American Water Works Management Discusses Q4 2012 Results - Earnings Call Transcript

Feb.27.13 | About: American Water (AWK)

American Water Works (NYSE:AWK)

Q4 2012 Earnings Call

February 27, 2013 9:00 am ET

Executives

Edward Vallejo - Vice President of Investor Relations

Jeffry E. Sterba - Chief Executive Officer, President and Director

Ellen C. Wolf - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Walter J. Lynch - President of Regulated Operations and Chief Operating Officer of Regulated Operations

Analysts

Kevin Cole - Crédit Suisse AG, Research Division

Andrew M. Weisel - Macquarie Research

Leslie Rich - J.P. Morgan Asset Management, Inc.

Michael J. Lapides - Goldman Sachs Group Inc., Research Division

Gerard J. Sweeney - Boenning and Scattergood, Inc., Research Division

Jonathan Reeder - Wells Fargo Securities, LLC, Research Division

Operator

Good morning, and welcome to American Water's Year-End 2012 Earnings Conference Call. As a reminder, this call is being recorded and also being webcast with accompanying slide presentation through the company's website, www.amwater.com. Following the earnings call, an audio archive of the call will be available through March 6, 2013, by dialing (303) 590-3030 for U.S. and international callers. The access code for the replay is 4593380. The online archive of the webcast will be available through April 17, 2013, by accessing the Investor Relations page of the company's website located at www.amwater.com. [Operator Instructions]

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

Edward Vallejo

Good morning, everyone, and welcome to American Water's 2012 Year End Conference Call. As usual, we'll keep our call to about an hour and at the end of our prepared remarks, we will have time for questions. But before we begin, I'd like to remind everyone that during the course of this conference call, both in our prepared remarks and in answers to your questions, we may make statements related to our future performance, and our statements represent our most reasonable estimates. However, since these estimates statements deal with future events, they are subject to numerous risks, uncertainties and other factors that may cause the actual performance of American Water to be materially different from the performance indicated or implied by such statements. Such risk factors are set forth in the company's SEC filings.

Now I'd like to turn the call over to American Water's President and CEO, Jeff Sterba.

Jeffry E. Sterba

Thanks, Ed. Good morning to you, all, and thank you for joining us today. I'll be joined in the presentation by Ellen Wolf, our Chief Financial Officer; and in addition, Walter Lynch, who heads our Regulated Operations this year to help with your good questions that I'm sure you'll have.

Before delving into the results of 2012, let me just make an opening comment. As you know, Ellen announced her retirement from our company in January. And I just want to take this opportunity to thank her for her tremendous dedication, expertise and leadership during the 12 years that she has served our company. On a personal basis, it's been a true pleasure to work with you and to really see the caliber and commitment that she has brought. Her direction of our financial objectives and obligations has helped us deliver strong results year-over-year, and she is about as red as the shirt that she's wearing right now. I also want to thank her for helping to ensure a smooth transition. As you know, Susan Story will join us on April 1 as our new CFO. I believe a number of you know her, and personally, I'm thrilled to bring someone with her diverse background to our company. Her experience and breadth of skills make her an excellent fit for this position and for American Water, and we look forward to introducing her to those of you who may not have had a chance to get to know her in the past at our next earnings call in May.

So today, we are pleased to present the very strong results that we achieved in 2012, really the outcome of sound execution of our business plan on many fronts.

So if you go to Slide 5, for 2012, we reported an 8% increase in revenue, an 18% improvement in cash flow from operations, a 22% increase in net income and a 20% increase in diluted earnings per share from continuing ops. Our return on equity, adjusted for the abnormally hot and dry summer, improved about 49 basis points over 2011. And remember that we've got about $1.2 billion of debt at the parent. And given the cost of that, when you take that into account, that means that our Regulated Operations earned a return on equity of just about 9% last year. And in the midst of this strong year of performance, our board authorized an 8.7% increase in the dividend in -- or for the dividend in 2012. So as a company, the challenge we laid out for ourselves in 2010 to build a culture of continuous improvement and excellence is firmly taking root and providing a pathway to sustainable and profitable growth.

