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American Water Works (NYSE:AWK)

Q2 2013 Earnings Call

August 08, 2013 9:00 am ET

Executives

Edward D. Vallejo - Vice President of Investor Relations

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

Susan N. Story - Chief Financial Officer and Senior Vice President

Analysts

Kevin Cole - Crédit Suisse AG, Research Division

Ryan M. Connors - Janney Montgomery Scott LLC, Research Division

Heike M. Doerr - Robert W. Baird & Co. Incorporated, Research Division

Jonathan Reeder - Wells Fargo Securities, LLC, Research Division

David A. Paz - BofA Merrill Lynch, Research Division

Spencer E. Joyce - Hilliard Lyons, Research Division

Angie Storozynski - Macquarie Research

Brian Chin - BofA Merrill Lynch, Research Division

Operator

Good morning, and welcome to American Water's Second Quarter 2013 Earnings Conference Call. As a reminder, this call is being recorded and is 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 August 15, 2013, by dialing (303) 590-3030 for U.S. and international callers. The access code for the replay is 4628550. The online archive of the webcast will be available through September 6, 2013 by accessing the Investor Relations page of the company's website located at www.amwater.com. I would now like to introduce your host for today's call, Ed Vallejo, Vice President of Investor Relations. Mr. Vallejo, you may begin.

Edward D. Vallejo

Thank you, and good morning, everyone, and thank you for joining us for today's 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 again 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 future performance. Our statements represent our most reasonable estimates. However, since these 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. And such risk factors are set forth in the company's SEC filings.

And 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 I appreciate you joining us today. Before Susan Story, our CFO, goes through our financial performance in detail, let me just set upon some highlights. As you've probably seen from yesterday's press release, our year-over-year second quarter results were influenced by the above average rainfall and cooler temperatures we've been experiencing versus the record-breaking drought and heat that was seen and felt in the second quarter of 2012. As you can see on Slide 5, this caused the decrease in revenues and earnings per share as compared to the same quarter in 2012. Other items that impacted the quarter-over-quarter comparison include higher depreciation expense, which Susan will touch on; and a retroactive regulatory adjustment that occurred in the second quarter of last year. In addition, looking at Slide 5, it appears that our 2013 year-to-date cash flow from operations is lower than the first half of last year, but this is really due to how our bank overdraft is now being treated as a reduction to operating cash flow as opposed to a financing activity. This is a result of a conscious decision last year to internally manage cash activities as part of our continuous improvement efforts. Year-to-date, this change in cash flow classification amounts to about $35 million.

Now obviously, the weather has a significant impact on our business. Our quarterly results really reflect a tale of 2 springs. Much of the country experienced above average rainfall and cooler temperatures in the second quarter of 2013, in sharp contrast to the same quarter in 2012 when much of the country was experiencing record-breaking drought and heat.

As if you look on Slide 6 at the precipitation charge, which by the way come from NOAA, the same large swath of the northeast and midwest that experienced severely dry weather in the second quarter of 2012 had either normal, or as is the case with the better part of the northeast, much wetter than normal and even a record wet weather this April to June. So clearly, this has an impact on customer usage. However, due to our geographic diversity across 16 states, that impact was somewhat mitigated by increased water consumption in other states. Nonetheless, we do attribute approximately $0.01 to $0.02 decrease in earnings per share from weather when compared -- which when you compare that to the $0.06 to $0.09 increase in earnings per share we attributed to weather during the second quarter of '12, that results in a total $0.07 to $0.11 impact of weather when you compare second quarter last year to second quarter of 2013.

Now turning to the continued growth of our business. We introduced Slide 7 to you last quarter to illustrate our growth drivers. We have core growth, which includes efforts to reduce regulatory lag and achieve appropriate returns on capital investment, as well as the tuck-in acquisitions that we make and the continued improvement of our regulated O&M efficiency ratio, as well as the execution in our current military contracts in the Homeowner Services business. Enhanced growth includes larger acquisitions, new expansion into the military business, as well as expanding into new territories and providing new services in our Homeowner Services business, providing products and services that are new in the municipal and industrial space, as well as continued expansion of the shale gas opportunity that we see in certain territories. Combined, these are the opportunities that we are confident will deliver 7% to 10% long-term earnings per share growth goal.

