美國水務 (AWK) 2017 Q2 法說會逐字稿

Good morning, and welcome to the American Water Second Quarter 2017 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 10, 2017. U.S. callers may access the audio archive toll free by dialing 1 (877) 344-7529. International callers may listen by dialing 1 (412) 317-0088. The access code for replay is 10110707. The online webcast will be available at American Water's Investor Relations homepage at ir.amwater.com.

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

Thank you, Brendan, and good morning, everyone, and thank you for joining us for today's call. We will keep the call to about an hour, and at the end of our prepared remarks, we will open up the call up to 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 June 30, 2017 Form 10-Q, each as filed with the SEC.

Reconciliations for non-GAAP financial information discussed on this conference call, including adjusted return on equity and our adjusted O&M efficiency ratio, can be found 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.

And now, I will 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 second quarter financial results; and COO, Walter Lynch, will give key updates on our operations. I'll start with what I'm sure are your 2 main questions today: why our earnings were down $0.04 for the quarter, and why we're affirming our 2017 earnings guidance of $2.98 to $3.08. A key fact is that our Regulated Business continues to execute and deliver solid results.

Second quarter 2017 results we're impacted by several items, some of which we've noted in earlier calls. The primary negatives for the quarter were 2 key 2017 items and 2 favorable items in the second quarter of 2016, which did not recur this year. $0.02 of earnings were down quarter-over-quarter from lower capital upgrades in our Military Services Group. We've covered this on past calls, and it's related to reduced military budgets combined with the completion of a large wastewater project at Fort Polk in the first half of 2016. Additionally, we had a onetime $0.02 tax adjustment from a state income tax change in New York that Linda mentioned on our last quarter call. She'll discuss this in more detail as well as another state income tax change in Illinois.

The quarter was also impacted by last year's favorable weather of $0.02 per share compared to a more normal second quarter this year and a 2016 onetime $0.01 benefit from an AWE contract settlement. However, even including these items in our range, we continue to affirm our $2.98 to $3.08 EPS guidance for 2017.

Our Regulated core business continues solid growth, delivering a 3.7% increase in net income for the quarter. During the first half of 2017, we added approximately 15,000 customers through closed acquisitions and 7,000 from organic growth. Walter will speak a little bit more about the pending acquisition agreements we have in place as of July 31 that will add about 34,000 additional customers. We continue to invest in our Regulated Business. This year, we will invest $1.5 billion to $1.6 billion total capital with a vast majority dedicated to water and wastewater system improvements and upgrades. We balance those investments by operating efficiently and effectively, which is reflected in our O&M efficiency ratio.

On the Market-Based side, although we are experiencing lower capital upgrades in military services, we continue to perform our 50-year O&M contracts quite affectively. We are completing the capital upgrades we do have, and we're working with bases to identify potential infrastructure projects for the 2018 fiscal year. Additionally, we have 8 RFPs outstanding with the possibility of 1 or 2 awards being made this year by the Department of Defense.

We continue to expand homeowner services, including a new partnership with Yonkers, New York. At Keystone Clearwater, we are seeing increases in rig count and well completions in the Appalachian region and have an increased backlog of work scheduled in the second half of the year.

So while there are a number of items impacting this quarter's results, we remain confident in our ability to deliver earnings for 2017 in our guidance range of $2.98 to $3.08. Beyond 2017 and for the longer term, our business fundamentals and outlook continue to be strong and compelling. Our growth triangle still holds as does our long-term 7% to 10% EPS guidance.

Now let me turn the call over to Walter to give you his update on our Regulated Business.

Thanks, and good morning, everyone. As Susan mentioned, our Regulated Business has delivered year-over-year second quarter growth by continuing capital investments and driving operating efficiencies to benefit our customers.

Let's walk through some highlights of this quarter. On July 21, after a strong show of support in the New Jersey Legislature, Governor Christie signed the Water Quality Accountability Act. In fact, the New Jersey State Assembly, in a bipartisan show of support, passed the legislation 76 to 0, which was followed by the state Senate vote of 39 to 0. This legislation calls for such things like regular testing of valves and hydrants, a 150-year pipe replacement rate, implementation of a cybersecurity program and action plans for notices of violation. We see this as a good thing because, first and foremost, it ensures that all citizens in New Jersey have safe, secure and clean water. It's also a great model for future legislation across the nation. American Water stands ready to be a solutions provider as other systems look to make needed investments.