Now let's turn to Slide 6, and let me talk about the other goals that we accomplished in 2012 that led to strong -- that lead to the strong prospects that I believe we have for the future. 2012 was a year of optimizing and enhancing our business portfolio to ensure that we're operating in areas that maximize value to our customers and shareholders. We acquired a total of 16 water and wastewater systems through accretive transactions, adding more than 55,000 customers to our base. We also closed on the sale of our Regulated Operations in New Mexico, Arizona and Ohio, which generated over $560 million in cash proceeds. That cash is now being more effectively deployed in our other Regulated Operations. We also saw growth through agreements with shale gas developers to build pipelines to support drilling operations in the Marcellus Shale area, which also enable us to provide the public with much-needed clean treated water service.

In 2012, we doubled the revenue from hydraulic fracturing contracts to about $3 million with a 74% increase in sales to in excess of 430 million gallons. Our homeowner services business expanded into 10 more states and has partnered with New York City to provide service line protection programs to its 650,000 eligible homeowners. This program, which was just launched last month, has seen a very strong response rate, already in excess of 7%.

Now in recognition of the investments we make in infrastructure in our Regulated Operations to ensure our quality service to customers, during 2012, we resolved 10 rate cases, bringing in annualized revenue increases of over $120 million, and we also filed 4 rate requests. An important regulatory tool, the DSIC mechanism, was approved in New Jersey. We responded by putting forward a plan to incrementally invest $220 million over the next 3 years in New Jersey, and that's in addition to the base level of about $20 million a year or $60 million for that 3-year period. With the inclusion of DSIC in New Jersey, we now have 6 states with such a infrastructure recovery mechanism, and that includes all of our 5 largest states, enabling the timely recovery of about 30% of our total CapEx spend.

The Regulated Business continued to increase efficiency and manage costs resulting in an O&M efficiency ratio adjusted for the midpoint of the estimated weather impact of 40.7% for 2012. So even adjusting for the weather, we drove 170 basis point improvement in this ratio, approximately the same reduction we saw in 2011 from 2010.

The investments we make into our infrastructure and systems, which have amounted over $1.8 billion in the last 2 years, is key to our commitment to provide safe and reliable service. If you think back about 2012, extreme weather highlighted the importance of long-term planning and appropriate investment to ensure sustainability and resiliency of our operations. During the summer drought, for example, we saw the benefits of our water supply investments in our Southern and Midwest service areas. And when Hurricane Sandy slammed into the East Coast, our dedicated employees, the preparation that they had done and our system enhancements kept the water flowing even through widespread and sustained power outages. It's also worth noting that as we build resiliency into our systems to help withstand weather volatility, one of the key tools that we use is the leveraging of technology and innovation. Let me just give you an example.

As you know, most utilities use GIS systems to locate on maps their facilities relative to other pieces of infrastructure, roads, curbs, gutter, those kinds of things, so you have a sense of where your equipment is relative to other equipment that may exist in the right-of-way. We've expanded beyond that to -- in some of our areas, we're starting to use GPS facility mapping, which means that we have the ability to locate it just through GPS coordinates and the satellites. And let me tell you how handy that came in. When Hurricane Sandy hit and the New Jersey barrier island was in the midst of devastation and you had 2 to 4 feet of sand and piles of debris and moved houses, some moved as many as 7 blocks, and boats littered every place, you couldn't find traditional landmarks. You couldn't find a curb, you couldn't even find the street. And so with our GPS coordinates, we are able to locate every one of our facilities, our valves, be able to control our valves so we can bring water back safely. And we are also able to help communities find their equipment that they could not find, like roads. So when they're trying to clear a road, they don't know where the [indiscernible] plows go. And so we were able, based on finding our equipment, then be able to map for them where the boundaries for those roads were. This will help -- this is the kind of tool that will help us with resiliency as we move forward.

In 2012, we also took Phase I of our conversion to SAP, and this included the financial and human resource modules, we took it live. Now while there are always struggles in implementing these complex systems, as I'm sure you have talked to many companies that have been through this, an independent review we had done concluded that this was an above average implementation compared to more than 100 similar projects. And at this stage, we are on the schedule and budget that was established almost 4 years ago for this project. While we did incur some higher O&M costs at the end of last year with implementation, these costs were relatively small compared to the overall $320 million project cost, and that number includes AFUDC, you may recall.

