Essential Utilities Inc (WTRG) 2005 Q3 法說會逐字稿

Good day everyone and welcome to the Aqua America Third Quarter 2005 Earnings Results Conference Call. This call is being recorded and at this time I’d like to turn the call over to Cheryl Hansen, Director of Investor Relations. Please go ahead.

Good morning everyone and welcome. We’re pleased that everyone was able to join us today. If you did not receive a copy of the press release, you can find it by visiting the investor relations section of our website at www.aquaamerica.com or by calling Christopher Pertell (ph) at 610-645-1020.

Presenting today is Nicholas DeBenedictis, Chairman and CEO of Aqua America along with David Smeltzer, the company’s Chief Financial Officer.

As a reminder, some of the matters discussed during this call may include forward-looking statements that involve risks, uncertainties and other factors that may cause the actual results to be materially different from any future results expressed or implied by such forward-looking statements. Please refer to our most recent 10-Qs, 10-K and other SEC filings for a description of such risks and uncertainties. During the course of this call, reference may be made to certain non-GAAP financial measures including the company’s EBITDA and earnings per share including one-time gains. A reconciliation of EBITDA to net income and non-GAAP earnings per share to GAAP earnings per share is contained in the investor relations section of the company’s website.

At this time, I’d like to turn the call over to Nick for his formal remarks after which we will open the call for questions. Nick?

Thank you Cheryl and good morning everyone. I’m pleased to report another strong quarter on the heels of two very strong quarters in the first half of the year. Just to recap the numbers which are in the press release for this quarter, revenues up 14% to $137 million. Net income up 16% to $24 million and earnings per share up 12% on 4% more shares outstanding from $.26 to $.29. For the nine months, revenues up 14% to $374 million. Net income up 20% to $69 million. Earnings per share up 16% from $.61 to $.71. And we’re very pleased with our numbers.

Year to date our customer growth has benefited greatly from two large acquisitions. We did in mid to late, mid-year in ’04 and a number of small acquisitions. I think we’re up to about 28 as we speak today.

We also received some major rate awards into, in mid year ’04 mainly New Jersey, Pennsylvania and Texas and they now all have been completely assimilated in the year-over-year comparisons. And as you’ll hear later in the conversation in the presentation, we’re ready to go back in, in two of those states in the next quarter and we have already increased the second phase of the Texas rates up 10% and that started in August.

Third quarter was also helped by a return to normal weather. It wasn’t a great summer but it wasn’t a bad summer. In most of our Midwest states and Pennsylvania, rainfall was slightly below normal. In a couple of our states, of course that depends on how hot the weather was and whether the rainfall happened after five days or after three days, the people have different lawn watering habits and also on a weekend. So it’s very hard to gauge just from average rainfall. But I can tell you that our numbers were more towards budget whereas the last year ’04 they were not. So that helped a little in the third quarter. It doesn’t have as much impact of course in the first quarter and the fourth quarter. Has a little impact on the second quarter, which includes your spring months of planting and so on.

So we, we’re very happy. We’ve assimilated most of this growth into our workings. And I want to talk to you a little bit about how the major growth we, that occurred over the past two years is now being managed and getting ready to go into rates as we fixed a lot of problems that we inherited with the AquaSource and the other acquisitions.

And to, just to put it in perspective, we normally predict that we can do 4% and if we do 4% we can get at least a 7% growth in revenue. And hopefully with retain, with controlling expenses and getting timely rate awards we should be able to translate that to probably 10% on the bottom line. In ’03 we actually increased 20% in growth, which is almost five years worth of normal growth. And in ’04, we increased over 10%, which was at least two maybe two and a half years of normal growth.

Now the-- normally when we do our normal growth, it comes in and starts earning what the rest of the organization earned immediately. On the other case in ’03 and ’04, most of that growth was high cost operations, which we’ve now got more in line with what we think is needed to run them. And they also needed a lot of capital, which would not be earning like we usually get timely rate relief in the north or have surcharge programs to get money back within a of couple months. In the southern states, we had to put a lot of money. That was not the case. On the other hand, we bought them at the right price and with the growth that we’re experiencing in the south we were able to make money on them. As we are waiting to get the benefits of going in for return on and return of. The major capital we’re putting in and I think you’ll start seeing that come to fruition as we talked about some of the rate cases we’ll be filing.

The, so we’re very confident that we can continue having our targets of the 7% top line and 10% bottom line growth, especially with the new platform we have now that’s assimilated this, well I’d say exceptional growth in ’03 and ’04 from these small systems into our revenue stream. And now we realistically are going to have to return to grind them out, block and tackle in the small acquisitions, which you see reported. We just reported some more yesterday. The second acquisition of a municipality in Illinois so you can see each of our states now are targeting not just private but public companies too. It takes a little longer that one Philo I think we were talking to the people for over two years, but they do come to fruition eventually because the logic is there.

We have a number of larger ones to do for the fourth quarter. We have a 4,000 customer system that we expect approval by the BPU in New Jersey next Thursday and we’ll close by the end of the year. In Pennsylvania we have already gotten approval and it’s waiting for closing, a 2,000 customer development in the Pocono’s. In Ohio, we have, we’re on third reading on November 16th and then a 30-day referendum period. But it’s been endorsed by the mayor who just overwhelming received reelection yesterday. And that’s a 3,500 person system through our Struthers Development and it will be merged in nicely with that. And we have an announcement we made I think about a week ago, not publicly but the local community announced that they would be selling it to us about 600, 700 customer system in the fast growing area of Lake Holiday in Virginia. And we also have some, we’re looking at in Texas. Now these all may close in early December, late December, early January, so I can’t say they’ll all close by December 31st, but these are all ones that we’re putting the final touches on to get closed into the, into the books.

