美國水務 (AWK) 2016 Q2 法說會逐字稿

Good morning and welcome to American Waters' second-quarter 2016 earnings conference call. As a reminder, this call is being recorded and is also being webcast with an accompanying slide presentation through the Company's Investor Relations website.

Following the earnings conference call, an audio archive of the call will be available through August 11, 2016 by dialing 412-317-0088 for US and international callers. The access code for replay is 10089150. The online archive of the webcast will be available through September 6, 2016 by accessing the Investor Relations page of the Company's website located at www.amwater.com.

I would now like to introduce your host for today's call, Greg Panagos, Vice President of Investor Relations. Mr. Panagos, you may begin.

Thank you, Bianca. Good morning, everyone, and thank you for joining us for today's call. We will keep the call to about an hour. At the end of our prepared remarks, we will open the call up for your questions.

During course of this conference call, both in our prepared remarks and in answer 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 assumption. 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 is provided in the earnings release and in our Form 10-Q, each as filed with the SEC. I encourage you to read our Form 10-Q for a more detailed analysis of our financials and other important information.

Also, reconciliation tables for non-GAAP financial information discussed on this conference call, including adjusted return on equity and our O&M efficiency ratio, can be found in the Appendix of the slide deck for this call which is located at the Investor Relations page of the Company website. 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 and earnings per share refer to diluted earnings and earnings per share.

And now I will turn the call over to American Waters' President and CEO, Susan Story.

Thanks, Greg. Good morning, everyone, and thanks for joining us. With me today are Linda Sullivan, our CFO, who will go over second-quarter financial results, and Walter Lynch, our COO, who will give key updates on our operations.

Once again, American Water employees delivered strong results during the second quarter of 2016. We executed on fundamentals by investing in our water and wastewater systems to ensure safe and reliable service.

We operated efficiently to reduce cost impacts on customer's bills. We continued to grow our business based on our reputation and core competencies, and we worked to provide excellent service to all of our customers.

As you can see on slide 6, we reported second-quarter operating revenues of $827 million, a 5.8% increase above second quarter 2015. Earnings were $0.77 per share, a 13.2% increase above second quarter 2015.

Our results reflect some timing benefits, partially offset by some one-time expenses. For the first six months, in 2016, EPS increased 8.8%, and revenues were up 6.1%.

Slide 7 highlights how we are executing on our strategy. Our foundation remains capital investment in our Regulated operations. During the first half of the year, we invested $552 million in capital, including $24 million for Regulated acquisitions.

The majority of the remaining $528 million was in regulated operations, primarily to improve water and wastewater system improvements for the benefit of our customers. We plan to invest $1.4 billion to $1.5 billion for the full year, mostly for regulated infrastructure investments. That level of investment is balanced by our continued focus on controlling O&M costs, as well as utilizing constructive regulatory mechanisms.

Walter will cover this in greater detail, but we never lose sight of our customers and what they have to pay. This quarter was no exception, and our employees continued to improve efficiency.

We had excellent growth during the first half of 2016. We have added approximately 7,600 new customers from closed acquisitions and 5,300 from organic growth.

We have agreements in place, pending regulatory approval, which would add 47,800 more customers. That includes both the previously announced Scranton Sewer Authority which will add 31,000 wastewater customers as well as our recently announced acquisition of Shorelands Water Company, adding more than 11,000 water customers in New Jersey.

I also want to mention the acquisition activity that exemplifies my earlier comment about growing our business based on our reputation and core competencies. On Tuesday, the citizens of Blue Grass, Iowa voted an overwhelming 86% majority to join the Iowa American family.

Subject to a final agreement and regulatory approval, these 720 customer connections in Blue Grass will join the 730 new customers in Yes Communities, Iowa which closed earlier this year. These two additions result in a 2.3% growth from acquisitions over the 63,000 customers we had in Iowa at the end of 2015. We're all very proud of the dedication, reputation and customer commitment of our folks in Iowa, as well as in all of our other states that we are privileged to serve.

In the Market-Based businesses in the second quarter, we launched a municipal partnership through homeowner services in Georgetown, South Carolina. Our contract services group signed a 10-year O&M agreement in July with the township of South Orange Village, New Jersey which has 4,700 customers. Our military services group began service to our military and their families at Vandenberg Air Force Base on June 1.

As we noted in the first quarter earnings call, we continue to see headwinds in AWE for the remainder of the year, primarily due to lower fixed capital upgrades on our existing military installations compared to previous years. Linda will discuss this a bit more in her comments.

Many of you know that drilling activity is picking up in the Marcellus and Utica formations where our Keystone Clearwater subsidiary provides water services. As noted on the slide, as of today, we continue to see Keystone as being EPS neutral for the year. However, we will continue to evaluate the market and services demand and provide any update on our third quarter call.