On the core growth side, during the quarter, we completed our wastewater tuck-in at Koppel Boro, tuck-in in Pennsylvania, which has got about 400 customers and received regulatory approval on the water acquisition of Whitwell Tennessee, that's about 2,800 customers. And in July, we received regulatory approval for the Pratt, West Virginia water system acquisition of about 450 customers. Those last 2 we expect will close later this year. We also made progress on regulatory approval of our pending acquisition of Tri State Utility, which provides water service to about 3,500 customers in the growing branch of Missouri area.

On the regulatory front, as you know, we filed rate cases in California, Iowa and Pennsylvania for a total of about $98 million in annualized revenue. While the final rate authorizations have not yet been received, we reached a settlement agreement in West Virginia for an $8.5 million increase in revenues. That's sitting before the regulatory for approval. And we implemented interim rate increases in Kentucky for the full $12.3 million, just at the end of July; and in Iowa for $2.7 million of that request. We've also received a total of $16 million in additional annualized revenues from infrastructure surcharges that become effective in Pennsylvania, Missouri and New Jersey in the April through July period.

On enhanced growth, in May, we announced an agreement to acquire Dale Services Corporation. This is one of the larger acquisition, that's a medium-size wastewater utility that serves 20,000 customers. We expect that transaction to close late this year.

On the Homeowner Services front, recall that the name of that -- of the company, our subsidiary, it's American Water Resources. It announced a nonexclusive partnership with the city of Houston to offer water and sewer line protection programs to more than 550 homeowners. And last month, American Water Resources was notified by the city of Nashville the intent to award the company an exclusive partnership to provide these protection programs to approximately 176,000 eligible homeowners. That's very similar to what we've done in New York, the program that we launched earlier this year. And just as an update on the service line protection in New York, recall that's being offered in partnership with the city's Department of Environmental Protection. We've seen just really good growth in that program. We've now got close to 100,000 customers enrolled. So that's a penetration rate of getting close to 20%. And nearly all of the customers are opting for both water and sewer line contracts.

Moving to Slide 8, we've made some significant progress in 2 large projects in our California subsidiary since our last call that I want to raise to your attention. Last week, California American Water reached formal settlements with a number of parties, including major environmental stakeholders, in our plans is to bring a stable water supply to the Monterey Peninsula. These settlements recognize the value of the portfolio approach to the water supply challenge that's presented in that area, which includes an offer for storage and recovery, groundwater replenishment and a desalination plant. The range of capital investment that's reflected on the slide reflects the ultimate sizing of the desal plant and whether groundwater replenishment moves forward, as well as contingencies on the capital cost estimates. The next step is a prehearing on the settlement which happens in a couple of weeks. And then going forward with the PUC approval, which we would not expect until towards the end of the summer next year. But we're very pleased to have this moving forward and real progress being made on this very critical project for the Monterey Peninsula area.

In addition, in June, we broke ground on our landmark San Clemente dam removal and Carmel River reroute projects. And if you think that's not a mouthful for a project name, they were challenged on how many words they could fit in. This will be a 3-year construction project and is the largest dam removal project ever to occur in California. That's something we're really pleased to be involved in. It includes an innovative engineering approach of rerouting the river around accumulated sediment to restore to its natural state. Removing the seismically unfit dam will provide many benefits to the region and its residents. First and foremost, it obviously removes a public safety risks posed by the potential collapse of the dam in the event of a large flood or earthquake, but it also aids in the recovery of threatened South Central California coast steelhead -- and as a fly fisherman that's something I'm particularly -- care about. By restoring the natural sediment flow and providing an unimpaired access to over 25 miles of essential spawning and rearing habitat. The neat thing about this, is it's it really is an innovative partnership between our company, state and federal governments and NGOs. Our hats and thanks go out to the California State Cultural Conservancy, the National Marine Fishery Services, the Planning and Conservation League, the Nature Conservancy and a number of others that we've worked with. We're grateful to our partners in this effort and pleased to see it moving forward. Between these 2 California projects, we will invest around $200 million or more over the next 3 to 5 years.