Also the, I’d like to talk a little bit about our efficiency. Very happy that we’re still moving in the right direction as you can see. The only issue that hit us a little bit this quarter and I’d like to drill down a little bit cause as you know I really track this and I think this is why we are able to get most of our rate awards when we go in for the capital which really benefits the shareholder. The third quarter, although we had a good third quarter, it was down considerably from the second. I think 38.7 versus 41.3 and for the whole nine months it’s 40.7 to let me say, here they are-- 40.7 to 40.4.

The areas that hit us a little bit this time and I want to tell you what we’re doing to correct it. What I call controllable expenses. The only two that and I think this is very understandable rose up in the third quarter more than we thought they would nine months ago was the gasoline related. And of course, the south where we have trucks versus pipes interconnecting our system, that is an issue. We’re starting to see gasoline prices come down again now so hopefully we think the worst is over. And nice sunny day here in Philadelphia so hopefully the same way where you’re all calling from and that means less heating oil being used in a crucial time period, maybe bring the price of gasoline down.

The second issue was the healthcare and pension. And, I’m sorry before I go on to, which I’ll call uncontrollable, the other controllable one that is going up is chemicals, although it’s not a big piece of our O&M budget, labor, benefits and electric and fuel are the biggest. Chemicals the chlorines and the aluminum, alums, and sodium hydroxides that we add to our water supply are starting to creep up a little bit. We think there are limited a lot of it’s fuel-driven, oil-driven pricing. But we did see a little bit of the kick in that, in the quarter on that also. But the bigger hits to our expense side, even though we show good positive results, it would have been better, are two areas that I want to drill down a little bit and say what we’re doing with them.

One is our pensions and the other is our healthcare. When we purchased AquaSource, we decided that we would not go with the traditional indemnity type plans and retiree healthcare plans and so on. And we started all new employees coming in under a different plan, which means that we limited the old plans until they basically ran out. To give you an example, about 60% of our employees now, we have about 1,500 employees, are on, are on what’s a self funded PPO. And then the bulk of our other employees from the consumer and Philadelphia Suburban companies that have been with us for a long while have been kept on an HMO. And that’s about 40% of the company. So it’s about 60/40 now that every year the self funded grows and the other diminishes.

And in ’03 and ’04 it was a tremendous decision because not only did we pay less in premiums but we didn’t even have the risk, we didn’t have any major claims against the reserves we had set up. And under the new Sarbanes-Oxley rules, you have to take those reserves back if it wasn’t used. You don’t carry them over year over year like a trust fund.

This year we had to budget feeling it would be some of the same experience and early in ’05 and into the third quarter, although we have a stop loss of 1.25 on any claim, anything over that is paid for so we wouldn’t get hit with someone who’s drastically ill and needs hundreds of thousands worth of treatment. We had just an abnormal according to the actuaries, number of cases four that hit the stop and eight who came right up to the stop, all occurring within a three, four month period. And that did, that did mean that we have to then put into the reserve and that did affect earnings in the quarter and in the, a little bit in the second quarter. The good news is the experience going into the fourth quarter has been much more normalized towards the ’03/’04 levels. And hopefully it was just a bad spout of experience. Our employees on this plan are normally the younger employees. So you would expect them to use less of the, of the benefit.

The good news is on the HMO side for this year we’re getting renewals with an actual decrease. That’s unheard of in today’s healthcare. But we’ve been able to make some plan designs and our experience there was good last year so that that one is not going up as, but the other, the PPO obviously we’re budgeting higher numbers, assuming that we could have similar experiences we did this year.

The other’s on the, on the pension and I wanted to let you know what we’re doing there. With the defined benefit plan, which was traditional with most companies in America, what we’re seeing today is public service unions, governments, utilities still carried defined benefits. And in many cases, with very little contribution towards the premium on healthcare and having retiree and what you’re seeing is manufacturing companies now either by bankruptcies or by other reasons, limiting or freezing or getting rid of their defined benefit plans.

Example a couple of the airlines, one of the ways they’re surviving and the legacy airlines are surviving are by going to the bankruptcy route, getting rid of their pension liabilities. And then the government basically ends up with that liability and I think it’s called PBG--

Pension Benefit Guarantee Corp.

Okay, so the more bad plans in there, they ask the more good plans to help pay the premium on it, so it’s going to help all the rest of the healthy plans. And the ones that we’re very nervous about, of course, are the autos, which there’s been a lot of discussion in the media and so on about the long-term legacy liabilities they have in their plans.

We looked at this two years ago and started taking action and, which is probably not traditional for a utility. And basically all new employees have an enhanced 401k, which is portable and I think younger employees would rather have portable benefits. And no one really asks when they get hired whether my defined benefit plans when I reach 65 with your company. So it has not hurt hiring. And so what we’ve basically done is limited the number of people on the former defined benefit plan to our existing retirees and that’s about, I have the number here, 398 so nothing like autos. We have 398 living retirees based and we have about 1,550 active employees, of which less than half are covered by the defined benefit plan. Now all those may not stay. All those may not retire. But basically we’ve limited and all new employees are no longer on that plan.