As noted on the slide, our market share continues to increase and is now around 35% of the water services market in the Appalachian basin. As Linda will discuss in more detail, we experienced an increase in our medical cost during the second quarter, some of which we expect to impact us through the second half of the year. I will address some of the more innovative ways we are looking to manage these costs in the future in my closing remarks.

As you can see on slide 8, based on the results during the first half of the year, we remain on track and we are affirming our 2016 guidance of $2.75 to $2.85 per share. We also continue our progress toward achieving our long-term goal of 7% to 10% EPS growth through 2020.

With that, Walter will now give you his update on our operations.

Thank, Susan. Good morning, everyone.

We're really proud of the results our employees have delivered this year. We've had strong growth, we've made smart investments, we meet or surpassed all standards as shown in our annual water quality reports and we continue to realize efficiencies across the business.

Through June 30, we have invested more than $535 million in our Regulated Business. Of that total, we have invested $511 million to maintain and improve the service we provide, and another $24 million for Regulated acquisitions.

As Susan said, this investment is balanced by our focus on cost management, constructive regulatory mechanisms and legislation that enables us to assist communities with challenged water and wastewater systems. Our commitment to invest in our infrastructure while focusing on customer affordability is clear in the rate cases filed and closed this year.

In Missouri, our rate case settlement was adopted and we received an order for $4.5 million of additional annualized revenues. As part of the rate order, the PSC further consolidated water and sewer rates of the geographic regions, going from 19 water rate regions to 3 and 13 wastewater regions to 2. This creates economies of scale by spreading costs over a larger group of customers, reduces Company administrative costs, and mitigates the volatility of our customer bills.

During the second quarter, Iowa and New York requested an additional $13.6 million in combined annualized revenue and lowered operating expenses by $3.6 million collectively. In California on July 1, we filed an application to set new rates in each of our service areas for 2018 through 2020. This application seeks a revenue increase statewide of $51 million over the three-year period.

Also, the State Water Resources Control Board approved a five-year time extension for California American Water to comply with a 2009 order to significantly reduce withdrawals of water from the Carmel river. This action by the board recognizes our significant progress in building cooperative alliances among California American, local Governments and communities and environmental organizations. With these alliances, we are pursuing projects in water recycling and reuse that augment our water needs both before and after completion of our planned desalination facility.

On slide 11, you can see the success we've had in working with state governments and our commissions, either on legislation or policy that enables water solutions to water and wastewater challenges. For example, the Pennsylvania legislature eliminated a consolidated tax adjustment in setting utility rates.

The new law now requires a calculation of the public utilities federal income tax expense on a standalone basis, separate from any gains or losses of unregulated affiliates. Prior to this law, Pennsylvania was one of a few states that had a consolidated tax adjustment.

In Illinois over last several months, Illinois American Water has worked to find solutions that help our customers have a more reliable water system more quickly. The Illinois Commerce Commission adopted new rules in June which removes the 5% cap between rate cases, and instead permits rates that can increase an average of 2.5% a year with no year to increase more than 3.5%. This will be a big help in a state with big infrastructure challenges.

Finally in Kentucky, the governor signed House Bill 309 into law. This law establishes a framework for public-private partnerships in Kentucky. For first time ever, the state and local governments can leverage private investment to complete necessary infrastructure projects to better serve the public. This law has been referenced as the most comprehensive P3 legislation to date in the nation.

As you can see on slide 12, during the first half of the year, in addition to our organic growth we welcomed about 7,600 new water and wastewater customer connections which is about 20,000 people. We have pending acquisitions which represent another 47,800 new customers. This includes the Shorelands acquisition which is more than 11,000 water customers.

This is another example of how we are able to provide solutions. Shorelands' service area is in a part of state that is designated by the New Jersey Department of Environmental Protection as a critical area in terms of water supply. Once the purchase is approved and closed, we welcome our new employees and our new customers.

We are also working to close our acquisition of the Scranton Sewer Authority by September 30. Here, we will welcome 31,000 new wastewater customers.

We will benefit it from our operational and engineering expertise and our commitment to make necessarily capital investments. You can also see in this slide how legislative efforts are helping us provide water and wastewater solutions for people across our footprint. Out of the nine states where we have pending or closed acquisitions, five have fair market value legislation.

The importance of this legislation is evident when you look at the numbers. Nearly 97% of the customers we have closed or pending are in one of these fair market value states.

Moving to slide 13, we continue to improve our O&M efficiency ratio, achieving 35.2% for the last 12 months. We remain on track to meet our O&M efficiency target of 34% by 2020. It is a great effort by our employees across our business, and it is all about bringing value to our customers.