Now turning to Slide 9. Combining our performance in it the second quarter with the strong results of the first quarter, we are reaffirming our 2013 earnings guidance range of $2.15 to $2.25 per diluted share for continuing operations. This represents an 8% to 13% increase over the weather-normalized earnings per share for 2012 at about $1.99.

And with that, let me turn the call over to Susan for more detail on our finance.

Susan N. Story

Thank you, Jeff, and good morning to you, all. It's a pleasure to be with you here today to review the quarter and year-to-date results ending June 30. Jeff has already reviewed some of the key highlights. I will now take a few minutes to discuss the drivers of our results for the second quarter in greater detail.

Turning to Slide 11. As Jeff mentioned, our second quarter results reflect the impact from unusually cool wet spring weather with related decreases in revenue, net income and earnings per share. During the second quarter, we reported operating revenues of approximately $724 million compared with $746 million reported for the second quarter of last year. Looking back at the exceptionally hot, dry spring we experienced in 2012 versus the weather in spring 2013, and so far this summer, this year-over-year impact on demand is not surprising. Also impacting this quarter's results versus last year's corresponding quarter was a significant onetime retroactive adjustment due to the California rate case effective in June 2012. Additionally, this past quarter, we experienced increased depreciation expenses due to additional utility plant placement service, including approximately $3.3 million in expenses related to the implementation of our business transformation project.

Lastly, the decrease in revenues is also attributable to a decrease in market-based operations, primarily due to the termination of certain municipal and industrial O&M contracts, as result of our ongoing business portfolio optimization efforts. Our consolidated O&M expenses for the 3 months ended June 30 were roughly flat, decreasing $300,000 or 1.3% over the same period last year.

Now let's discuss, on Slide 12, the different components of our income from continuing operations starting with revenues. I also encourage you to read our 10-Q on file with the SEC for a more detailed analysis of both revenues and expenses. Overall, operating revenues decreased $21.3 million with revenues from our regulated business decreasing $19.7 million or 3% from 2012. The decrease in revenue associated with a lower demand was approximately $31 million. The year-over-year comparison obviously impacted predominantly by the weather effects, which we spoke of earlier. This demand decrease was partially offset by revenue increases of $15.8 million from rate increases obtained through rate authorizations awarded for a number of our operating companies and additional revenues associated with acquisitions of $2.2 million. Additionally, as I mentioned earlier, in the second quarter of 2012, we benefited from a retroactive adjustment totaling $7.2 million as a result of a California rate case.

For our market-based businesses, revenues for the second quarter of 2013 decreased by approximately $2 million. The net decreased in revenues is primarily attributable to lower contract operations group revenues of $5.1 million. These decreases are predominantly related to the termination of certain municipal and industrial operations and maintenance contracts, which amount to around $6.9 million for the 3-month period. These contracts were ended as a part of our business optimization efforts, designed specifically to optimize margins in our Contract Operation business. Additionally, revenues from capital project activities associated with military construction decreased $900,000 for the 3-month period due to lower levels of work as compared to the prior year. As we mentioned last quarter, when the military construction revenues were more significantly impacted, the majority of this work should take place later in the year and we have every reason to believe that these projects will be completed as they already been awarded and approved for construction. Also contributing to the decreases were lower revenues in our residual operations group of $1 million for the 3 months ended June 30, 2013 compared to the same period in 2012 due to lower levels of work performed. These decreases were offset, however, by a $2.3 million increase due to price redeterminations for 3 of our military contracts, as well as increases of $4.5 million for the 3 months ended June 30, 2013 in our Homeowner Services revenues associated with those customer and contract growth, most notably in New York City.