Now what’s happened? So therefore, we’ve limited the liability somewhat. But what else has happened is although our investment portfolio and our plans we keep fully funded. We add contributions when needed to make sure they’re fully funded. Our investment results have been fine. I think over the last ten year our [inaudible] over 9% and you have to put in to this formula what you think you’ll earn on your assets. Now everybody got hurt in ’01 and ’00 and ’02. And that really hurt and made a lot of companies have to put a lot more money in.

The other thing that’s affecting and this is affecting America cause we don’t have a separate number, but [inaudible] at the end of the year, whatever Dave you have to help me, is this the 30-year Treasury they go by?

A discount--

A discount--

Rate.

Yes, whatever that is, it is and for the last three years the discount number has dropped precipitously from almost 7% down to 5.75%. Now we don’t know what it’s going to be at the end of this year. I think it’s getting towards the bottom but if it drops again another 25, 50 basis points that means we have to add more of into our pension plan each year. And that has had a significant effect. We look at this year’s versus last year’s, Dave we’re up $3 million in expenses?

Right.

So you take a look at our total loan end number and you add the healthcare and the, and the pension, I think you’ll see that’s where a lot of the growth in the O&M number in total is coming. And then when you put that into the O&M to revenue ratio, it’s made it more difficult for us to lower the numbers. Now if we have the old days when the market’s gone up faster and the discount rates not gone down, you’ll see that turn around. But in the meantime, we’re putting money into the pension plan and charging it to earnings. So sorry for the longwinded thing, but I think that’s needed to understand what we’re doing.

If you look at our labor costs, our electric costs, they’re still growing much less than the revenue side. And therefore that ratio should look well, to look good in the future.

The other thing I want to remind people is that two events, one 4Q in last year’s Q4 and also the fact that stock gets split effective stockholders of record November 17th, and the actual split occurs on 12/01. So your fourth quarter numbers should reflect that 4 for 3 split. This will be our 7th, 6th split in how many years?

Nine.

Nine years. And our 15th dividend increase in 14 years is accompanied by a 10% increase in the dividend. This was some-- this is old news. We announced it on August 2nd when our board decided after having our five-year strategic plan that they would take this action. And now it’s getting implemented.

The other thing was in Q4 of last year, so if you look at GAAP earnings, we earned $.24 last year in the fourth quarter, up sharply from the $.20 the prior year in ’03. And but $.02 of that or half of the 20% gain came from a one-time sale of our Geneva system. And under the new rules in accounting that is handled as, it’s not handled like it used to, which is a gain on sale of properties or something where it’s offset. That’s actually now in the GAAP earnings. So if you take operating earnings, ‘04’s operating fourth quarter would have been 22, up from 20 the prior year. And that’s our normal, what we hope to be our goal of being able to grow the bottom line 10%. So I ask you to look at that because we do not anticipate anything like that in the fourth quarter of ’05. It’ll all be just normal acquisition growth, normal rate recovery and normal expense control.

The other thing I’d like to comment on is the capital spending we’ve been doing and the fact that we are now ready to go in for some major rate relief based on the fact that we’ve been spending a lot of money on pipe and new plants in a traditional consumer Philadelphia suburban properties, I’ll call it the Aqua Midwest, Aqua Pennsylvania, Aqua New Jersey area. And a lot of money to get out a consent decrees that were left to us when AquaSource and Florida Water left the businesses. And we felt that the only credibility to build in the southern states was to first to fix everything, get rid of those consent decrees and show the regulators that we were long-term players and that we were credible. Then go in for the rate relief we need. And I think that is better for the company long-term. The worse short-term for income and net income, but it’s much better long-term. And I think most of our investors are long-term investors and that’s why we made that decision.

Just to give you an idea, this year we’re, our capital budget’s up $260 million. That’s up from probably $125 million pre-AquaSource. So you can see the kind of money we’re spending both in the older states but we’re putting even faster amounts of pipe in to keep up with standards. And then of course the major expenditures we’ve been doing especially in the Fort Wayne area in Indiana, the Sarasota area and all throughout Florida and of course Texas, which had a major consent decree that we had to fulfill in over a thousand systems and of course North Carolina, same thing.

So let me go over a little bit of the, of the rates that we’ll be received. And then I’d also like to give you what the long-term implications of this is because when you put a lot of capital in and it’s not all pipe, your depreciation factor also increases. Now that hits expense so it’s hurting earnings, if you want to call it that. But it also means that you are allowed to recover that in rates. And if you are successful and we’ll be seeing that over the next three to six months to nine months, what that does is provides you with increased cash so that it’ll support your ongoing business, which as you know is to reinvest in these systems buy our older systems and fix them. And just continually consolidate and become a national footprint.

So just to look if you, if you refer to your depreciation increases, you’ll see that it’s jumping pretty heavily. And I think this quarter to quarter was probably over 10%. I was looking at the cases we’re going to be filing. In some cases, they’re up even more than that, mainly in the depreciation areas. So yes you do recover it. Yes it counts as an expense. But the cash it generates is going to help us support ourselves going forward.

Now to talk about rates, cause I really think this is the biggest advantage and also challenge we’re going to have going forward over the next four quarters. We’ve done very well in the first two quarters. We’ve received, of course I mentioned to you that we had huge cases that we received in the mid ’04 and that’s helped us unfavorable comparisons all the way through this quarter. We also got about $3.5 million in rates in the first quarter. The bulk of that being the [disk] in Pennsylvania, which we started in the first quarter of ’05. In the second quarter, we assimilated $6.3 million of additional rates. Again the [disk] in Pennsylvania, but we received a major case in Vermillion, which is our Danville operation in Illinois. And we also, I think that was about 12% rate increase. And in North Carolina, we received a significant rate increase. I think that was in the teens also and accumulated to about a million and a half, and we considered three or four small wastewater cases in Pennsylvania. So the 3.5 plus 6.3 in the second quarter.