As I did last quarter, let me provide you with a couple of examples of what we're doing to drive these results. The first example is in our customer service centers, where we recently introduced new features to our customer self-service site. These changes improve the customer experience by using easy to understand language for reoccurring payments, and enabling our customers to change the bank account they use today pay their bills without the need to contact us.

For the month of July, more than 17,000 customers signed up for paperless billing and that's more than three times the amount of customers that signed up in the month of June. These changes are a true win-win, they make it easier for our customers to do business with us and they enable us to drive down costs.

In New Jersey, an energy deregulated state, we have taken advantage of reverse auctions to reduce our electricity costs. We first did this in 2011, and completed another auction this past fall. Through this process, New Jersey American Water will save a total of $9 million for the next three years in energy costs, benefiting our customers.

When we reduce $1 in operations and maintenance expense, we can invest $6 in capital. The $9 million cost reduction will translate into an additional $54 million in capital improvements without impacting our customer's rates.

Finally, we thank our employees in West Virginia for the way they responded to the devastating floods there this past June. Once again, our team rose to the challenge, working safely and getting our service restored as quickly as possible.

Additionally, they assisted state-wide emergency response efforts. For example, we loaned two water tankers to the West Virginia Department of Homeland Security and Emergency Management to provide potable water for flood devastated communities outside our service area. We also provided three large generators to run critical facilities in neighboring communities without power. It was great effort by our employees there, and we're very, very proud of them.

Now I'll turn the call over Linda for more detail on our second-quarter financial results.

Thank you, Walter, and good morning, everyone.

In the second quarter of 2016, American Water delivered strong financial results and year to date we remain on track. Slide 16 shows the earnings-per-share contribution from each of our businesses.

We reported earnings of $0.77 per share in the second quarter, up $0.09 or 13.2% over same quarter last year. Year to date, we reported earnings per share of $1.23, up $0.10 or 8.8% over the same period last year.

For the quarter, the Regulated Businesses were up $0.08 and the Market-Based businesses were up $0.01. Parent, which is primarily interest expense on parent debt, was flat compared to the same period last year.

Turning to slide 17, let me walk through the components of our quarter-over-quarter increase in earnings per share. The primary driver for earnings growth was in our Regulated Business, which was up $0.08. Regulated revenue was up $0.10 from authorized rate increases, infrastructure surcharges and new revenue from completed acquisitions and organic growth.

O&M expense was down $0.01 per share. This represents continued improved O&M efficiency that Walter discussed, and some timing impacts. Including a one-time $0.02 benefit from settlement of the Missouri rate case that will be offset during the remainder of year.

Largely offsetting these positive items were higher medical and prescription drug insurance costs of about $5 million pretax that are managed through our Viva trust. These higher costs are the result of three items.

First, we have been managing down the overfunded status of our Viva trust, and this year the funded status went from being overfunded to being fully funded. Second, we are seeing an increase in claims costs. And third, we trued up our liability based on our claims experience.

As I mentioned, the second-quarter impact was about $5 million pretax or $0.02 per share. For the remainder of the year, we estimate increasing claims will add another $3 million pretax, putting the full year increase at about $8 million pretax or $0.03 per share.

American Water, like other employers, is challenged by rising healthcare costs, and later, Susan will discuss actions we are taking to manage these costs going forward. Next, interest expense was up $0.01 and depreciation expense was up about $0.02, both driven by growth associated with our Regulated system investments.

Moving to our Market-Based businesses. Quarterly net income was up $0.01 per share, primarily from a favorable contract dispute settlement of about $3 million pretax which we had expected to receive later this year. Absent this favorable settlement, the Market-Based businesses were relatively flat.

Increases in homeowner services as well as the acquisition of Keystone last July were largely offset by lower capital upgrades in our military services group. As noted in our first quarter call, we expect lower capital upgrades in 2016 from reduced federal budgets, and because these capital upgrades can be lumpy year over year. One of the biggest reasons capital upgrades were lower in the second quarter was the wind down of an $85 million three-year project at Fort Polk.

Let me now cover the regulatory highlights on slide 18. We currently have six general rate cases and one infrastructure surcharge request in process, for a combined annualized rate request of $113 million. For rates effective from July 1, 2015 through today, we received a total of $102 million in additional annualized revenues from general rate cases, infrastructure charges and step increases.

As you can see on this slide, our requested ROE in our outstanding general rate cases is generally 10.75% to 10.8%, with recent authorizations at 9.75% in several in our states. Overall, our weighted Companywide authorized ROE was 9.9% at the end of this quarter. Looking at the change in ROE over the past three years since 2013, the Company's average authorized ROE has only moved about 10 basis points from a prior average of 10%.