On Slide 13, total operating expenses for the second quarter of 2013 increased by about $7.4 million or 1.6% from 2012. Operation and maintenance expense in the regulated business increased $2.3 million or about 8/10 of 1%, roughly flat compared with the prior year period. Production expense decreased approximately 3.4% for the 3 months ending June 30, as a result of the lower production and sales during the quarter. Operating supplies and services increased $8.6 million or 18.3%. It's important to note, this is primarily due to higher contracted services, resulting from about $6.2 million of incremental temporary labor costs related to the continued maturing of the ERP process implementation related to Phase I of our business transformation project. These enhancements are necessary for ongoing and future efficiency improvements resulting from our new SAP system. Also contributing to increases and operating supplies and services in the second quarter of 2013 were operating costs associated with the New York acquisition. Partially offsetting these increases were lower transportation expenses due to a reduction in leased vehicle costs.

Maintenance materials and supplies decreased $1.8 million or 11.1% for the 3 months ended June 30, 2013, mainly due to lower tank painting [ph] costs in our New Jersey subsidiary of $1.4 million.

Employee-related and other, decreased $2.2 million, primarily due to decreased pension expense. The decrease in pension expense for the 3 and 6 months ended June 30, 2013 was primarily due to decreased contribution in certain of our regulated operating companies, whose costs are recovered based on our funding policy. Which is a fund at least a minimum amount required by the Employment Retirement Income Security Act or ERISA Act of 1974.

Other operation and maintenance expenses include casualty and liability insurance premiums and regulatory costs. For the 3 months ended June 30, 2013, cost decreases was primarily driven by lower casualty insurance costs as a result of historical claims experienced and retroactive adjustments. In the second quarter, we also reported a higher depreciation and amortization expense of $8.8 million and a higher general tax expense of $2.1 million. The increase in depreciation and amortization is primarily due to additional utility plant placement service, including a depreciation expense of approximately $3.3 million for our business transformation project, which has a much shorter depreciation schedule than most of our other utility assets. None of our basic costs have been disallowed from rates at this time. The increase in general tax expense is primarily due to higher property taxes incurred as a result of our New York acquisition in the second quarter of 2012.

The market-based business operations decrease and total operating expenses corresponds with the decreases in revenue, which I have previously described.

Turning now to Slide 14. We have included a new side to better explain the period-over-period difference in our earnings per share figures. As you can see from this chart, we have broken out the positive $0.06 to $0.09 impact of weather for our 2012 results, as well as the net impact of the retroactive adjustment of $0.03 from the California rate case, which was booked in June of 2012. After taking these extraordinary events into account and using the midpoint of our weather impact, we get to what we consider a normalized earnings starting point for the second quarter of 2012, $0.555 per share or $0.56 rounded up. From there, we have laid out the various elements that explain the difference in our year-over-year earnings per share result. I'm not going to go through each one, but I do want to point out a few things here.

First, just for clarification, you do note here a $0.02 impact to earnings due to depreciation, and we had shown a $9 million expense increase in the expense line. For all of you modelers out there, the impact of the $9 million in depreciation expense is split on this slide between the $0.02 decrease in the depreciation bar, as well as being reflected in the 2012 California rate case decision and the New York acquisition bars. Second, we have broken out the weather impact for the second quarter of 2013 from declining customer usage from other factors on this chart.

And lastly, you also see a $0.01 increase quarter-over-quarter due to lower interest expense. And this is due to us taking a proactive approach to looking at refinancing alternative. For the quarter, our interest expense was reduced $2 million. For the June 30 year-to-date, it has been reduced by $3.5 million.

Now let's look at the regulatory highlights for the quarter. Slide 15 utilizes the expanded rate base -- rate case input we introduced last quarter, showing formal rate cases awaiting final order, which we separated between those filed for 2013 versus those filed in 2012. And also, any step increases our DSIC filings, which impacted the quarter or are still pending.

Including Pennsylvania, Iowa and California, we now have approximately $98.5 million in requested additional revenues from formal rate case we filed this year. And looking at the timing of these rate cases versus previous years, the rate cases we expect to resolve in 2013 should be towards the end of the year versus midyear in 2012 when we had 3 rate cases finalized in the second quarter.

As Jeff noted earlier, West Virginia's water and wastewater cases have a settlement agreement in place reached by West Virginia American Water, the PSE stack and the consumer's advocate division, subject to the formal TSC ruling expected in the fourth quarter. Kentucky rates were increased $12.3 million on an interim basis, subject to refunds effective in July. Under Kentucky regulation, if an interim increase is put into effect, only the full amount of the rate increase request is allowed prior to the formal PFC decision, which we expect in October of this year.

