the Pivotal acquisition and the effects of tax reform, we expect our long-term growth to be in the top half of our 7% to 10% target EPS CAGR. American Water will invest $8 billion to $8.6 billion over the next five years, excluding Pivotal, with more than $7.2 billion spent to improve our existing infrastructure. Under this plan and normal operating conditions, no new equity is needed. We see line of sight to our 32% target O&M efficiency ratio by 2022. We affirm our earlier guidance of dividend growth at the high end of our 7% to 10% EPS CAGR also through 2022. Walter will now give you his update on our regulated business.

Thanks, Susan. Good morning, everyone. As Susan mentioned, our Regulated Businesses had a strong first quarter, making capital investments to ensure clean, safe, and reliable water service while continuing to improve our operating efficiencies to benefit our customers. We also had tremendous growth driven by acquisitions. Let me start on Slide 9 with an update on our Missouri rate order that we just received yesterday afternoon. As you know, we filed the Missouri rate case last June, requesting an increase of $64 million in annual revenue adjusted for tax reform. The request was driven by more than $250 million in investment in our systems since our last rate order in 2016. On May 2, the Missouri Public Service Commission issued an order approving new rates resulting in approximately $38 million in additional annual base rate revenue, which includes $5 million of previously approved infrastructure revenue. Our calculated return equity for this settlement is 10% with a 52.8% equity ratio. New rates are expected to take effect in late May or early June. Turning to Slide 10, let me provide an update on our ongoing rate cases. 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. All parties have engaged in settlement talks and we are currently analyzing the recently filed position. Settlement discussions may resume at any point, and the company is preparing for a debenture hearing scheduled to begin in June. Our customers have already received a rate decrease of almost 6%, effective April 1 of this year, to reflect the impact of the Tax Cuts and Jobs Act docket in New Jersey. The company is in act to participate in the tax docket, which is expected to be resolved in June of this year. In West Virginia, we filed an application to adjust rates with the Public Service Commission on Monday, requesting an increase of approximately $29 million in annual revenue already adjusted for tax reform. The primary reason for the rate request is the approximately $200 million that the company will invest in system improvements to replace and upgrade aging infrastructure since its last rate order in 2016. Our team in West Virginia has worked hard to keep operating expenses relatively flat for the last 10 years by working more efficiently, improving processes, utilizing technology, and leveraging economies of scale. The filing also proposes a proactive approach to addressing lead service lines, which is part of our commitment to maintain excellent water quality and protect customer health and safety. Moving to the California general rate case for 2018 to 2020, the California Public Utilities Commission is considering the impact of the recent tax reform, and we now expect the commission to issue both a proposed decision and a vote on a final decision in the third quarter of this year. Rates will be retroactive to January 1, 2018. Turning to Slide 11. Let's continue discussing regulatory matters in California. In March, a final decision was issued which authorized California American Water a return on equity of 9.2%, with an equity ratio of 55.39%, up from 53%. I thank our California team for working collaboratively with all parties to get that result. Lastly, in California, the Monterey Bay National Marine Sanctuary and the California Public Utilities Commission released a favorable final environmental impact report or EIR in March related to our desal project. This is the final plan for the project that meets both the National Environmental Policy Act and California Environmental Quality Act standards. After reviewing environmental impacts, the federal and state governments believe this is the right project at the right location. The commission will accept final comments and may consider approving the final EIR likely in the third quarter of this year. On the legislative front, Senate Bill 362 was enacted in Indiana during the quarter. This act is part of Indiana's commitment to water, similar to legislation enacted in New Jersey in 2017. It sets new standards and requirements for water and wastewater systems in areas such as capital asset management, cost-benefit analysis, and cybersecurity programs. We believe this legislation, along with the legislation in New Jersey, is in the best interest of all water customers. Recently, in Iowa and Maryland, fair market value legislation has been enacted, which allows communities to receive an appropriate value for the systems. This legislation provides an independent expert appraisal system that removes roadblocks for communities to solve their water and wastewater challenges. Our state teams have done a great job working with many stakeholders to replicate meaningful legislation across their entire footprint, all to benefit customers. Turning to Slide 12. We added 3,700 new customers to date and have another 47,000 customers through signed agreements, in addition to the 1,500 we added through organic growth. In April, we announced an agreement to acquire Alton's Regional Wastewater System, which will add 23,000 new customers. Illinois American Water has owned, operated, and maintained the water system serving Alton for the past 140 years. This is another example where we will deliver efficiencies by providing wastewater services where we already provide water services. Alton Mayor Brant Walker said that this agreement, 'puts our wastewater system in its ongoing needs and professional hands with Illinois American Water, a company that's familiar with Alton and its residents. The deal will give existing city employees more training, career advancement, and professional development opportunities.' Just yesterday, Pennsylvania American Water announced an agreement to acquire the wastewater assets of Stansberry Township in Chester County, which serves approximately 1,000 customers. Our company and our employees have been long-time water service providers for this community and we’re excited for the opportunity to provide wastewater service to our Stansberry customers. Moving to Slide 13, 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 $302 million in our regulated operations this quarter. This was critical to reliable service but it’s also about affordable service. We continue to progress towards our long-term goal of 32% by 2022 because of our employees and their commitment to our customers. I’d like to provide some examples. We continue to see O&M savings associated with the enhanced functionality and integration between our work management systems and our primary asset management systems. Creating, editing, or retiring an asset record was historically very cumbersome. Now our people can access asset records directly through our user-friendly system called MapCall. It reduces our time spent on basic asset control functions by approximately one-third. Across the business, this will translate to about 10,000 hours saved per year. We also continue to realize savings in our telecommunications spending. For example, we’re migrating from dedicated leased lines for data to cellular solutions at a fraction of the cost. In New Jersey alone, we’ll save approximately $200,000 in 2018 and we plan to roll this out system-wide in the near term. Lastly, I want to acknowledge the tremendous effort by our employees to deliver exceptional customer service and to manage costs during a brutal winter in the Northeast and Midwest, which puts tremendous stress on our underground infrastructure. To give you an idea of their challenge in the first quarter, our Missouri team has addressed 1,700 main breaks, which is triple the normal rate. Our West Virginia team handled 1,100 main breaks, which is double their normal rate. I want to thank all of our teams for working safely in frigid and dangerous weather conditions to keep life flowing in our communities. That was a good quarter with continued growth, smart investments, and engaged employees driving efficiencies and quality results all to benefit our customers. With that, I’ll turn the call over to Linda for more detail on our financial performance.