The third quarter we have a number of cases. They’re in the final stages. And they amount to an additional, this is without the [disk], of course the [disk] was another $3 million in Pennsylvania. But that plus another about $4 million of cases that were filed and we expect to receive results by late ’05, which would be sometime in December or early ’06. Three cases are in Illinois that was the risk factor there was about $1.2 million. And we just heard yesterday that the judges ruled 4-0 in Illinois and we got about 80% of our request, which is, which is better than normal from, if you, those of you who follow rate cases. Usually you don’t get what you ask for because they, you ask for what you think you deserve on the return on equity, which is usually in the 11+ category, and sometimes the return on equity comes in less than that. In this case for those of you who follow that piece, our ROE was 10.4, which is up from the cases in Illinois in the past. We don’t have a written order yet, so I’m giving you that as just what we’ve heard over the phone from our counsel.

In Missouri we filed for over $1 million in rates. We expect some ruling from Missouri late this year. We have eight cases ongoing in Virginia and three cases ongoing in Florida. So you can see we’re starting to file in these small systems and where we’ve put money in. And have not gotten any recovery yet. And in southern Indiana we have two cases filed in July, which we anticipate an answer by the end of the year. That’s for about $300,000.

Now these are cases that we will be filing over the next three months. None of these have been official yet, so I’m just going to give you a, names of the states, not the exact amount, but they total over $58 million. So you can see this is the big chunk that’s going to be going in. If it goes in over the next three months, six to nine months later is when you get your results on these. That’s Pennsylvania, New Jersey, Illinois, Maine, a major case in Indiana, Ohio we have two cases we’ll be filing, Florida, a major case in Sarasota and New York, another index filed in New York.

So you can see we are very much now concentrating on getting fair return on the monies that we’ve been putting out in a timely manner. And we have had some lag and will continue to have some lag in the southern states. We’re very careful trying eliminating lag as much as possible in the northeastern states. And [disk] has helped us a great deal on that. But with a $150 million capital budget in Pennsylvania, which included a number of plants, you can’t avoid the lag. And with interest rates going up a little bit on the short-term side, you’re starting to see that affect us.

So on the other hand, when and if we’re treated fairly, which I anticipate we will be, in these cases we will be able to recover some of the quote uncontrollable costs that we’ve had to put out that aren’t in our current rate, i.e. pension, healthcare, and we’ll also be able to recover fair return on the equity and also on the debt side for there’s $260 million worth of capital that we’re spending this year.

One more thing I’d like to talk about the debt. We are now closing in on a $1 billion in debt and that doesn’t scare me because we’re, of our rating and the fact how we do our debt and I’d like to take a minute on that. We’re about 875 in traditional long-term debt, about 125 in short-term debt, which means we’re going to move that short to long as we go into these rate cases. We’re finding the flat yield curve being very positive to do that with. And although the rapid rise in short term has cost earnings to us, basically we’re at this time last year, I think we were about 2% over. We borrowed 35 points over LIBOR, basis points over LIBOR. And I think this time last year, we were under 2%, carrying short-term debt. Now it’s up to about 4, so you can see that’s a little bit of a hit to our cost to carry on this capital, especially at the levels we’re at.

But with long-term rates staying so low, with the long-term nature of this investment and for our shareholders and our customers, it’s the best thing, to move it in the long. And as of 9/30, with all the refinancing, capital we’ve been borrowing on the new capital, we’re doing tax freeze in many states and low-interest loans from the state, our weighted cost of capital and that is less than 5.7, well it’s actually 5.74%, less than 5.75.

I have to put that up against any utility as to how much they’re carrying their long-term debt at. And we are [incentivized] on that. That helps the customers. All our goals are geared to how much we can keep the average weighted cost down each year. And each year, we’ve beat it by doing innovative financing and basically the hustle factor, getting on the allocated list from each state governor and then getting those low interest loans that brings the cost down for a long time in the future.

So, I wanted to give you a little bit more detail as to what’s the basic underlying things that other than just the net income and normal growth things and so on. I think that’s important. And what you’ll see is EBITDA continuing to grow over 10%. You’re seeing depreciation growing at, accelerating, which means that the little bit of a pressure on earnings, but a very positive to the cash generation. And it means that going in every other year on these cases is very important so it doesn’t give you too much lag, but it does give you a very positive cash flow so that you can support the future capital programs, which we know are going to have to continue to get our water infrastructure in this country where it should be.

I think I did everything. Yes, so [inaudible] explanation with interest and everything else, I think, I think you, we think we’ll still be positive on the O&M to revenue ratio over last year, which without Geneva was in the high 40’s, it was 40.7, 40.9 and we’ll still bring that down somewhere in between the 40 and the 40, will definitely be between 40 and 40.9. I can’t tell you where it’s going to end up without the final numbers on the healthcare and so on. But we’ll see a decrease but probably not the 100 basis points that I was hoping to see this year. But we’ll be back on that pattern next year.

Open it up for questions.

Yes, thank you. The question and answer session will be conducted electronically. [OPERATOR INSTRUCTIONS] We will take our first question from Michael Gaugler with Boenning and Scattergood. Please go ahead.

Morning Nick. Morning Dave.

Good morning Mike.

Congrats on another good quarter.

Thank you.