Turning to Slide 7, our long-term EPS growth target has been and continues to be 7% to 10%. And our history over the last 3 years demonstrates our capacity to achieve that long-term target. Given our past performance and the strategy we are implementing for the future, we're confident we will continue to meet that long-term goal. For 2013, we announced our guidance range of $2.15 to $2.25 per share, which puts our annual growth from a weather-adjusted 2012 between 8% and 13%. Interestingly, our EPS in 2008 was $1.10 per share. So at the midpoint of our guidance range for '13 of $2.20 per share, in a 5-year period through 2013, we will have doubled earnings.

And with that, I'll now turn the call over to Ellen, who will provide details on our financial performance.

Ellen C. Wolf

Thank you very much, Jeff, and good morning to those of you who are listening to our earnings conference call. Let me take a few moments now to describe the underlying factors that drove our 2012 results. More details will be available when our 10-K is filed.

Turning now to Slide 9. As Jeff indicated, 2012 was another year of solid financial results with continued increases in revenue, net income and cash flow. For 2012, we reported operating revenues of approximately $2.9 billion, a $211 million increase over the revenue reported for 2011. Net income from continuing operations for '12 was approximately $374 million or $2.11 per common share, an approximate 23% growth rate over the prior year. This is driven mainly by higher revenues in our Regulated Businesses of around $196 million and our continued focus on expense control. As we have mentioned previously, we believe the estimated impact of the hot, dry weather in the summer of '12 was around $0.13 to $0.16 per share for the year. Net cash provided by operating activities for '12 was around $956 million compared to approximately $808 million for 2011, primarily driven by the increase in operating revenues, changes in working capital, lower pension and postretirement health care contribution and long-term tax planning.

Now I'd like to discuss briefly the various components of our income from continuing operations starting, of course, with revenues.

Turning to Slide 10. Overall, revenues increased approximately $211 million, with the Regulated Business increasing around $196 million or 8.3% from 2011. The increase in revenues was primarily driven by rate authorizations related to the needed maintenance and updating of our water systems and higher customer demand in our Midwest and Eastern states over the prior year. For 2012, the impact of these rate authorizations, including investment surcharges, was approximately $129 million. The increase in revenues associated with higher demand over the prior year amounted to approximately $39 million. Also, in 2012, revenue increases from acquisitions was approximately $27 million, primarily driven by the acquisition of systems in New York in the second quarter. For our market-based businesses, revenues increased approximately $3 million, with continued growth in homeowner services and our military contracts.

Turning to Slide 11. As you know, our ability to invest in our infrastructure is driven by our ability to earn an appropriate rate of return on our investments. The extent to which requested rate increases are granted by the applicable regulatory authorities varies. This slide shows rate cases that have been filed and we are awaiting final orders on, as well as rate cases and infrastructure charges that have been recently granted. Annualized revenues from general rate cases effected in 2012 were $120.5 million. After year end, an additional $4.9 million in step-increases authorized in previous rate cases became effective. For 2013 through February 26, we were granted $24.9 million or about $25 million of annualized revenues related to infrastructure surcharges.

We are currently awaiting final orders for general rate cases in 2 states where we are requesting around $37 million in total additional annual revenues. And as Jeff mentioned, in 2012, our New Jersey subsidiary submitted and had approved a foundational filing for a distribution system improvement charge. The benefit of this filing for our customers and our shareholders is not expected until later in 2013 as we ramp up our infrastructure investment spend in New Jersey.

Turning our attention now to water sales volumes. Total sales volumes increased 4.1% in 2012. As you can see, this increase in water sales volume was mainly driven by our residential customer class, which is up 5% from 2011, mainly as a result of warmer, drier weather in our Eastern states through July and Midwestern states into September; and also, our customers -- our commercial customer class, which is up 4.1% for the year. Also contributing to the increased sales volume was our increase in customers mainly from our New York acquisition.

Turning now to Slide 13. Total operating expenses for 2012 increased approximately $89 million from 2011, driven by our increased consumption, acquisitions and a $7 million donation to the American Water Charitable Foundation. Let me take a minute and discuss the main categories on this chart. Production cost in the Regulated Business increased $12.2 million, driven mainly by an increase in purchased water cost, particularly in California and Illinois, which was a result of higher consumption. Our employee-related costs decreased almost $18 million, primarily due to higher capitalization and reduced headcount as a result of vacancies. Conversely, operating supplies and services did increase around $23.7 million for the year, primarily due to incremental contractor costs related to backfilling the vacancies that I just mentioned and incremental costs relating to the stabilization of our ERP conversion.