Of note, our first infrastructure charge in New Jersey took effect on July 1 for $4 million in additional annualized revenue. In our continuing efforts for transparency, we have created a new slide, which you can find in the Appendix, Slide 25, entitled Regulated Utility Rate Base and Allowed Return on Equity. Many of you have requested this data showing each of our Regulated Businesses authorized rate base, authorized ROE, authorized equity and the effective date of the rate case used. We have included this information for our 10 largest regulated subsidiaries on the slide. These are historic cases and we advise you to review this footnote for a fuller understanding of the particular case in question. While you can never project how any new case will be determined, we hope this will help you understand our rate environment.

Turning now to Slide 16. This is a slide we introduced to you last quarter, which illustrates our commitment to keep our cost structure efficient and utilize the majority of our requested customer rate increases to fund capital investment, which includes infrastructure, system resiliency and customer service. This is also a validation of our continuing efforts to meet our O&M efficiency ratio goals, as shown on Slide 17. You will note that despite the revenue challenges we faced in 2013 second quarter, we have maintained a 40.4% ratio for the last 12 months ended June 30.

And finally, as part of our commitment to shareholder value, last week, we announced that our Board of Directors declared a quarterly cash dividend payment of $0.28 per common share payable on September 3, 2013 to shareholders of record as of August 19, 2013. This continues our commitment to an annual dividend payout goal of 50% to 60% of net income.

With that, I'll turn the call back over to Jeff.

Jeffry E. Sterba

Thanks, Susan. If you go to Slide 19, this is a slide on expectations for the year that we use every quarter. Nothing is changed. We've already really spoken about our progress on all of these efforts, which will anchor our long-term earnings per share goal of 7% to 10%, which we continue to be committed to and believe is achievable. Let me call your attention to 1 item, and that's the issuance of our new corporate responsibility report, which covers the years 2011 and 2012 in terms of data. And you can find this on our website. Our commitment as a company from the board level down, the corporate responsibility and sustainability, is truly one of our company's guiding beacons and we're proud to be the only water company the U.S. that's included in the Dow Jones Sustainable Index.

Lastly, let me also just remind you, as I know a number of you probably have it already marked up in your calendars, but we will be hosting our 2013 Analyst Day at the New York Stock Exchange on Tuesday, December 17. And we'll provide you more information about this in the coming months.

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Mr. Kevin Cole from Crédit Suisse.

Kevin Cole - Crédit Suisse AG, Research Division

I see in June, the EPA released another study indicating that the U.S. will require about $400 billion in clean water infrastructure, I think, over the next 15 years or so. But I guess if I look back, those dollars are rarely spent. Do you see any changes in federal or state policy, either on the policy front or the enforcement front to actually require action going forward? In either clean wastewater side?

Jeffry E. Sterba

Yes, Kevin, I think, frankly, it's enforcement actions being taken largely through consent decrees on the wastewater sides that are really starting to create some challenges and tension for a lot of municipalities. On the water side, the drinking water side, probably a little less so. There isn't a driving issue like arsenic was a few years ago that's mandating investment, although probably the next one that has attracted some attention is the chrome 6 issue, which is one that we've really got our hands around already. So again, it's this notion of -- as that infrastructure is out of sight, out of mind, the level of investment is trailing. I mean, that's why you see the average investment cycle of 250 years really going up to 350 years, whereas we as a company, are about 125. It's an issue that's attracting attention, but I don't think there's a solution. Well, there's not necessarily a solution that a lot of municipalities are yet facing up to. And that solution is really, you got to bring private capital in because the federal money is just not going to be there.

Kevin Cole - Crédit Suisse AG, Research Division

I guess I saw I think a couple of weeks ago, like San Antonio, I guess EPA forced San Antonio to, I think, spend around $1.2 billion given they were -- they didn't scale up their system to population growth, so they're distributing wastewater, I guess, just raw waste into water. So are you using that as the most actionable vehicle of growth given the EPA is actually fining those systems?