Just kind of a follow-up on expanding the footprint of Aqua a little bit. I know last quarter you talked about wastewater opportunities. And I was wondering if you were seeing any more of those or had seen more of those in the past quarter and going forward?

Yes we are and in the southern states especially but we’re starting to see some of the older towns talking to us about you own our water, would you consider buying our wastewater? So I’m working on some national legislation that I think is needed to protect private interests going into the water systems. I think a bill was passed down in the Senate, a bill was passed down to Senate which was very positive.

And I think we’re going to see that area growing mainly for two reasons. There will be no federal grants with the deficit to bail out the cities. We’re not talking about Philadelphia, New York. They’ll raise their rates and do it themselves. But it’s the small towns. As a matter of fact, we were asked to put a bid in on the water system in a little town called Greenville, 3,000 customers, Pennsylvania and this was about three, four months ago. As we were doing our due diligent, they said we’d also like you to consider the wastewater, which would mean now 6,000, 3,000 water, 3,000 wastewater that we’ll bid on. Whether that’ll ever happen or not, I don’t know. Sharon, Pennsylvania has asked us to look at their wastewater.

The other part of the wastewater that we intend to grow and we’re talking to a number of people is in the, what’s called the [Septage] business. [Septage] is what is in, what ends up in septic tanks. In other people, not everyone is on a public sewer system and they sometimes have backyard septic systems and there, and you need to clean those out and take them to a viable treatment facility, which of course we have. We bought our first company in southeastern Pennsylvania. It’s beating all the goals we set for it. And the small business type organization, no one is too big. No one’s much more than $5, $6 million in revenues. But there’s a lot of them in all different areas of the state and also every state. So we’re looking at that as another area that we’re concentrating on growing in.

All right that’s--

I just covered those two cause you said wastewater. I mean obviously water’s still going to be the premiere part that we’re looking at. Of course--

All right. You guys did a good job on the overview. So that’s all I have.

Thank you.

Thanks.

We’ll take the next question from Doug Thomas with JET Investment Research.

Hey good morning Nick.

Morning.

A quick question, you did a good job I thought of outlining some of the, some of your issues with respect to the regulatory effects of utilities and private equity buyers. And I’m just wondering maybe you can talk a little bit about the environment. You know we’ve got RWE now announcing that they’re going to sell, basically sell American Water again in Thames and so forth.

Right.

Are you, did you make the statement because you are aware that there are books out there and that there are, that the there are, financial buyers are stepping forward here. Or what’s, what does the environment look like?

Well first of all Jeff thanks for asking the question because it looks like I was a prophet in the sense of giving a speech, putting a press release out and then four days later American, I’m sorry RWE announcing they’re considering selling it to financial buyers or an IPO. But if you look back for the last year I’ve been making these statements. And I guess the policy walk and from my regulatory days.

I just think, I didn’t think the electrics would follow the model correctly when they got into the program. And I also, and they’re in and out. That was the Enron model, which thought they could trade water, which like they were going to trade electric futures. And the European model, which I guess now after our experience with the [NaVende], [NaVende’s] experience or Veolia’s experience with U.S. Filter. And now RWE’s experience and Nuon’s experience with the two companies they bought, I think it’s clear that the European model, which is based not on asset investment but on operating efficiency and long-term contracts and political relationships. And I don’t mean that in a negative sense. In other words, having to know that you’re going to have the city of Paris for 200 years, you can do a lot more planning then if you think every five years you’re going to get a bidding process. It just was clear to me Doug that the numbers are not, they’re not going to do the same type of numbers that we’re looking at, which gives you the cash flow. All that discussion I gave you on depreciation and EBITDA--

Right.

To start investing. So you have, you had the European model, which was we’ll run it for you but somebody’s got to make the investments where we can’t be efficient i.e. Atlanta after three years and United breaking off their relationship. Indianapolis is current controversy regarding their relationship with Veolia. And I think all the companies that were European decided that they could use the United States obviously people pay their bills here. They gain the instant expertise of great companies like United Water and American Water. I can’t say the some for the third company because it’s so small I don’t think many of you know it, it’s called, a company, little company called Utility Inc. that was purchased by Nuon.

But the-- then what happened was when they, when they started to become a cash drain, these companies say way, we like cash positive. Well that’s almost impossible if we’re going to rebuild the infrastructure of the United States. So now the latest entry is invest, is not investment bankers but equity fund. Now if an equity fund says, we’ll be around in 100 years. We have all the money you need to reinvest in pipe and take slow returns. It’d be negative cash. Then they belong in our field. Our investors want dividends. They want security of product. They’re not looking for 12-- they’re not looking for I guess we’re looking high teens, probably returns. They’re not looking for a situation where maybe the company could be sold in three to five years, which one of the equity funds said they were long-term in nature and then three to five years they would be holding the product. Now if that same fund said no, no we have a fund that’s going to be locked in place for 50 years, different story.

Let me ask you this though. Have you seen any change in the, in the U.S. in terms of the domestic regulatory climate based on, is-- are the America guys still functioning the way they are and over time, who do you see as the ultimate, as your ultimate competitors or colleagues in this business here if in fact a lot of these assets are going to come back out on the market? And sort of just to follow up on that, does it make it more difficult for you to go in and get rate hikes the way you would like to if in fact you’re competing with private equity guys who are saying, oh no, we can do it for much less.