And, during this same time period, our weighted authorized equity ratio increased about 20 basis points. So even with sustained low interest rates over this period, changes in ROE have tended to be slow and gradual.

Slide 19, highlights our continued strong financial performance. We made total capital investments of $316 million during the second quarter of 2016, and $552 million year to date, primarily for Regulated system investments, mainly for the replacement and renewal of transmission and distribution infrastructure.

We expect total capital expenditures to be in the $1.4 billion to $1.5 billion range in 2016. Our capital expenditure range was updated to include our pending acquisitions.

I would also like to point out that the Shorelands acquisition announced yesterday is a stock-for-stock transaction and the maximum number of shares to be exchanged at closing be less than 500,000, with the final number of shares based upon American Water's stock price. We expect to close the transaction in the first quarter of 2017.

For second quarter of 2016, cash flow from operations increased $51 million or about 23% to $271 million. Mainly due to focused efforts on improving the aging of our accounts receivable, as well as the timing of accounts payable and accrued liabilities.

Our adjusted return on equity for the past 12 months was 9.55%, an increase of 57 basis points compared to last year from continued execution on our strategies. We also announced, in July, a $0.375 common stock cash dividend payable on September 1, 2016 to stockholders of record as of August 8, 2016.

Turning to slide 20, we are affirming our 2016 earnings guidance. I would like to point out a few items.

First, weather impacts in July are expected to be minimal, as the hot temperatures across many of our states were also accompanied by rain fall. Second, our year-to-date earnings were strong across the business. However, as I have noted, they also include some timing-related items, including the favorable contract dispute settlement at AWE, which we had expected later in year and the $0.02 benefit of settlement of the Missouri rate case that will be offset during the remainder of the year.

Third, looking forward, despite the expected increase in group insurance costs and the headwinds we have previously discussed, at our military services group in Keystone, we affirm our earnings guidance range of $2.75 to $2.85 per share.

With that, I will turn it back over to Susan.

Thanks, Linda. Before we move on to Q&A, I would like to take a couple of minutes to talk about healthcare costs.

Like other companies, our healthcare costs are going up. This is especially true in utilities, where we have an even more pronounced aging workforce.

We are currently partnering with our healthcare and pharmacy providers for better pricing, while strongly promoting a healthy and safe culture for our employees. We continue to promote wellness and health management programs, preventive care screening and education for employees on being thoughtful consumers of healthcare. But we're going a step further.

Earlier this year, American Water was a founding member with 20 national companies, which you see on the chart, to form the Health Transformation Alliance, HTA. Since the initiative was kicked off in February, an additional 13 companies have joined the alliance with the now 33 companies, representing more than 5.5 million people across the country. We are proud to be part of this cutting edge effort.

The overall goal of the HTA is to create higher quality care by first partnering facilities and physicians that have better outcomes, while also aggregating the purchasing power of all the member companies to keep costs down. Additionally, HTA companies will pool our data without identifying individual information for better treatment options, better health outcomes and more reasonable and efficient pricing.

The HTA is following a similar process for pharmaceutical purchasing and contracting systems. The HTA's efforts have been highlighted recently in several media publications, including the Wall Street Journal, Baron and the Boston Globe.

This is just the start of an exciting collaborative effort. We will keep you updated as we work with leading companies throughout the United States to improve the quality of healthcare, and slow the rising costs for our Company, employees and their families.

So in summary, our year-to-date financial performance reflects the successful execution of our strategies. Investing in our systems, operating efficiently, growing our business and remaining steadfast in our commitment to the highest standards of customer service and water quality.

And with that, we are happy to take your questions.

(Operator Instructions)

The first question comes from Ryan Connors with Boenning & Scattergood. Please go ahead.

Great. Thanks taking my question. I wanted to talk a little bit about the infrastructure surcharge and the new rates coming out of the P&L.

If I read the slides correctly, you have got more than $40 million worth of DSIC and other surcharges that are coming on to P&L in the first half. Which puts that DSIC revenue, if my calculations are right, upwards somewhere around 1.5% of total consolidated sales which is a pretty high number relative to the historical average.

So can you just talk a little bit about transitioning those rates across our system from DSIC and surcharges over to base rates? And whether that's, as this becomes a bigger and bigger part of the system DSIC and surcharges, is that a seamless process or will that be create complications that were not there in the traditional set up of a regular general rate case cycle?

Ryan, this is Linda. Thank you for the question. Great question.