Jeffry E. Sterba

Yes. The wastewater side is the one that is more susceptible to enforcement. And you've got, gosh, I can't -- I saw recently the number of cities that are under enforcement action. I don't remember the number, but whether it's Kansas City, which is a large metropolitan area or a smaller city like Chattanooga, Tennessee, they've got multi $100 million dollar enforcement actions. The challenge will be how strongly does the EPA enforce the timing of it. Do they give them slack so that instead of it needing to be done in the next 5 years, oh, well, we'll give you 7 or 10. That's where we've seen slippage in the past. I would say one of the things that Sandy brought to light was the risk. When you have increased volatility of weather and the risk of flooding and the like, whether it be from storm surge or rain or what have you, is the amount of untreated or only partially treated wastewater that got dumped, that gets -- and that is, I think, the risk that is starting to attract a lot more attention. Just with Sandy it was over 11 billion gallons of raw sewage that was dumped. And so that's a broader base challenge, but it puts a focus on the issue of adequate wastewater treatment and doing the right things relative to storm water. So I'm hopeful that the EPA will keep the pressure up to ensure that we, as a country, are doing the right things. I think it's important that environmental groups and others help support that.

Kevin Cole - Crédit Suisse AG, Research Division

Actually just -- I have an obnoxious question for Slide 23. Just because I know someone's going to ask you this question later. So is your 7% to 10% -- is it right to think about your 7% to 10% EPS growth rate being anchored to 2012? Or if I'm looking at 2014, should I re-anchor it to the midpoint of 2013?

Jeffry E. Sterba

Yes, we've always talked about it as a long-term growth rate and so that's the anchoring in 2012. I know every year, we get pushed about, well so is it off a new base. And we're trying to say, look, 7% to 10% is a long-term growth rate, and yes, we're anchoring it off 2012. Even though our range is above that, and, of course, we'll provide you a range for 2014 as we get a -- probably in the December session.

Kevin Cole - Crédit Suisse AG, Research Division

Okay. And then is this chart to scale? Because if I look at -- if I apply 10% growth rate to $1.99, I get $2.19, and that's kind of to closer to midpoint of this year's guidance, not at the bottom. And so am I not just understanding the chart or is it just not the scale?

Edward D. Vallejo

Kevin, it's Ed. Yes, it should be up to scale. So let me know when you have that service that sees if it is to scale, if it doesn't work out enough, but in our side, it is.

Jeffry E. Sterba

I always get nervous because we've got those engineers and financial players and whether it's something they put it on logarithmic paper or what, I always get a little very nervous, but just kidding.

Operator

Your next question comes from Mr. Ryan Connors from Janney Montgomery Scott.

Ryan M. Connors - Janney Montgomery Scott LLC, Research Division

So I wanted to get some thoughts on the regulatory side and I guess, we're coming off the recent May [indiscernible] summer meeting, I'm sure you had folks there and you got some briefings, Jeff. Anything jumping out of you in terms of the evolution of the regulatory environment in water, either positive or negative, and either specific to any mechanism, a specific state or just the terms of the overall tone?

Jeffry E. Sterba

I guess, the ones -- a couple that I just touched on. I mean, we are getting increased understanding and recognition about the issue of declining use. And I think this is one where the industry was slow on the uptake, but is rapidly trying to move this forward. So frankly, there hadn't been much of anything done up until really probably the last 3 years or so. So, except in California, where there's an overall policy mandate. So I think that's on the positive side. I think on the risk side is, okay, so what does -- where do returns go and how successful are we in helping people understand that when you have artificially held down risk-free rates, it -- that doesn't necessarily change the cost of equity. And I think we've seen what's probably best described as mixed results. There are some states that have gone fairly low. I think the majority of our states have approached that with a more reason than tempered response in thinking about what that cost of -- what's an appropriate cost of equity. I think the 2 things that we keep a real ear on are the issue of degree of rate change, so that we don't push that frontier too hard, yet at the same time, we have great reception to the investment of capital. And so as we've talked to regulators about the chart that Susan has talked to you all about, about how we shifted, how much of our rate increases are capital versus O&M base, that's something that they receive positively. But I think those are the issue of declining use. And now, frankly, you're starting to hear a lot of electrics say, oh we no longer have growth. And so they're starting to scramble on that issue.