The private equity guys aren’t going to be saying that. They’re going to say, we can give you all the money you need. But you’re going to see seven different, this is me speaking. I can’t say cause they haven’t asked us for anything. But I think if you look at the traditional private equity structure, you’re going to see LLCs not corporations. You’re not going to see Sarbanes-Oxley type transparency in board of directors. You’re going to see a general manager versus a general partner versus a board making the decisions. You’re going to see probably two, three, or possibly four levels. No ring fencing so that the assets are locked into the state that’s regulating it. And I think you’re going to see possible and I’m not saying this going to happen, but the possibility of a leverage factor in the pyramiding of those different legal structures that may not be allowable in some state regulatory climates.

And if you look at the two that have turned down private equity investors who wanted to buy electric companies, Arizona and Oregon, you’ll see that was probably the primary reason because the equity funds were very truthful and ethical. They said this is how we’re going to fund it. And it was very clear that it wasn’t a traditional 50/50 model where you borrow 50% of your money. You put 50% of your own money up. Therefore, you’re locked. You’re going to stay in the water business. And you accept a, like I just mentioned, a 10.4 return. Now I don’t know how many high net worth individuals are going to say, we’ll take some risks and yes, sure. If you give me 10%, I’m happy with that.

Okay.

And I think that’s the, that’s the disconnect that I see. Having said that, I’m sure they’ll hire good people. I’m sure the companies will be run well. And I want to comment on one other thing you said Doug, the colleagues is the right word. We don’t compete. As a matter of fact, we’re all in the same association. We’re trying to explain to regulators what we need in the water business. And it’s been a very good relationship we’ve had with the British counterparts of American Water over the last two years.

And I think the only negative that we’ve seen in the regulatory front because of the foreign ownership is there’s a little bit of myopic thinking on the part of a lot of local public officials and it may translate even to the state that foreign interests owns something as crucial as a local water supply. And the answer was, yes but these are long-term companies. They’re going to be in it for the long term and we’ve seen Nuon in and out in two years.

Right.

And we’ve seen American now unfortunately and I can imagine what, it does not bode well with employees to be bought and sold in a five-year period twice.

Right.

So I think that hurts our industry and therefore the regulators probably are looking at it as a net negative. Now having said that, I don’t think we brag and are proud about being America’s largest water company. So I think it actually, in a way by comparison could actually help us.

Okay. Thanks Nick. I appreciate it. Keep it up.

Okay thanks Doug.

Next is David Schanzer with Janney Montgomery Scott.

Yes good morning everybody.

Morning Dave.

Just wanted to clarify some things from the results. That it more look at it in a certain way. The performance in terms of revenue and top line had to do primarily with the fact that the weather was offset by rain. Is that pretty much the way and that sort of made a normal environment for you? Is that the--?

That’s right. We did have hot weather.

Right.

But we had enough rain that people and a lot of it was weekend rain that people didn’t use more water than normal. They did use more water in ’05 in Ohio, Illinois, and Pennsylvania than they did in ’04 however. But ’04 was a bad winter year, summer year and we did all right.

Right. And then you were very clear in terms of enumerating the things that were affecting or impacting O&M. I guess my question is that kind of gives you kind of a 10% area to work down by reducing some of those items. I mean I think you might agree that O&M was probably about 10% higher than--

Yes.

You would liked to have seen it. My question is for how many quarters going forward do you think it’s going to take to get that 10% kind of back down from normal. I mean it’s not going to be able to be done right away.

Well--

Because there’s external factors there.

Yes, I’ll, I think and I’ll let Dave help me with this. I think the bigger hit on the pension Dave came between ’05 and ’04 comparables. Because we now have the new funding level, short of the discount rate dropping again from 5.75 drastically like below 5, it could even turn around and go up which would help our pension numbers. We’re not under funded in the plan. That’s why we put more money in. There are two or three bills being considered by Congress now that could affect pension plans in general. And I honestly believe personally this is not an easy thing for employee relations, but that these defined benefit plans are going to be Neanderthals. And we’ve taken the position to posture ourselves, so we’re not going to be the last one to turn the lights out.

On the other hand, as long as the regulators allow it, we get it back it’s just the lag. And I think regulators will allow it because utilities, public service companies, and governments are the last of the U.S. industries I guess. And that’s the one where the unions are strong and they want to keep these benefits. So as long as it’s allowable, the only problem is lag. And what I guess I’m saying long term is the lag is now. But once, unless these bills change things drastically, unless the discount rate drops drastically from 5.75 something below 5, we should be accommodating the current amount we’re putting in, in each of these states that’s already in earnings to accommodate it. And that was a big hit between ’04 and ’05. David, am I okay on that or do you think there’s going to more?

No I think you’re right on. I think we still see continued upward pressure beyond the normal expected level of increases in things like benefits, insurances, in power and chemicals--

Yes.

Related to the oil.

That’s traditional in thinking.

And I would electricity as well, yes.

Going to hit us too David. You know because these de-reg states are now going to be coming off and--

Right.

Now luckily as you know we are base load. We have, we hired the fellow from [PECO] that tells us when to turn the switch on and when not so we get the lowest rate. But the water companies if they run their systems right, should be the beneficiaries of base load usage, which keeps your rates. Cause that’s what everybody, every nuke wants to sell its base load first, guarantee their price. And then if you want to use a lot of electricity on the hottest day of the summer, that’s when you’re going to pay maybe a $1,000 a kilowatt. So megawatt, excuse me. So that’s our protection there. But I think we are figuring probably an 8 to 10% increase in power too.

Right.