This quarter, 2 states received orders to adjust rates. The New York Public Service Commission issued an order that will add $3.6 million in annualized revenue to recover about $150 million in water system improvements. These investments made over the past 5 years include replacing over 33 miles of water mains and bringing 1 new iron removal treatment plant online, while making improvements to 3 other treatment plants. We also reduced operating expenses by $2.7 million in the same time period.

In Virginia, the State Corporation Commission issued an order that adds $5.2 million in annualized revenue to recover $53 million in infrastructure improvements made since 2012. Here, too, we reduced operating expenses by 2% since our last rate case. This is a great job by our New York and Virginia teams as every dollar we save, we can invest $7 in our systems with no customer bill impact.

During the quarter, we filed 2 rate requests, 1 in Pennsylvania, which we discussed last quarter; and 1 in Missouri. On June 30, we filed a rate case in Missouri requesting an increase of $84 million in annual revenue. This request covers investment of $490 million in water and wastewater infrastructure. Included in this investment is the replacement of a large treatment plant at Parkville and the installation of AMI meters in St. Louis County, which will give customers more timely billing information. It also helps us monitor usage better, which is important in identifying leaks.

Finally, in West Virginia, we filed for an updated infrastructure surcharge to incorporate new projects to be started in 2018 over and above the 2017 projects now underway. The 2018 projects include $29.9 million that we'll invest in various systemwide upgrades, including replacement or upgrade of more than 39 miles of water mains and upsizing 2 water storage tanks. These investments will drive system reliability and equate to only a $1 increase per customer per month.

Turning to Slide 10. We added about a 15,000 new customers from closed acquisitions through June. As discussed last quarter, we closed on our Shorelands, New Jersey acquisition, adding 11,000 customers. In California, we closed the Meadowbrook Water Company, serving approximately 1,700 customers. We also entered into a contract to purchase the Fruitridge Vista Water Company, which serves approximately 4,800 customers. Among the acquisitions pending approval, the largest is McKeesport, Pennsylvania, which will add 22,000 customers. We expect that acquisition will close later this year or in early 2018. This and other pending acquisitions will add approximately 34,000 customers. The remaining 7,000 new customers added during the first half of the year came from organic growth.

Moving to Slide 11. We continue to increase operating efficiencies across our company so that we can make smart investments without significantly impacting customer bills. Our adjusted O&M efficiency ratio improved to 34.5% for the last 12 months ending June 30, 2017. We continue to work towards our goal of 32.5% by 2021.

Let me highlight 2 examples of the steps we're taking to drive efficiencies. After modifying our process for a new service installation, a field worker now has the ability to tap the main, run the service line and install the meter on one visit as opposed to multiple visits in the past. As a result, the project team generated nearly $0.25 million in savings in 8 states over the past 12 months. We plan to roll this new process out nationally. In addition, we continue to drive efficiencies, reduce waste and improve safety across the entire company by routinely conducting waste walks. One waste walk in Tennessee resulted in a modification of existing meter lids, which improved meter reading accuracy and resulted in annual savings of about $150,000. We're looking to expand this modification across all of our systems.

On Slide 12. One final highlight is in the town of Bel Air, Maryland, where we've identified a much needed backup water supply. We recently broke ground for a 90 million-gallon water impoundment reservoir and a new intake. If all goes as planned, the $15 million impoundment will provide service in 2019. This is a great example of many parties coming together to ensure a long-term water supply solution. We thank state and local officials, community members from Bel Air and Harford County for helping make this solution a reality. In fact, the town administrator, Jesse Bane, said that the solution saved the town from what could have been its eventual demise if it didn't have a reliable source for water.

With that, I'll turn the call over to Linda for more detail on our financial performance.

Thank you, Walter, and good morning, everyone. Today I will cover our second quarter results, 2 legislative tax changes impacting us this year and our earnings guidance range.

Turning to Slide 14. Second quarter 2017 earnings were $0.73 per share, down $0.04 from second quarter last year. Susan outlined the primary drivers of the lower quarter-over-quarter results, so let me walk through the results by business segment. I'll start with our Regulated segment.

For the quarter, our Regulated Businesses were up $0.02 per share. Revenue was up $0.12 per share. Included in that $0.12 increase was about $0.09 from authorized rate cases and infrastructure mechanisms to support capital growth, and $0.04 from acquisitions and organic growth. Partially offsetting this was $0.01 of lower demand.