Thank you, Walter, and good morning, everyone. I’ll start on Slide 15. We had a strong first quarter. Earnings were $0.59 per share at $0.07 or 13.5% over the first quarter last year. The regulated businesses were up $0.05 or 9.4%. The Market-Based Businesses were up $0.03, and the parent was down $0.01. Let me walk through our results by business segment in more detail. As I mentioned, our regulated operations were up $0.05. Revenue was up $0.03 in total, and included two major components: a $0.16 increase from authorized rate cases, infrastructure mechanisms, and acquisitions, including the Pennsylvania rate case settlement, which became effective on January 1 of this year. Partially offsetting this increase was a $0.13 reserve, which represents the estimated amount of revenue that will benefit our regulated customers as a result of the lower federal tax rate. Next, we had higher production costs of $0.03 per share, mainly from purchase water price and usage increases in California. O&M expense increased $0.06 per share from regulated acquisition growth and higher main breaks resulting from the frigid weather conditions that Walter discussed. Depreciation was higher at $0.02 driven by our investment growth. Our income tax expense was favorable at $0.13 mainly from the lower federal tax rate. Turning to our Market-Based Businesses, the full $0.03 increase was from our Homeowner Services Group due to operational efficiencies from improved management of key contractor partnerships, customer growth, and the favorable impact of a lower federal tax rate. Our Military Services Group was flat compared to the prior year as operational improvements offset the impacts from lower capital upgrades for the first quarter of this year, and Keystone was slightly positive compared to the same period last year. Lastly, the parent decreased $0.01 mainly from the lower tax shield on interest expense. Turning to Slide 16, let me provide an update on the impacts of tax reform. From an earnings perspective, we see tax reform as largely earnings neutral in 2018 with the lower tax rate benefiting our customers in our regulated businesses and the benefit in our Market-Based Businesses being largely offset by the lower tax shield on interest of the parent. From a cash flow perspective, we have had some positive developments. In late March, a bill was passed that clarified bonus depreciation eligibility for projects that began before September 27, 2017. With this clarification, we expect to be able to increase estimated bonus depreciation in the range of $150 million to $300 million, which would increase expected cash flow in the range of $30 million to $65 million. This impact is expected to push the timing of when we become a federal cash taxpayer into the beginning of 2020. We continue to work through the regulatory process of tax reform with our 14 regulatory jurisdictions. In terms of status, we have adjusted rates to reflect the benefits of the lower tax rate in two states, New Jersey and Illinois. Four of the remaining 12 states have agreed to address the impacts in their next general rate case. We will continue to work with our regulators on the best approach to return these benefits back to our customers. In all of our jurisdictions, we are working to defer amortization of the remeasurement of accumulated deferred income taxes until we receive further clarification. This is the portion required to be normalized or returned to customers over the remaining life of the assets. A few of our jurisdictions have agreed to this deferral. Overall, we are trending positive on cash flow from our original estimated tax reform impact. We expect a positive impact to operating cash flow from the Pivotal acquisition, which, once closed, is expected to increase overall cash flow from our Market-Based Businesses by 30%. The excellent progress we have made so far this year is due to the tremendous efforts of many employees across our company, especially our finance, tax, and regulatory teams. Turning to Slide 17, let me provide an update on our regulatory filing. We have $110 million in annualized new revenues effective since January 1 of this year. This includes $95 million from the Pennsylvania and Missouri rate case settlements and $15 million from infrastructure mechanisms. We have also filed requests and are awaiting final orders on three rate cases and one infrastructure surcharge for a total annualized revenue request of $165 million after adjustment for the lower federal tax rate. Turning to Slide 18, today, we are affirming our 2018 earnings guidance range of $3.22 to $3.32 per share. Although we are off to a strong start this year, we still have nine months of the year to go and as you are all aware, generally, the most significant variable to earnings is weather, with the largest impact typically occurring in the summer months of the third quarter of each year. Turning to Slide 19, we are committed to continue to deliver value to our customers and shareholders so you may have confidence in our disciplined financial approach. We have consistently delivered strong total shareholder returns far outpacing the UTY index over the one, three, and five-year periods and the S&P 500 over the three and five-year periods. We’ve been a top leader in dividend growth for six consecutive years, with dividend growth at about 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. We continue our targeted dividend payout ratio of 50% to 60% of earnings. Our adjusted return on equity improved from 9.7% to 10% for the 12-month period ended March 31. Our weighted average authorized return on equity across our regulated footprint remains approximately 9.8%. We continue to execute on our commitments and drive value through a continuous improvement culture that focuses on O&M efficiency, capital efficiency, and constructive regulatory outcomes. Through this disciplined financial management, customers and shareholders may be confident that American Water will continue to deliver value. With that, I’ll turn it back over to Susan.