Additionally, in 2012, there were also costs involved in projects to improve processes and operating efficiencies over the long term. As we've discussed previously, for 2013, our business transformation project will be rolling out the enterprise asset management system, which will manage an asset's life cycle, and our customer information system to better serve our customers. We will continue to keep you posted on our progress in these areas.

Maintenance, materials and services, which includes emergency repairs, as well as cost for preventative maintenance increased $8 million. This is mainly attributable to increased preventative maintenance expenses throughout our regulated subsidiaries, including tank painting; meter testing; pump, tank and well maintenance; and paving costs.

Operating expenses for our market-based business decreased slightly in 2012. This, combined with their revenue growth, produced an over 16% increase in our market-based pretax income from continuing operations.

And lastly, we also experienced higher depreciation of around $30 million compared to the same period last year. This is due to our continued investment in needed infrastructure for our utilities.

Finally, based on these strong results for the year and attention to cost controls, our regulated O&M efficiency ratio continues to improve. For 2012, stripping out the weather impact, the ratio stands at 40.7% compared to 42.7% for 2011. This is due to the great efforts of the employees throughout all of American Water.

And with that, I'd like to turn the call back to Jeff for any closing comments before we open it up for your questions.

Jeffry E. Sterba

Thanks, Ellen. Going to Slide 15, so besides EPS of $2.15 to $2.25 per share, what can you expect from us in this next year? First and foremost, we will maintain the same customer-centric dedication to providing safe, reliable water and wastewater services. We'll also continue to stay very active on the public policy and regulatory front, promoting constructive regulatory frameworks and continuing to address regulatory lag that impacts our return on investment. We plan to resolve 3 rate cases in the course of the year and file up to 4 general rate cases, as well as infrastructure surcharge filings. We will also continue our focus on operational efficiency and bolstering a culture of continuous improvement, effectively managing costs and leveraging processes and technology to create value. So the implementation of the SAP platform is an example. That is going to provide us greater transparency into our cost drivers. And the impact of the best practices that we will be able to study and understand that we have in one state and be able to transfer that to the rest of our operations. This will help us approve our regulated O&M efficiency ratio and meet our 5-year goal of having it below 40% in 2015, 1 or 2 years early.

You can expect that we'll also continue to invest approximately $900 million to upgrade our systems, with the goal always being to balance these needed investments to ensure reliability with our concomitant rate impacts. Realizing savings and efficiencies from our supply chain initiatives will help us achieve greater efficiency of capital spend so we generate more dollar for each -- more value for each dollar invested. And there's just a fascinating array of examples that we have on the supply chain side of where we're finding opportunities.

On our market-based businesses, we're focused on new offerings in existing markets and product and market line extensions. For example, we have now successfully piloted a program to provide gas and electric line protection programs, and we'll be rolling these out to existing customers of our water and service line protection products. We've also expanded homeowner services into more states and expect to have operations in 39 states by the end of the year. And we have a growing pipeline of additional military bases slated for privatization, though we recognize that this is not a fast process, as it usually takes 18 to 20 months for anyone to go from a bid to contracting stage. Finally, we also anticipate additional extensions in our regionalization strategy to help serve shale gas development in the Marcellus area.

We will also continue to leverage technology and innovation through our innovation development process, which we've talked about in the past, and we'll look to commercialize these offerings. Recall that this innovation development process effectively creates a testbed where we can look at taking emerging technologies, allow them to be demonstrated in the hands-on environment of an operating utility. In return for doing that, and obviously, we control it through its process, we will have the opportunity to take an interest in that business and also to help ensure that we can deploy that technology effectively through our regulated and market-based operations.

So in 2012, we did a lot of work leveraging the interdependency between water and energy. Earlier this year, we signed a joint development arrangement with a company that developed a standardized communications platform that creates interoperability among any meter manufacturers. In addition to seamlessly integrating different types of meters, this platform is able to receive many kinds of data from the water distribution network, including pressure, water quality, leak detection and flow, and not just meter data. This creates a powerful tool for meter reading and billing but also for the collection of real-time system data so that we can better manage and operate the distribution network, detect leaks and the like. Now this is just an example of the prospects we see coming from the innovation development process.