Next, as Susan mentioned, we had favorable weather in the second quarter of last year, which negatively impacted the quarterly comparison by $0.02 per share. O&M expense was higher $0.04 per share from increased production costs mainly in California, increased waste disposal costs driven by acquisition growth and higher customer uncollectible expense.

Finally, we had higher depreciation and interest expense of $0.04 per share driven by our investment growth. I would like to point out that although the growth rate for the Regulated Businesses was lower this quarter, their results are on plan for the year.

Turning to the Market-Based Businesses. We were down $0.02 per share compared to the same period last year. As anticipated, we continue to experience lower capital upgrades in the Military Services Group, which includes the quarter-over-quarter impact from completion of the major project at Fort Polk in mid-2016. In addition, as Susan mentioned, in the second quarter of 2016, we had a $0.01 benefit from an AWE contract settlement.

Homeowner services came in relatively flat for the quarter as revenue growth of $4 million was offset by higher claims expense and several true-ups related to our system implementation last year. Keystone results were also relatively flat for the quarter, although we are seeing increased activity and backlog expected to favorably impact the second half of the year.

Lastly, the parent was down $0.04 per share in the quarter. $0.02 was due to the onetime cumulative tax adjustment from the legislative change adopted in New York during the second quarter, which I'll cover in more detail in a moment. We also had higher interest expense and other of $0.02 to support growth.

On Slide 15, let me discuss in more detail 2 legislative tax changes that occurred this year. As I discussed last quarter, we had a legislative change in New York that no longer allowed water utilities to qualify for the manufacturing exemption. This will increase our effective state tax rate in New York beginning in January of 2018. Also, effective July 1 of this year, Illinois increased the state's corporate income tax rate from 7.75% to 9.5%. Both of these changes require us to remeasure our deferred tax balances at the new rates in the period of the tax law change so in the second quarter for New York and the third quarter for Illinois. This onetime, noncash, cumulative adjustment of the deferred tax balances will total $17 million. A portion of this adjustment calculated on a standalone basis for each regulated state subsidiary is expected to be recovered through future customer rates and will be recorded as a regulatory asset of $10 million in total. The remaining portion will be allocated to the parent through our state tax apportionment factors and will reduce 2017 earnings by $7 million or $0.04 per share in total. This earnings decrease is included in our annual earnings guidance range affirmed today.

Turning to Slide 16. Let me provide an update on our regulatory filings. We have $65.4 million in annualized new revenues effective since January 1 of this year. This includes $43 million authorized through general rate cases and $22.4 million from infrastructure mechanisms. We have also filed requests and are awaiting final orders on 3 rate cases and 2 infrastructure charges for a total annualized revenue request of $234.9 million.

Turning to Slide 17. Today, we are affirming our 2017 earnings guidance range of $2.98 to $3.08 per share. I would like to call out a few items that are included in the earnings guidance range.

First, weather variability of plus or minus $0.07 is included in the range. The third quarter is generally when we experience the majority of our weather impacts. And through July, we have experienced warmer weather in several states, approximately a $0.01 benefit versus normal weather in July. However, as you know, we are only 1 month into the third quarter. Second, as we mentioned at our December Investor Conference and previous earnings calls, we expect the lower capital upgrades in the Military Services Group to continue through 2017 due to the completion of the large project at Fort Polk in mid-2016 and reduced military budget. And then finally, included in the guidance range are the portion of the onetime cumulative tax adjustments expected to reduce 2017 earnings by $0.04 per share, as I discussed earlier. Again, these items are included in our affirmed earnings guidance range of $2.98 to $3.08 per share.

With that, I'll turn it back over to Susan.

Thanks, Walter and Linda. Before taking your requests, I'd like to talk a few minutes about customer-owned lead service lines and American Water's efforts to address this growing national issue. With the problems of lead pipe highlighted in Flint last year, we know that having confidence in the quality of their water is most critical to our customers. American Water has increased our communications and educational efforts to our customers about lead, and we're taking progressive steps to help them with their own lead lines. Our scientists, along with the EPA, have determined that when we're replacing our water main, it's in the customers best interest to replace their own lead service lines at the same time. So we're working with our states to develop plans to do just that, which includes a priority focus on low income customers.

Pennsylvania American Water has filed a PUC request to replace customer-owned lead service lines when we're repairing or replacing company-owned lines. Customers there who believe they have a lead line may also contact the company. And once verified, we would replace them over a period of time.

In New Jersey, we conducted a lead service line replacement pilot project in a financially distressed community and replaced customer lead lines when we found them. We're working with our regulators at the BPU on recovery of these investments. We will continue to replace customer-owned lead lines as they are encountered during our main renewal and replacement programs.