Thanks, Linda. I mentioned in my opening remarks that we believe long-term financial success is an outcome of doing everything else right, of successfully executing on the fundamentals of our business. What this means to us is not only developing solid strategies but also clearly communicating our basic beliefs and philosophies on running a business. Our strategies focus on safety, customers, people, growth, technology, and operational efficiency. Our values, or how we accomplish these strategies, include safety, which is both a value and a strategy, trust, environmental leadership, teamwork, and high performance. So why should you care about any of these? Because this is at our core, and what we continually evaluate our actions by, not just a bunch of words on a piece of paper. We continually ask ourselves key questions. First, are we providing a safe environment for our employees and the public with all that we do? Are we developing our people to their fullest potential in their jobs? How are we implementing technology to improve customer service and reduce our costs? What are we doing to protect our natural resources and water supply? Are we a respected voice for clean and safe water throughout the U.S.? Will these initiatives lead to higher trust in us by our customers, communities, and regulators? Our story is pretty simple and straightforward. We know and love the business of water and water services. We’re committed to finding and delivering cost-effective solutions to problems and challenges related to water supply, water quality, and water infrastructure for our customers and communities throughout the country. We truly believe in the importance of values and purpose in all that we do, including achieving financial results. The world, and yes, even the water industry, can be chaotic at times. Our customers and our investors have plenty of things to worry about. Our goal is not to be one of them. With that, we’re happy to take your questions.