Over the base of the whole company, Texas especially and so on. But again that’s in these rate cases that we’re putting forward. So that won’t be lag cause we’re anticipating that and we’ll argue that in our rate cases because of what we’re hearing what the electrics are doing.

Chemicals are not a big piece of our budget but that’s something that we don’t have buying power. I mean if chemicals go up because up across the country to the municipalities too and that’s one where I think the, they haven’t been able to raise prices for a number of years. And I think with the oil, everybody’s blaming the oil price increases.

Yes, okay. I’m sure you’ve noticed that the temporary insanity in Illinois seem, the fog seems to have lifted. I guess my question is do you think sanity will return? Are we hearing anything about who might be the new chair of the Illinois Commerce Commission?

Well as you know Dave I usually stay out of the politics and don’t know much [inaudible] baseball but we got a 4-0 vote yesterday. I think this tells you something.

No we’re not hearing any rumors as to who the new chairperson is.

I am hearing some names. It will not be obviously the head of the consumer advocate. That person did get turned down Mr. [inaudible].

Are these more reasonable ideas?

Yes I think so.

Okay. And then lastly, you were talking about the private equity people coming in, into the industry. Are any of them interested in some odds and ends, New York water utilities that you might have do you think?

Well I think, I think if the, there are some quote small private equity people, which probably would buy some things, look at them as an annuity and be willing, and they can run them properly. Our New York property’s only 2,000 customers. I think it’s the bigger buys where you’re in 12 states, 15 states that makes it difficult. Because then you’re really running a full company. It’s not just hiring a professional guy who used to run the or woman who used to run the local water company to run five, six small systems and you make a few bucks on it.

I do think you did hit on another thing though. I think some of the discussion that will eventually take place because I think with American being the largest asset ownership, American Water and in 22 states, there will be whether they go with a private equity fund or do it themselves before that a number of I’d say less condensed state properties that probably for the efficiency of the whole system should be sold either to municipal governments or a company like United or Middlesex or something like that. That’s probably a bad example because New Jersey’s way too big.

But they have small-- let’s take Virginia. I think they only have 10,000 customers, 20,000 customers in Virginia except for Fairfax and I’m sure the authorities around D.C. are already analyzing the property there. I think you’re going to see a little bit more of that. And obviously we want to be in that mix as long as it makes sense. I was asked to, if we were interested and I said how, how can I say we’re interested when we don’t even know if when it’s for sale and how much it’s for sale for? I mean we’re interested if it helps our shareholders and we can help the customers of American. Other than that, it’s difficult. I don’t, I think the competition with equity funds, you can’t compare the two. One’s going to be a different model and I’m sure will be acceptable to the regulators. The other will be one that the regulators are really going to have to study, which is more of the financial model.

Okay great. Thanks.

We’ll now go to Debra Coy with Stanford Washington Research.

Yes, good morning Nick.

Good morning Debra.

And Dave. A couple of questions. One just going back on the, on the CapEx, you mentioned that you were budgeting around 265 this year, up from about 125 where you were before the AquaSource acquisition. Can you give a sense of how leaving aside any additional large acquisitions like American Water Works, kind of what your CapEx budget looks like in say 2006, 2007, 2008?

I think you can anticipate a more normalized acceleration in growth. We used to grow CapEx 8, 10% a year. And that gets you in the range Debra that doesn’t give you too much risk in lag. The fact that we’re doing more pipe now then plants in the northeast gives us less risk so you could accelerate it faster and get faster recovery. Plus the depreciation alone, Dave help me? I think we were, we’re up to about $70 million now in depreciation?

Annual.

Annual. And I bet you before AquaSource, we were less than 50, maybe 45. So Debra right there’s $25 million more we have to spend just to, just to tread water.

Well right. Because as you’ve moved into some fix up properties in some of the southern states, you are spending money on shorter term depreciation CapEx rather than pipe?

That’s exactly right. And we’ll continue and a lot of that’s going to be growth properties. And I think you have to look at it as almost two companies. The traditional company, which will be probably in the, let’s take the quarter billion spending level. Probably of that quarter billion up to 200 will be used for fixing old systems that we’re buying and/or just maintaining and upgrading our existing systems. And the other 50 would be really for growth projects, some fix up in the south but mainly for growth projects. And that should generate free cash immediately.

Okay that helps.

Our shift as we grow more in the south and if there is any opportunity for us in some of the European owners that are thinking of selling their properties, obviously it’ll, we’ll look at those also. But I think we’re going to see almost a shift of cash coming out of the bigger depreciation from the traditional. The cash you get back from the surcharge and the cash you get back from actual running systems that are not very sophisticated but you just have to watch expenses and watch-- and their growth is good. Texas and North Carolina was 6% this year to date and Texas is 4 and we really haven’t started quarrying yet. That’s just on the normal process we bought. I think we’re going to have like a little bit of a, one company supporting the other company. So we won’t--

Yes.

Probably won’t have to go to the market as much for new equity. We’ll use some of our own.

Which should be good for EPS?

Absolutely.

Yes. All right understood. And then just to follow up on all the discussion we’ve been having about RWE and the private equity firms, I wonder if you could talk about your view on what happens if they do decide to do an IPO instead. I mean I think that it’s pretty clear with the financial returns are that private equity guys are looking for, I would think it would be very tough for the private equity guys to make the numbers work relative to where the stocks, even not including yours, are trading at? And I guess the question is, one of the things you’ve talked about that Aqua has benefited from is the scarcity premium, if you will, since we lost American Water Works and Aquarian and United Water, how do you see it impacting the marketplace if these companies come back as potentially publicly traded stocks versus being buried in the European owner or in a private equity fund?