This is actually a pretty smooth transition from the DSIC mechanisms to general rate cases. Because generally, these types of mechanisms are really set up for the purpose that we will be able to continue to make these investments in an on going basis in our much-needed infrastructure upgrades.

So that's really purpose of it, and then they roll into the general rate cases. It also allows us to spread out the time between general rate cases, and smooth the impact of our capital investments on our customer rates.

Okay. And then, and I know that most of these DSIC type mechanisms actually have a return on equity component to them. Is that typically equal to what you expect to receive in a given state when you move from a surcharge over to a base rate?

Typically, it is. Every state is say little bit different, but typically it is the same.

Okay. And then my other question was a little bigger picture in terms of the new fair value legislation. Obviously you have the Act 12 in Pennsylvania, and, Walter, you mentioned five different states now. I am just wondering whether this is really catching on more broadly.

I know we just had the NARUC Summer Meetings, I believe, Walter, you were there. And curious whether that is something that is getting a lot of play in the hallways and whatnot, and whether we might see other states move in a similar direction? Or whether this will maintain -- stay pretty niche oriented?

Yes, Ryan, thanks for that question. We are seeing this as catching on in many of the states, and you can see that be each of the states adopting it.

What it really does is providing a center for municipalities to look to monetize their assets to be able to provide a fair market through the systems. And before this, we could pretty much only pay original costs minus depreciation, and then anything above that was that risk for us getting in rate base.

So this just worked for everybody, and it is getting a lot of traction in each of the states where we operate. And you can see that from the slide that we had up there, five of our big states have fair market legislation.

Ryan, so the driver for this, just like Walter and Linda said. The reason that this is for water is because there is a recognition that with every increasing infrastructure need, every increasing retirement, smaller systems increasing water quality standards, there's a general concern. Do we have the ability to be meet the needs of water and wastewater systems.

Public service commissions also are residents of states they're in. So even if, in many states, municipalities aren't regulated by th PSCs, the recognition of water and wastewater challenges is shared by everyone.

So we do find that in many of our states the commissions are concerned about water quality, water issues, along with their governmental entities. And the whole point here is to offer optionality to municipalities, so that whatever works for them and their citizens, they have the options to do. And fair market legislation just helps out that whole situation.

That's very helpful color. Thank you.

Then one just last quick one, is, Walter, you mentioned the Scranton acquisition and wanting to close that by the end of September. Is that pretty much buttoned up now, or are there any lingering issues that could actually complicate that regulatory approval?

Ryan, we are working towards closing by September 30, and we continue to work with the city on that.

Okay. Thanks for your time.

Thank, Ryan.

Our next question is from Shahriar Pourreza with Guggenheim Partners. Please go ahead.

Good morning.

Hello, Shahriar.

Apologize if this was asked already, I had to hop on a little bit late. But so on the fair value legislations, Susan, is there any other states you are thinking about where we could see some sort of passage? And I am thinking more like Illinois or New York, is there any opportunities there?

Well, actually Illinois was the first. When you look at the fair market legislation, at least in our service area, it started with Illinois legislation. They were among the first to do that.

The general question though is, I think that as you continue to see water and wastewater systems under distress across the country, this is a very viable solution. That enables municipalities to benefit from water utilities like us and others to benefit, and to solve -- the main thing is to solve a problem for the citizens out there who are depending on the best water quality. But also you have communities around the country who are doing an amazing job, first of all, but they have all of these different priorities.

They have to provide for schools, and for roads, and for parks. And the responsibilities that these municipalities have is so long, and as we know, a lot of the federal funds aren't there anymore that were there during the 70s and 80s and even 90s. So they're trying the very best they can to service the citizens of their communities. So where it makes sense and this is an option for them, and they choose to put their systems up for sale, having this type of legislation takes an obstacle away from that.

In the past, we've had situations where a municipality or governmental entity wanted to sell its system, we wanted to buy it. But because of the way things worked between the book value and what we were able to put in a rate base that wasn't considered premium, it stopped a lot of deals before they ever took place.

So I think this is an effort by states to have a win-win situation. But at the end of day, the people in those communities need be better off, and the municipalities are able then to provide the critical services that they're responsible for.

Got it. That's helpful. Then just around obviously there hasn't been any issues growing, and you have got organic opportunities, you've got acquisitions opportunities.

But when you think about the next leg of growth, is there -- where are we at with storm water? And is that something we can see as a potential driver of that growth maybe next year or the year after?

I think that is a big open question right now, Shahriar. I think one of the things we know is that on some of the military installations where we serve water and wastewater, a question has come up about storm water so that we provide services for the whole water cycle. So that is really the immediate issue that we are looking at in clarifying in Washington in terms of roll of storm water in the privatization legislation which, by the way, is actually there.