Thank you. Two questions. One is a bigger picture question, so we’ve seen a lot of corporate M&A involving water utilities and a recurrence of water utility at the big two potentially acquiring gas utilities. If you could share your thoughts about it given that you have announced a number of municipal deals as of late, and again, what’s your take on what’s going on in the industry?

First of all, good morning, Angie, and thanks for listening in. It’s interesting. We don’t really comment on what other companies do, but we are happy to talk about the way we look at things. We constantly survey the environment for opportunities, but at the end of the day, we're very comfortable with our growth strategy. It's very transparent in the triangle, the 5% to 7% from infrastructure investment, and we've laid out clearly our plans for that. We have decades of investment needs, and through tax reform and our continuing O&M efficiency, we're finding ways to make that much more affordable for our customers. As you mentioned, the 1% to 2% that we put in our growth triangle is strictly our history of these regulated acquisitions, the stress municipalities being a solution provider for those entities that need help, and our Market-Based Business, although very limited in what we want to get involved in. We want to do very well in those businesses we know, like we've mentioned before, homeowner services, military, and Keystone. So we watch and are interested, but at the end of the day, as I mentioned in my concluding remarks, our core is water and wastewater services. We think that's where we excel. We believe there are lots of opportunities for further investment and getting better as we continue to see this highly fragmented industry and sector with 53,000 water providers and 17,000 wastewater providers. If managed from an overall coordinated standpoint with an entity as large as we are, we can leverage volume procurement and our technology, scope, and scale. We think that's very attractive. So we watch, we survey, but we're comfortable with our strategies as we've laid them out.

Perfect. And my second question to Linda. So given your updated views on operating cash flow, especially in light of the Pivotal acquisition, have you been in discussions with credit agencies and do you think that this improvement is going to be sufficient for you guys to avoid any potential credit downgrades?

Yes, we are constantly working with our credit rating agencies. We have meetings set up on an annual basis and we would expect to continue to hold those meetings. We were also in discussions with our credit rating agencies regarding the Pivotal acquisition. We continue to navigate that. As we mentioned, when tax reform was implemented, we expected our FFO-to-debt metrics to drift a bit lower. However, we've been making positive improvements on the cash flow front since then and will continue to manage our cash flow carefully. It is an important metric that the rating agencies consider. The bigger item around ratings is the risk profile of the water and wastewater industry, which has not changed, and we are well-positioned within that.

Okay, thank you.

Thank you, Angie.

Hi, good morning, everyone, and thank you for taking my call and great quarter too.

Thanks, Rich.

I’m quite clear on everything, but I have a question on another area outside of the quarter, and it pertains to safety culture. As you guys all know, I'm pretty active with presenting on the conference circuit, and for about the past two years, I've noticed the topic of safety and protection has become more and more prominent area discussed by other presenters at these events. Originally, it could be considered filler, but it really does appear that this is an emerging trend with some potential for positive impact. I was at the Southwest Infrastructure Water Summit earlier this week and heard from an executive of American Water, which is discussing how the companies at the forefront of ensuring employee safety. It was interesting because he was delivering remarks stating that American Water is considering a bunch of different technologies, one of which is robotics. I was just wondering if you could share with me what implementing these technologies could mean for employee safety and what that could do for both the American Water financials as well as for the customer. Depending on how that's implemented, it could be a cost and not an investment.