We will also continue to offer the scale, scope and efficiency of American Water's operational water resource, environmental, supply chain and capital management expertise to other utilities through tuck-ins and acquisitions, as well as well-structured long-term market-based arrangements. All of our 2013 targets will anchor our long-term EPS growth range goal of 7% to 10%. We're pleased with the performance that we achieved in 2012 coming on the heels of also another great year in 2011, and we look to continue that momentum in 2013.

With that, we'd be happy to take any questions you may have.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Kevin Cole from Crédit Suisse.

Kevin Cole - Crédit Suisse AG, Research Division

Ellen, congrats on your retirement and finding a worthy successor.

Ellen C. Wolf

Thank you.

Kevin Cole - Crédit Suisse AG, Research Division

I guess, Jeff, just on, I guess, this process. I guess given your holdco structure, you obviously had an abundance of qualified internal candidates. And so what new skill set do you believe that Susan will bring to the organization, and how do you expect her to evolve the CFO position?

Jeffry E. Sterba

Yes. Very good question. What Susan brings to the table is, one, senior roles in a much larger company that has strong multistate experience. And her breadth of experience goes from everything, from all of the fundamental services that have financial impacts like supply chain and IT, et cetera, to the running of a business and the reporting of a CFO to her through that process, to being part of that management team and the financial acumen that she developed both through her school, through schooling, as well as through the roles that she had, which included oversight over a number of different functions, everything from the marketing and the derivative issues associated with that to rates. And what I think you'll find with Susan is that she is a very well-known commodity in the regulatory community with exceptionally high marks. And so it's that breadth that she brings, and I would say that, that breadth we're able to utilize because of the strength of the financial team that we have inside the company. Bill Rogers and Mark Chesla highlight really that -- our 2 key folks, bring enormous capacity and capability in the controllers function, and Mark is moving to be the Principal Accounting Officer. And in Bill's case, not just capital markets but also -- because that's second nature to him because of his background, but he also brings a strategic acumen. So I don't think about finance as a functional, narrow silo. I think about finance as a resource that enables the business to be the best that it can be. And the broader base the experience of the people that are in that area, the better able they are able -- they can provide that value while we also make sure that we've got the necessary and appropriate controls, accounting mechanisms and visibility, transparency into the financials of the company.

Kevin Cole - Crédit Suisse AG, Research Division

All right. That's actually a very good answer. And then should I also view this as it's CFO position today but likely evolving into maybe succession plans for you as well, your successor, sorry?

Jeffry E. Sterba

My succession plans are not even my subject, that's the board's. So what my objective is to ensure that when we have the opportunities to expand our skill sets, strengthen our bench, that we exercise those opportunities because they don't come around very often. And I think through a number of the hirings that we've done in the last 1.5 years, 2 years, probably with the exception of maybe them deciding to hire me, we've had great success. From Bill Rogers coming in as Treasurer, to a person that we hired, brought in recently to head supply chain who's got a wealth of experience as VP of supply chain in many companies from pharma to telecom, to the individual we've got running our continuous improvement in process excellence, Lean Six Sigma, to a new head of HR. In each of these cases, we have, I believe, enhanced our bench strength that gives us the ability to look at succession in a different way for a lot of positions. So I had the luxury of never being able to hold a job for about more than 18 months because I just kept getting moved to different things. And the result was I learned a lot about a lot of different pieces. That makes an executive much more effective, I think, particularly at the senior level. So to have people that have that broad-based experience, for Walter that have operated in the competitive world and now operate in the regulated world, that gives great exposure and experience to both of those markets which are different. So anytime we have the opportunity to enhance and strengthen our bench, I'm all for it.

Operator

And our next question comes from the line of Andrew Weisel from Macquarie Capital.

Andrew M. Weisel - Macquarie Research

Just one question on behalf of Angie Storozynski. Regarding the flow through tax accounting for repair cost in Pennsylvania, why haven't you changed your tax accounting for that?

Ellen C. Wolf

Thanks. Let me -- if I could just step back and give a little history on this. Let me start with the fact that we adopted this in 2008 on a system-wide, total company-wide basis. So we have had and will continue to have the cash benefit of this since 2008.