So I think it is one of those that as the entire country looks at water supply challenges and we look at the entire water cycle, it is not -- in the past, we tend to say it is the drinking water, it is storm water, it is sewer water. Where you have draught situations, where you have the need and we need promote water recycle reuse, you are going to start everyone looking at the whole cycle. So I think it is very early in the stage to do that, but it is something because it is part of the water cycle that we have to look at.

Got it. That's helpful. And then just lastly on Keystone, obviously, you reiterated the earnings neutral and I think I would assume cash flow positive up until the second quarter.

But obviously, you highlighted that drilling activities picked up a little bit and you sounded a little bit more constructive. So if we continue with the fundamentals we are seeing right now on drilling activity, is it something that is -- is there an opportunity to look at that earnings profile this year, or is it are we too late in the year to revisit that neutral status?

Well, Shahriar, what we know -- so we like to go -- we like to base our guidance on what we know. So market conditions have stabilized. We know that, and they have begun to slightly improve.

So we have seen some increases in rig count, commodity pricing, as you all know, some customers are resumed completion and drilling activities. But we're looking at capital spending, how much of it will hit at the end of this year versus 2017. So I think it is really a timing issue that we are looking at.

So what we want to do is look over next few months to look at how that has stabilized, what that means for 2016 versus 2017. But the good news, as you said, is that we are starting to see activity.

It is widespread. We are starting to see our growth in market share. The last we had shared with you before this call was about 30%, we're now seeing about 35% as some of the smaller players have fallen by the wayside during the really tough times.

So our customers are steady. We're not seeing any further deferrals of completion activities, we are picking up some new customers. But we just need to monitor over the next few months and see what we have got.

Excellent. Thanks, congrats.

Thanks.

Our next question comes from Richard Verdi with Ladenburg. Please go ahead.

Hello, good morning, everyone. Congrats on another nice quarter, and thank you for taking my call. My first question --.

Thanks, Rich.

Thanks, Susan. My first question is a follow up on Ryan's question about the DSIC. I had asked this of Aqua on their Q1 call.

So in early Q2, I had a conversation with one of the more prominent members in NASUCA. He told me that the consumer advocates are basically looking to meaningfully push back on the DSIC and similar surcharges in other states, because the group feels the DSIC is being abused with its one filing after the next. So I'm wondering if American Water is hearing about this, expecting it, and if so, I am wondering how it could impact the Company's strategy?

Well, Rich, I'm not going to comment on NASUCA because they need to speak for themselves. But I will tell you from our standpoint, here's what we know. There is a recognition by the EPA throughout the country about the infrastructure needs that we have in the United States.

Our plans are very open. In our state in our DSIC in any of our infrastructure surcharge, we present plans. We also go in when we have either quarterly, sometimes semi-annually filing where there is a close monitoring of the projects we're working on, what we're spending.

In addition to our O&M efficiency, at least for American Water, we also have several efforts in terms of capital efficiency. What are we doing not only to spend every O&M dollar, but what are we doing to show that we are actually even improving how we spend every capital dollar.

Because for us, it is this situation. We're faced with years of investment. We want to be as efficient with every dollar as we can possibly be, because that means we can put more in ground, not impact the customer bills and to be able to get the infrastructure replaced more quickly which still is a decades-long issue.

So that's one thing we know. I will also tell you that with the recent, I will say attention to water quality issues, in a time when you have infrastructure but you also have emerging water quality issues. And we have seen what happens in different parts of the country when you don't invest in infrastructure, I am not sure that is a risk that we are willing to take.

Great. Thank you, Susan. That's perfect.

And then another question I have. I want to focus the rest of the questions on the Non-Reg segment. This follows up also on the last caller's inquiry.

When you had laid it out to him, I just wanted to get some clarity though about the, let's call it, cautiously optimistic Q3 and Q4 for Keystone. Oil is expected to pull back because of seasonality in late Q3 and into Q4. A lot of these guys go on vacation because of weather around Thanksgiving time and drilling activity dries up.

So I am assuming you're optimistic because Q2 was probably strong and Q3 probably followed that strength, but what keeps you cautious? Is that seasonality potential for an oil pull back keeping you cautious, or are you now seeing customer indications where they're keeping you cautious on Q3? I am just looking for a little more clarity on that.

Sure. So first of all, understand that our Keystone executives and management spend a lot of time with our customers. We do have a lot of -- we share with them and they share with us some of their plans, their drilling plans. So the cautiousness is not really related to timing of holidays or vacations, it is more of you're talking about an E&P industry that's extremely cautious, because of what they have gone through the past 18 months.