Well I think from what I’ve heard from investment bankers and we’ll keep it general is they feel that putting, if they were to go back on the market as an IPO, whether now or when the equity fund buyers buy it, they do it three years later. Either way--

Right.

The theory is that there’s so much thirst on the plan for long-term dividend paying stocks, that it’ll just increase the interest out there. Now I think if you put 100 million shares on the market, which is how many American had when they left, they haven’t really grown their assets much. So I’m assuming you could, theoretically say the same thing. And I think they sold at $45 or bought at $45.

Yes it was $4.5 billion.

Yes, so if you figure that that’s what they want, I have no idea what their earnings are going to look like after the prospectus. But I’m pretty comfortable that they’ll be getting, if they get what they pay for it from the equity fund, probably close to what the trading multiples are on the market today. Maybe we’re a little higher but I think we’re better.

So I think I welcome either way if they want to look at it. Obviously I think probably efficiency wise, probably selling this one to this one doing this different. I mean they have a lot of options open to them cause they have such a huge amount of assets.

But this is such a long process as you remember. It took them almost two years to get through the sale before. And that sale if you remember was to go from a publicly traded company to private, but with the largest water company in England saying we will provide you capital. We know what we’re doing and so on. And a lot of that was the selling point. And a very fair selling point for a regulator who was nervous about foreign ownership but said yes, but we’re getting the best and the biggest and less cost in capital and best practices and everything else. If you say now we’re going to go back as an IPO and then you have to look at who is there management team? And what do they bring to the table? Because the regulators care about the customers not about the shareholders.

Right. And there isn’t any real precedent in this business for water, big water IPO’s. We just simply haven’t had that.

Yes we had one, Enron.

That one doesn’t count. It was regulated utility. But I have heard that from a couple of regulators that they’re, they don’t really have the-- there isn’t really the precedent for looking at this because they’ve mostly been looking at acquisitions not at IPOs.

Right, right. It’s all new territory just like deregulation on the electrics was.

Okay. Thanks Nick.

Okay.

Keep it up.

Thanks.

And at this time there is one name remaining in the roster. [OPERATOR INSTRUCTIONS] And we’ll now go to Stewart Scharf with Standard & Poor’s Equity Research.

Good morning.

Morning Stewart.

Hi, most of my questions regarding American Water Works have been answered. But just a couple of quick ones. On the O&M expense ratio declined by a fairly large margin sequentially. I was wondering if you could discuss that a little bit.

Sure, that’s, Stewart that’s fairly normal because you have more of your revenues coming in on the summer months. So your denominator gets bigger in the summer and your expenses normally the only variables are for that larger revenue stream are maybe some more chemicals, some more electric to pump the pumps. You don’t hire any more people because you’re pumping more water in the summer nor increased trucks and so on. So you’re, it usually goes down between the second and third quarter.

We wanted to show the comparison because if it doesn’t then that means you’re getting more inefficient and I wanted to show that we are getting efficient, more efficient by the day at AquaSource, which was our big drain on that O&M to revenue ratio of a year ago. And I say AquaSource, the southern states in general. But the reason it didn’t go down more year over year. I don’t know if we used the nine month or year over year on the relief--

Year to date.

Was because of the unexpected increase in pension and chiefly the increase in pension and the fuel costs that hit us in the third quarter and then the healthcare, which was just bad karma this year.

Right and based on the hurricanes in the Gulf, does that have any impact Florida, Texas, or do you have any interest in entering some of the states now that have been affected by hurricanes?

Well we have no properties in southern Florida. The only one we have is Captiva Island, if you’ve ever been down there. It’s a quaint island off of Fort Myers and that missed it this time. That got hit pretty hard last time and after nine months we were just getting ready to get it back on and we had to delay it for a couple of weeks so the hurricane season would pass. And we have nothing in Louisiana, Alabama, Mississippi. So we really were not affected by the hurricanes at all this time.

Now Texas we were affected in Beaumont, we have a little facility in Beaumont, which is Orange County. We had our generators. We had half of our workforce down there ready for a huge hit and we didn’t get it. And we never lost a day cause we had our standby generator. So people had water and wastewater services even though they didn’t have electric for a week.

And do you have any interest in looking for systems in Louisiana or Mississippi?

Well never say never, right? There’s a couple fine companies Baton Rouge, which never lost a day. That’s a private company and that’s where a lot of the population has shifted now from New Orleans. If asked by government and it’s profitable, we would always consider something as one of the larger companies. And I think a lot of companies are looking at it that way. My understanding is that the federal government is paying for a lot of this. And in fact you become profitable from the people that actually help to redevelop in New Orleans. But we’re not, we’re not looking to buy a system there and fix it. If the government pays for it, we can always obviously look at it.

I think you can look at the Enron situation-- not the Enron, the Entergy situation where they are asking for huge bail out from the government based on the fact that they had the New Orleans system. And you can take a look at the kind of money that’s flowing in to infrastructure and utilities and if that made sense, we’d look at it.

Okay thank you very much.

[OPERATOR INSTRUCTIONS] And it appears there are no further questions. So I’ll turn the call back to Nick DeBenedictis for any additional or closing remarks.

Just thank everybody for an inordinate amount of time we spent today, over an hour. But I think we got into depth and I think that was important with the changing industry standards and also some of our changing national trends like pensions and healthcare. I was able to explain a little bit of how it affects our small company. So thank you everyone.

Thank you very much. And that does conclude our conference for today.