Jeffry E. Sterba

And really that goes back to 2005, right? Because...

Ellen C. Wolf

Right, right. To the extent we could identify any of those generated losses to prior years, we were able to do that. We have created out of this, plus other things that have happened over the years such as bonus depreciation, we have an NOL on our books of about $1 billion. And our goal is around maximizing cash. So what we wanted to do, my run to the normalization is really match when the benefit is given to our customer with when we actually receive the benefit on our taxes. And because we have NOLs, most of that benefit will be in the future, and that's when we are matching it with when we give the benefit to our customer.

Jeffry E. Sterba

Let me add just one thing. If you think about -- the way I look at it, obviously, I weren't around, when they had the foresight to take this action as early as they did, so we've picked up the benefit of this for our customers for now really going back to 2005, so 8 years. If you think about it, when you flow through something, yes, it flows through your income statement but it also flows through the rate-making treatment for that year. When you normalize it, it goes over time to the shareholder and to the customer, so it links the 2. For us, given that NOL position, if we flowed through, yes, you may get a bump in earnings in 1 year, but then you're going to reduce in the following year when you have the rate case occur. And for us, we operate in 16 states having a policy that works across all states, has worked well. We'll always take a look at new approaches. But what doesn't sound very attractive to me is to give the cash back to customers when we can't get the cash from the IRS for another 10 years because we've got the NOL carryforwards that are already keeping us from being a cash tax payer except for AMT. So for me, that's the real issue. If we were in a different tax position and didn't have the benefit of that NOL position, I may have a different approach to it.

Ellen C. Wolf

I'd also add, you can see the benefit of our doing the repairs and maintenance in our cash flow, it continues to grow stronger every year. And that's important to us as a company. It's important to our customers because it allows us to invest more in the infrastructure. It's important to our shareholders and customers in the sense of it's very low-cost financing.

Jeffry E. Sterba

Well, and it's what keeps us from having to issue other instrument that would be dilutive to your earnings.

Operator

And our next question comes from the line of Leslie Rich from JPMorgan.

Leslie Rich - J.P. Morgan Asset Management, Inc.

I wondered if you could go into a bit more detail on the New Jersey DSIC spending. I think you said it was $220 million of spending, and I'm just wondering over what period of time and how that actually rolls through your rates in terms of the timing of the true-ups and things.

Jeffry E. Sterba

Yes, let me ask Walter to answer.

Walter J. Lynch

Yes. In our foundational filing, we said we'd spend up to $220 million, that gets us to the 5% of revenue cap that we have. And that's over and above the $20 million each year of base spending. So that $220 million, we'll invest, and every 6 months, we'll do a filing, and then the commission wants 60 days to look at it, and then allow us to put it on the bills.

Jeffry E. Sterba

And that's over 3 years.

Leslie Rich - J.P. Morgan Asset Management, Inc.

The $220 million is over...

Walter J. Lynch

That's over 3 years, that's correct.

Jeffry E. Sterba

And I will tell you, we are looking at whether some of that should be advanced into a tighter period but it will be $220 million over no more than 3 years.

Leslie Rich - J.P. Morgan Asset Management, Inc.

And then you -- I'm sorry, could you go through the timing of how that actually rolls through rate?

Ellen C. Wolf

Sure, well, what happens is you file a filing with the commission, so similar to New Jersey where -- to Pennsylvania where you have a surcharge on the bill, you would have a surcharge on the bill for every 6 months for your filing and what you're authorized to spend and approved to spend. And then when you file your rate case, that surcharge rolls up into the normal rates.

Operator

And our next question comes from the line of Michael Lapides from Goldman Sachs.

Michael J. Lapides - Goldman Sachs Group Inc., Research Division

Subbing in for Neil a little bit right now. Real quick, just a question on the dividend. How are you thinking -- I know you've kind of talked about the dividend increase, but how are you thinking about long-term dividend payout ratio policies? And can you put that in conjunction with your view on kind of credit metrics, target credit ratings and how you're thinking about managing capital overall over a multiyear period?