In Missouri, we have filed a plan and have already replaced around 60 customer lines in a pilot project. We expect to replace lead service lines of about 100 to 150 customer homes this year in Missouri. In fact, you can see a picture on the bottom left of an impressive hard-working crew with one lightweight on the far right side in her steel-toed boots and hard hat. While in St. Louis County last week, I had opportunity to watch our crews do a water main replacement and identify those homes with customer lead service lines for replacement. They said everyone was very positive, and one customer even gave our guy a bear hug.

In Indiana, enabling legislation passed for replacement of customer-owned lead service lines. We're working with the Indiana Utility Regulatory Commission for approval for our plan under the new law, including projects in financially distressed communities with higher lead line concentration.

And finally, the Virginia Department of Health is funding a grant program for lead service line replacements, and we're pleased that Virginia American was approved for some of the funding.

Our efforts are beyond anything that is required and are driven, first and foremost, by our commitment to the safety of our customers and our communities. It is simply the right thing to do.

So with that, operator, we're happy to take the questions of any of our participants.

(Operator Instructions) Our first question comes from Michael Lapides with Goldman Sachs.

Just curious on 2 things, one on your Regulated Businesses. You've got some pretty big rate cases outstanding, right? I mean, Pennsylvania, for example, I think Missouri, the other, both in the $85 million, $100 million range. Just curious, what's embedded in the multiyear growth rate for outcomes in those? And how such of those rate increases are tied to costs that you're not incurring today that you could pull back on if you get outcomes in those cases that turn to be a -- could be a bit less than what you're seeking?

So Michael, as you know, when we put together our 5-year financial plan, we look at what do we believe are going to be successful outcomes for us to continue to invest in our systems and make those rates affordable for our customers. So embedded in our 7% to 10% EPS growth range are those judgments that we use on an ongoing basis.

Got it. One other question. Can you talk a little bit about what you think the returns on invested capital are for your Market-Based Businesses these days? Are you earning utility like returns or something that are dramatically above or below that level?

Yes, Michael, we look at that from the standpoint of risk-adjusted returns. And so when we look at each of the businesses in our Market-Based Business, we kind of think of it a little bit differently based on the risk return profile of each of those businesses. So we've consistently said when we look at our military business, it's kind of regulated-like in risk profile, so you'd expect the returns to be somewhat commensurate with that. And then we look at homeowner services and Keystone based on their risk-adjusted return.

And also remember, Michael, these are very much a margin business. I mean, we invest very, very little capital, actual capital to the same point of it's not taking capital away from the Regulated Business because we do very little capital investment. And in fact, when we talk about the capital projects or the fixed capital upgrades on our military bases, that's working capital only. Because the way the Department of Defense operates is typically they like to own the assets, so we basically get recovery plus a margin on that working capital. So another way to look at it is it's more of a margin business.

Got it. One follow-up on that. Just curious, how is, given results for the first half of the year, the earnings growth expectations for the Market-Based Businesses relative to what you laid out at the Analyst Day 6 or 7 months ago.

Okay. Thank you, Michael, for that question. This quarter is down. We've talked about it this year. When we do our financial plan, we look at a 5-year time period. We also talked today earlier about the fact that our growth triangle is intact, so we do planning on a 5-year cycle. If we ever saw a point at which we did not think that the Market-Based Business over the longer term would be able to deliver what we've outlined, we would change it. That is not the case right now.

Our next question comes from Spencer Joyce with Hilliard Lyons.

One quick one from me, perhaps, Linda. I know we have 2 kind of discrete tax items to discuss this morning, both in New York and Illinois, and my question is if you are seeing any other measures in other states you operate in that could lead to some more of this type of item or if it really is just kind of a random event that we have a couple of these to discuss this morning.

So we have seen these 2 from a legislative tax change position. We have also seen in Missouri several of our counties are looking at changing the way that they calculate some of the property taxes in those areas. So we are seeing that across 3 of our states this year. We continue to believe that these items on the Regulated Business will be recovered through our customer rates, and so we're monitoring this very carefully so that we can continue to drive down our customer rates as best we can.

Our next question comes from Jonathan Reeder with Wells Fargo.

Just wondering, Walter, what's the remaining process for the McKeesport approval? I know you said you thought it could close later this year or early '18?