Great, that's a great question. First of all, I will start by saying that we tell this to all of our nearly 7,000 employees: The number one thing is that every employee goes home to his or her family in as good a shape as they came to work. I don't believe any company can be great if people get hurt or killed at work, period. Nothing else you do matters. It sends a clear message about the value placed on people and the nature of our business. That's why it’s a value and I mentioned it's also a strategy. Strategically, we’re very excited about technology implementations. We actually launched an internal safety app last week. This app allows field personnel to provide feedback on unfamiliar equipment. It will help report any safety concerns and associated needs for equipment. We see a significant investment in the technology, but the long-term reduction of injuries and associated costs from that safety focus is essential. It’s simply the right thing to do for our employees and general public. For example, many of the manual, physical tasks our frontline staff must handle often lead to strain or sprains, and we’re investing in devices that simplify these tasks. Yes, it's an upfront investment, but it is an investment that pays off from both a safety and financial standpoint. Walter, you might want to add something.

Yes, thank you, Susan. Safety is our number one priority, and the safety culture is expanding significantly in our company. As Susan said, there's nothing more important than ensuring our employees return home safely at the end of the day. We have been expanding safety through the use of new technologies. We’re utilizing drones to conduct inspections, something that used to require people to physically climb on tanks. We’re looking at every available technology to ensure we do things safely.

That’s interesting. Thank you very much, guys. I appreciate the time. It’s really interesting, and again, great quarter, I appreciate it. Thank you.

Thanks, Rich.

Hi, great quarter. Thank you so much for taking the question.

Thanks, Claire.

Yes. I wanted to do two quick housekeeping items on the Market-Based Businesses. The first is, I think with the Pivotal transaction, you guys are coming pretty close to the 15% mark for EPS contribution from your unregulated businesses. I just wanted to get your thoughts there on, is that how you think about that 15% or is that metric have a little more flexibility in timing?

Yes, Claire, thank you for the question. What we disclosed is that the Pivotal acquisition nearly doubles the size of our Homeowner Services business. We expect over the next five years to maintain the Market-Based Business representing less than 15% of our total earnings per share. You are correct that we see it there. When we strategically step back and look at our overall risk profile, 15% to 20% from our Market-Based Businesses is our comfort zone, but only up to 20% if it has a regulated-type risk profile. Nothing has changed in our fundamental strategy, and we remain comfortable with how large these businesses could expand.

And Claire, this is Susan. To add to that, when you consider the small percentage of our total business that the Market-Based Business represents, it would take a lot to significantly alter it even with doubling the Homeowner Services aspect. Our aspiration is to have it at and below 15%, focusing primarily on those types of contracts that are regulated-like for certainty in our projections.

Got it. That’s really helpful color. Thank you. And the second question is, since you've had a bit of time to review the Pivotal transaction. Just to be sure, you guys are still saying it will be ratable in terms of earnings contribution as in it will be 0 maybe 3, 6, 9, 12. Just wanted to get some color on that.

Absolutely. We disclosed that we would be earnings neutral in 2018 after transition costs, assuming we close in the second quarter. We anticipate being accretive in the first full calendar year, 2019, and expect that accretion to steadily grow to about $0.12 per share by 2022. We will conduct a purchase price allocation upon closing. The nature of these businesses is capital-light but requires some capital investments, operational improvements, and customer system upgrades over time which will involve accelerated depreciation as we work to integrate.

Got it. That’s all for me. Thank you.

Thanks, Claire.

Thank you, Brian, and thanks to everybody for participating in our call today. Please know again that we value you as our investor owners and as the financial analysts who research our company for the benefit of your clients and their futures. We always want to be open and transparent in all of our discussions and dealings with you so you have confidence in your decisions around our company and the investments in our stock. If we've not been able to address your questions or if you have additional inquiries, please call Ed and Ralph and they will be happy to assist. I'd like to remind everyone that our annual shareholders meeting will take place next week on Friday, May 11. Thanks again for listening and have a great week.