Jeffry E. Sterba

Let me address the dividends and have Ellen address that relative to the credit metrics. From the dividend side, our philosophy and belief is that -- because it's always a trade-off between what are you -- how you can invest that cash and how you can return that cash and the balance between the 2, is that we have targeted a payout ratio in the 50% to 60% range and to have the dividend grow at something close to what our rate of increase in earnings per share is. If you look at the early years after the company came back into the public markets, the dividend probably lagged a little bit. And so we took a step of an additional increase last year. We're now frankly a little below the 50% payout ratio and the yield has gone down as our stock has been bid up. We view that positively but we also will look at that long-term philosophy of paying 50% to 60% relative to how we go about dividend decisions in 2013 and forward.

Ellen C. Wolf

A couple of things to note. Our cash flow continues to get much stronger. That has helped contribute to covering our capital and also our dividend. Our shareholder base looks at a combination of both growth in the stock and growth in the dividend, and we'll continue to look at dividend growth in terms of the right balance for our shareholders, as well as for the company so that we can reinvest that money back into the business. I'd also like to add that because of the strong cash flow that we've had and our known dividend policy, both rating agencies have put us on positive outlook. So we continue to see the benefit of our focus around this area.

Jeffry E. Sterba

And just to reinforce what Ellen said, our focus there is on cash, not cap structure. It's not that we don't look at cap structure, we do, but it used to be that you had to really focus on cap structure and think about getting to a 50-50 or what have you to be in the BBB+ or to move up into the A category. I think the rating agencies in one sense are more focused and smarter about what they really ought to be looking at is cash flow and the security of that cash flow, while you have boundaries around the cap structure that probably aren't as tight as they were before. So we're not focused on thickening the equity ratio for the sole purpose of getting an increase in rate. It's just that there's just not value there. But all the things we're doing to drive cash flow improvement, those will have the same impact, we believe, with the rating agencies.

Ellen C. Wolf

And if I could also add, just our equity ratio continues to strengthen based upon the strength of our earnings. So as of year end, we're a little bit above 44% equity where we started much lower 3 years ago.

Jeffry E. Sterba

Yes. I think there used to be some analysts who are always nervous that we're going to issue equity to thicken the equity ratio, and that's just not -- we see no need to do that.

Operator

[Operator Instructions] Our next question comes from the line of Gerry Sweeney from Boenning.

Gerard J. Sweeney - Boenning and Scattergood, Inc., Research Division

[Audio Gap]

on your retirement. A quick question for you, Jeff. Obviously, with the hiring of Susan Story, she's got a lot of services experience, and you've talked about in the past always looking for some regulated-like programs. Are we going to see a little bit more additional focus in coming years on this, and maybe to rephrase it or to put a different way, what's your vision and strategy for this, the market-based opportunities? How is that going to develop and I sense there's stuff percolating under the surface, but I wanted to see what your thoughts were.

Jeffry E. Sterba

Relative to our market-based businesses, it's a small but important and growing part of our business. We demonstrated 16% increase year-over-year to '12, and I think it was higher than that in '11 to '12 -- I mean '10 to '11. So it's an important part of the business but it's not going to grow to be 30% of the business. It would have to grow exceptionally rapidly to just double its impact on our bottom line. We're focused on red light kinds of things. So certainly the businesses that we're in, which include the military services, the homeowner services, a revamped contract services group as we've talked about how we are not going to participate in the old traditional kinds of short-term based contract services groups, plus doing more frankly on the waste management side. As we expand in wastewater, we see more opportunities in solid waste management, and I don't mean trash, I mean the solid that come from wastewater, as well as reuse, which is effectively using the liquids that come from wastewater. So those we view -- I think about it in terms of logical business line extensions. At the same time, one of the things that we went out and said very early on was we're going to make sure that we get very good inside before we ever try to take anything outside. Because otherwise, it's a great recipe to get bad bigger -- bigger bad, and not get better. And so as we've increased, for example, our supply chain capability, is that something that we could also bring to the benefit of customers that are utilities, municipal utilities, that don't have access to the things we do, does it open other doors for us? Those are things that we'll explore, but I wouldn't -- I don't expect there to be any dramatic change in our risk profile, in the way that we think about the balance of our Regulated Business versus our competitive business. But do expect that, that focus on excellence will give us -- will open doors for what I'll call business line extensions, where you have adjacent opportunities rather than completely new opportunities.