So you don't have people that have going from being so far down to saying we're going to pull out all the stops and ramp everything up immediately. They have a cautiousness, so we have a cautiousness. It is a testing of the waters, the foundations are becoming stronger. We are seeing natural gas prices I think NYMEX closed yesterday at $2.84, for example. Just in April, it was $1.90 per million BTUs.

You are starting see better pricing as the supply is being drawn down because of the heat across the country this summer. We are starting to see some activities where people had not been doing drilling, and now they are. We are starting to see more drilling rigs come up.

So our cautiousness is the timing. It is the spacing. It is how quickly will we see this come up, how quickly will we see the supply that basically is being drown and being replenished. What are the forecasts for the winter months, how cold will the winter be.

So we try to base looking at objective third-party data like price projections, like drilling projections. We look at all of that, then we also look at our internal discussions we have with our customers and their drilling plans are.

So the cautiousness is, what you don't want is for people to flip back and forth to say it is not good. It is great, it is not. We just want to be very cautious as we look at the ramp up and the continuing strength of the natural gas drilling market, and make sure that we are very careful in how we look at that emergence.

Great. That's excellent color. Thank you, Susan.

Then staying on the Keystone here, it is in the Appalachian footprint, it is in the Marcellus and it is in the UTICA. So I am curious, given the market shares that you -- the 35% market share you shared which I am very thankful for, what basin do they focus on more over the other? Is it the Marcellus or is it the Utica?

Really, it is both. They're so close. Basically it is three states, it is Pennsylvania, it is Ohio and it is West Virginia.

Of course, the formations are beside each other. And also, importantly, as we mentioned on the first quarter call, Shell has announced that they're going to build the cracker plant there south of Pittsburgh. Which is right in heart of where the Marcellus and Utica, and some of the formations are very close together.

So we are very excited about that. Because what they will do is if they start construction as they have said in 2018 and finish in 2020, you are talking about even more valuable natural gas drilling where you can get the NGLs along with the natural gas.

So we just see that area and the intersection between Utica and Marcellus being very rich, in terms of -- the fact is we know it is the cheapest to drill for the drillers, and it also requires a good bit of water because of the depth of the formations. So we think that is the right place to be, and we have been asked. Also at this point, we're not interested in going into other formations, because we think that the Utica and Marcellus is where we have the most key areas for production growth in the future.

Okay. That actually helped answer my next question then. And then of that 35%, does Keystone work with Ontario Resources?

We do. We work with a lot of -- we have right now, I believe, somewhere between 22 and 27 different customers.

Okay. That's helpful. And I guess the last question is this.

When I think of the Marcellus, there are 10 rigs there. 6 of them are Ontario Resources, which then means that their midstream arm who has a water business, that water business is going to the midstream arm. And so then there's the 4 other guys there, and then the UTICA there's only 1 Ontario Resource rig there, and of the 13 remaining they're all other players.

So of those other players, I understand that oil prices are supposed to decline because of seasonality. But they're also expect to climb following that. And in addition to that, if you look at any upstream player they're all outing about how they're expecting to use -- I think they were using something like 1,500 pounds of sand per lateral or somewhere around there, and it is expected to go up to 2,000.

So I am wondering if there's a potential to expand and capture more business in the Utica because it is so -- it is open there? And then two, that increased sand means increased needs for water there.

So how -- are you guys factoring that into your figures, and if so, are you expecting -- how much of a positive impact? Because a year ago, that was a 1,000 pounds and now we're talking doubling that. So that could be really meaningful for American Water.

Well a couple of things. So, Rich, in recent weeks, the drill count has been about 36 in the Appalachian basin and ours is -- we're all natural gas by the way. So we do very little to no support for oil, actually for us it is mostly natural gas. So that's one.

Second thing, you are exactly right. What we are finding is that in order to more efficiently utilize wells that have already been drilled, they are looking at higher pressure more sand, which does require more water, you are exactly right. But those changes in the market and the efficiency are things that our folks at Keystone work closely with customers in terms of estimates of how much water we need.

So your right, there's changes. That's one of the reasons that the wells have become so much more efficient, is they're doing the second and third frac, and they're also putting a lot more sand and al lot more pressure with the sand when they go to those second and third fracs. So you're exactly right.

There's a couple of other things we're involved in. One of them is, we are working with a couple of customers on some automated pumping that really is not pretty standard right now. So we consistently look at working with E&Ps on how to make the production more efficient, how to get the most they can out of each individual well, and to make sure that we are a solutions provider on everything around water and water services.

Fantastic, and then thank you for that, Susan. That's great color and then. The very last question and I will jump out, I know I'm taking up a lot of time.