Jonathan, there are hearings actually today and tomorrow on McKeesport, and they have a 6-month requirement. So we're looking sometime in December to be able to get an order, and then we've got to work through just some issues with the DEP before we take ownership. So that's really the process. 6 months, we're a good deal through that and hopefully, we're going to take ownership at the end of this year or beginning of 2018.

Okay. Have the like third-party evaluations or valuations in the [commissions], have those come in already?

Yes, they've come in, and the commission is actually working through those. It's part of the evaluation.

Okay. But from your end, I mean, no issues there?

We'll, we just continue to work through the commission and any questions they have, and it's just part of the process, Jonathan.

Okay. Just wondering, Susan, are there any other states considering bills similar to the New Jersey Water Quality Accountability Act? Is that kind of model legislation that you're going to be pursuing in other states where you think it kind of opens up the door further for M&A opportunity?

I will start, and then Walter can jump in. So we absolutely believe that it should be model legislation for all the states across the country, first and foremost, because of the fact that the ability to ensure the safety and quality of water is something that every citizen should be able to expect, and it shouldn't matter who is running their water system as in terms of the quality of that water. So we think it is good model legislation. The fact, as Walter mentioned, that it was unanimously passed in the assembly, the Senate, is just really extraordinary in this day and age. So we're very encouraged by that. We do believe its model, and Walter can talk about any efforts that we've got going across the rest of our states.

Yes, just to emphasize, it is model legislation. And I think Senator Sweeney and Governor Christie did a great job just promoting the benefits for the residents in New Jersey. We know that other states are looking at similar legislation, primarily in the Midwest. And so we'll be working with them as we can in each of our states to make sure that we give our views as to the benefits about legislation and how again the purpose is to make the water safe in the communities that are in the states.

Right. And then last, I don't know if you guys have any thoughts, I know California isn't the biggest subsidiary for you guys, but the cost of capital proceeding there, ORA came out with their recommendation. What's kind of your reaction to that? Do you think a settlement on reasonable terms will be achievable from your end?

Yes, Jonathan, I think the ORA testimony was not unexpected. As you know, they put in there a lower ROE compared to our 10.8% ROE request. They did come in also with a lower cost of equity, just north of 54% where we requested 55%. So not unexpected on all of this. We will be filing a rebuttal testimony later this month, and then we would expect a final decision in the normal course by year end.

(Operator Instructions) Our next question comes from Angie Storozynski with Macquarie.

So I wanted to ask about your shale water business. I mean, it's broke even last year. It seems like we have some increased drilling activity in the Appalachian region and yet we haven't really yet seen the pick up of earnings. Why? I mean, is there basically a lag between when those activities pick up and when you record additional revenues?

Thanks, Angie. This is Susan. So you are absolutely right on all accounts. So what we are seeing in Appalachian is that we're seeing more active rigs. There's a timing issue there. And one of the comments I made is that we schedule projects -- we plan projects and schedule projects, and we have a backlog scheduled for the second half of the year. What we found in the Appalachian is that it did pick up, but it's not picked up as quickly. And interesting think that's happening in Appalachian now because things have been quite busy in the Permian that a lot of the E&Ps have actually had trouble keeping groups, keeping the crews on the rig sites, so now they're trying to get more people up here. So it's been a little slower than they thought. So that's one of the things that we're hearing from our Keystone Clearwater. They are now trying to make sure that we're able to recruit enough people. I mean, we have hired 75 people just this year and are trying to hire even more to staff our crews, so it's pretty competitive to get crews. Now with what's happening in the oil markets now, don't know if that's going to slow down in the Permian and release more for work in Appalachian. We certainly hope so, but we do have active projects planned. And interesting just from a statistic standpoint, as of July 28, there were 192 active rigs in the U.S. and 75 were in the Appalachian basin. And just last year, that was 86. So we do see an increase in the number of rigs, the number of completions and hopefully, some of the labor shortage issues will be taken care off so we can see more of a buildup in Appalachia more quickly.

At this time, there are no more questions in the queue. I would now like to turn it back over to Susan Story for any closing remarks.

Thank you so much. First of all, we want to thank everyone for participating in our call today. We value you as our investor owners and as the financial analysts who research our company for the benefit of your clients. We will always be open and transparent in all of our discussions and dealings with you, so you can have complete confidence in your decisions around our company and investments in our stock. If we have not been able to address any of your questions or if you have additional questions, please call Ed and Ralph, and they'll be happy to help you. Thanks again for listening, and we hope you have a great week.

The conference has now concluded. Thank you for attending. You may now disconnect.