Gerard J. Sweeney - Boenning and Scattergood, Inc., Research Division

Okay. And any comments on the revamped contract business? Obviously, there's always talk about 50,000-plus water systems in the U.S. There's pension issues, there's health care issues, in terms of payment of liabilities. Another thing that's sort of percolating under the surface, you see it now in town, thoughts on how that's developing?

Jeffry E. Sterba

I think from day 1, or at least when I came, I kind of expressed the sentiment that a number of my senior level cohorts here had, which is this is a slow market to develop. It reminded me of the old fuel cell issue, that fuel cells will be here in 5 years, but it's always another 5 years. But I do believe that it's changed some because of the persistency -- the persistence of the financial issue. And whether it's driven by pension, whether it's just driven by the lack of revolving fund access from the federal government, the shrinking of that pot, the almost complete dearth of grants from the federal government, and states being in the same situation, I think communities are having to face a different set of challenges. And if they're interested in having someone like us operate their systems and be a part of their community, we're going to be very interested in doing that, whether we do that under a acquisition, which is generally a preference on our side because it fits with what we do well, or it's done under a longer-term contract, we're willing to look at that. So I think there are more cracks. I mean, even in last year, we acquired some municipal systems. I expect that, that will happen this year. And so I think we'll see more, instead of the private tuck-ins, we'll see a little more on the municipal side. But it's still not going to be farm gates get opened.

Gerard J. Sweeney - Boenning and Scattergood, Inc., Research Division

Sure. I mean from my perspective, I would look at it as an incremental growth avenue, 1%, 2% in a good year, or something like that.

Jeffry E. Sterba

Absolutely.

Operator

And our next question comes from the line of Jonathan Reeder from Wells Fargo.

Jonathan Reeder - Wells Fargo Securities, LLC, Research Division

Ellen, congrats on the upcoming retirement. I am truly jealous but you've done some great work, since [indiscernible] you came back to the public market in 2008, so it's well deserved.

Ellen C. Wolf

Well, thank you, and I also want to thank you and everyone on the phone for their continued support for American Water. It's a great company.

Jonathan Reeder - Wells Fargo Securities, LLC, Research Division

Most of my questions have been asked already this morning but, Jeff, are you targeting any sort of improvement in the O&M ratio in 2013? I know you have the 2015 goal that you said you may even hit 2 years early, which would be by the end of this year. But do you have any sort of kind of internal target that we might want to build into the model?

Jeffry E. Sterba

Well, until you said the last phrase, it was a one-word answer. And so there's 2, the answer is yes, but no, I'm not going to tell you. Well, I don't mean to be funny or flip about it, but we do obviously have a number of targets that we focus on internally. They're not, they all -- they have caveats and they've got ties, and so it gets too complicated to try to explain all of those to the external market. But rest assured, we do have targets, and I feel good about the progress we'll continue to make on that front. And that we will beat the 40% by the end of '15 by 1 or 2 years.

Jonathan Reeder - Wells Fargo Securities, LLC, Research Division

Okay. And then I don't know if you can talk about the usage that you saw in 2012 absent the weather, was it similar to what you were forecasting going into the year, which I think was a decline of 0.7% to 0.8% on the residential side?

Ellen C. Wolf

Historically, what we've seen in terms of decline is about 1.5% to 2.5%. It's difficult to pull that out in any time frame, but in the off months, we do continue to see some decline.

Jeffry E. Sterba

Although it is -- we may see some leveling of that.

Jonathan Reeder - Wells Fargo Securities, LLC, Research Division

Okay. So your expectation for 2013?

Jeffry E. Sterba

It builds into it.

Ellen C. Wolf

It builds into the '13 number.

Operator

And I show no further questions in the queue at this time. I'd like to turn it back to management for any closing remarks.

Jeffry E. Sterba

Well, let me just thank you all for joining us today. I want to thank Ellen again for everything that she's done for the company. And I'm going to give her the last word.

Ellen C. Wolf

All right. With that, this is a first. I just, again, I want to thank each and every one of you who are listening to this call for your continued support of American Water, for your in-depth questions -- they've kept us on our toes -- and your continuing to push us as we become each year a better and better company, so thank you.

Operator

Ladies and gentlemen, this concludes the American Water Fourth Quarter 2012 Results Conference Call. We would like to thank you for your participation, and you may now disconnect.

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