Last quarter I had asked, Susan, And I think this is a great move on American Water's part, I had asked if American Water with their smart metering initiative, they were trying to team with the electric companies to their infrastructure and you had given some great color. But just wondering if there was any sort of update on that, if there's any more progress, what have you, just some color, to see if there's an update.

Yes, well we actually have an AMI team that we're working throughout the Company to come up with a rollout. Unlike electric, the water bills are so much less expensive. Of course we're looking at the ability to be able to justify them economically.

One good things is we're seeing a lot better technology with the meters that will allow us to actually put in AMR meters that we can then do software upgrades to actually make them AMI meters which is good. We continue to work with some electric utilities on utilizing some of the same backhaul infrastructure, so that our customers don't have to double the cost of those investments. We're working with commonwealth Edison ComEd in the Chicago area, as well as there's a couple of other utilities that have expressed an interest and we're very exited about that.

Because it truly is a win-win for our customers, where we put in a water meter. But the one reason it does push to do AMI is interestingly, still a lot of water meters across our footprint are in people's homes. So the ability to put in AMI that we don't have to actually send people out to people's homes and set up times to go into their home is a real not just efficiency improvement, but also a customer satisfaction improvement.

So we are taking all of those factors. We have got a plan in place to roll out AMI over the next few years. And where we can partner with electric utilities to offset some of that cost for our customers, we are all for it.

That's great. Thank you, Susan, and congrats again on the success this quarter and moving forward. I appreciate the time, it's great color.

Thank, Rich.

(Operator Instructions)

Our next question comes from Jonathan Reeder with Wells-Fargo. Please go ahead.

Hey, good morning, you all. I will try to be quick since this call has been extended a little bit recently.

Could you give us an update on the military base RFP process? Obviously your main competitor was awarded a pretty large base here recently, if you could just say maybe what happened there on your end. And do you get the sense that any new bases are on the verge of being awarded?

Okay. That's a great question, Jonathan, thanks. It is that as we look at the military bases, there are several RFPs that are outstanding. From the time we do an initial bid, it can be anywhere from three to five years before bases are awarded. And we do have several outstanding bids.

Again, we only bid on those bases that the 50-year contract value is from $250 million and above, because for us the smaller bases, with the cost of bidding and all of that. So you are correct. The last one that was awarded was Eglin, and we did bid on it, and American States Water did win that one, and we are taking our lessons learned and seeing what we could do better next time.

We do think that we know that there are others in the process, several we have already bid on, others that we think will come out for bid. It is an ongoing process, so we are just looking to get better every time we make a bid.

Okay. So no anticipation necessarily of any announcements in second half of the year at this point?

We don't foresee any announcements the second half of year. With that said, however, one never knows.

So when you have got a bid out there that has been out there for a couple of three years, depending on the particular installation and where the Department of Defense is. So it is very difficult to predict, but at this point we don't foresee any further awards this year. But we could be wrong.

Okay. Great. And then, Walter, did you say the Illinois infrastructure surcharge changes removes the total cap in terms of how much revenues can increase under the program between rate cases?

Yes, that's right. It removes the cap of 5% between rate cases. It allows us to increase rates 3.5% -- no more than 3.5% a year.

Okay.

It also includes a number of other things that we can invest in and get recovery, not just pipes. So it was very favorable for the industry.

Okay. So a 3.5% annual cap, how does that impact the frequency of rate cases in the state for you now?

Well --.

Does it stretch it out a couple more years given the broader application and the 3.5% annual cap?

It could lead to that. We're going to continue working our capital program to invest wisely within our systems, and if that extends the rate cases, that's great. But we're going to continue to invest per our capital management program.

Okay. Do you think it expands the overall CapEx budget in the state where it moved the needle at all on the consolidated budget going forward, or too soon to say?

Yes, it is really too soon to say, but it is favorable for us to continue to invest, again a timely recovery. So we will consider that as we are working through our capital plan for the next five years.

Okay. And then last question, and I think I already know the answer. But I guess year to date, weather hasn't really had a meaningful impact. Is that correct?

Jonathan, that is correct. We have looked at the weather impacts through July across all of our states, and although we did see more heat in those states and hot weather, it was offset by also having rain fall in those areas as well.

Okay. Great. Thank you so much for the time this morning.

Thanks, Jonathan.

Thanks.

Thank you.

Operator, I think that concludes our question-answer-session for this morning.

Yes, I would like to turn the call back over to Susan Story for any closing remarks.

Thanks, everybody, for participating on our call today. And as always, if you have any questions, please give Greg or Melissa a call. They will be happy too help.

We want to thank everybody for participating. Look forward to seeing you in November, and thank goodness in one month, football season starts. So everybody have a great day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.