Ryan M. Connors - Janney Montgomery Scott LLC, Research Division

And how do you see that evolving, Jeff? I mean, will it be -- is the talk of a California style RAM-based decoupling or are there other approaches that you see prevailing?

Jeffry E. Sterba

I think each state has to approach this on the basis of its own regulatory background and on a philosophy. There are some that they look at the California RAM mechanism and they wonder if it's too complex for them, is there a different way to do it, is there a way we can kind of build it into base rates, what is it that we're trying to protect against, is it all changes in consumption or is it just the intrinsic ongoing reduction in use per customer, so what is it that we normalize? So I think we'll see, and we are seeing, states take a number of different approaches. I think the one that most states move to most readily is, okay, let's take into account what you've seen over the last set of years, 5 years, 8 years, whatever it might be, and build that into your future and let's try to step and then we negotiate how far forward do we step to get the building determinants, if you will, the denominator, right. I think automatic adjustment mechanisms create some nervousness of regulators unless they come out of that mechanism. For example, Florida has a number of mechanisms. California has a number of mechanisms. And New York has a number of mechanisms that has just been part of their regulatory psyche. Other states appealing purchase prior adjustment clause. And on the water side, maybe an electric energy supply cost or something like that. That may be about all they're comfortable with. So I don't know how many states will adopt automatic mechanism as opposed to recognizing the pressing nature of the issue, but do it in a different way. Susan, do you have anything to add?

Susan N. Story

Yes, and I think consistent with what Jeff said, we take very seriously our responsibility on water efficiency and so we are proactively working with all of our states in terms of how we can promote water efficiency and address declining usage through, as Jeff has said, either decoupling type mechanism, looking at revenue adjustments for future test years, looking at performance incentive for some of the water efficiency program. So we're really looking at lots of different options to address this -- the same issue. And also on the key elements coming from [indiscernible] in looking at some of the commentary, as well as hearing from some of the people there, the commitment of state regulators to the replacement of aging infrastructure may be as strong as it's ever been. The recognition that this is something we have to address and that if we begin to address it today, that it would be far better than waiting until we have more severe problems in terms of main breaks, leaks and the economic impacts of that. So I think that we think increasing and growing commitment to that, and as Jeff said, what that means to us is, how do we find a way to promote that investment while also controlling price increases for the customers. And that is through our control of O&M so that any or most the majority of price increases will be for investment and -- CapEx investment and not O&M expenses.

Jeffry E. Sterba

One of the things that I think all that says is, of course, we may -- he have bias, but if I was going to focus on communities that have the greatest potential for growth and expansion, because they're going to be able to provide service to customers and it's -- and they're not going to have main breaks, et cetera, I'd look to those communities that are -- provided service by privately held companies that are regulated, because Susan's exactly right. We're seeing recognition of that on the regulatory side. Unfortunately, not at all communities, but in a number of communities. Your politician elected today, that's an out-of-sight, out-of-mind investment, it's a little harder to make, were a little easier to set a side and not necessarily keep up with that infrastructure. I think there are some cities, which -- and I commend -- I'll commend Chicago for what they're trying to do and Philadelphia for what they're trying to do in terms of their green cities initiative. And I don't mean solely them. I think New York is also there and there are others that are there. But boy, there is a whole host of that 50,000 communities or individual utilities that, that's not necessarily getting done.

Operator

Your next question comes Heike Doerr from Robert W. Baird.

Heike M. Doerr - Robert W. Baird & Co. Incorporated, Research Division

Can you share with us what are re-stipulated in the settlement that's pending in West Virginia?

Jeffry E. Sterba

Well, yes, sort of. What happens is that the party submits a -- as part of their testimony, a basis for the cost of service that's been agreed to. It is a black box settlement, so there isn't a formal ROE. What we have submitted and what -- and I'm trying to remember which party it is that joined us with that, just Consumer Advocate, submitted -- resubmitted our cost of service than the Consumer Advocate did that the ROE is at 9.9, 9.9%. Whereas the staff has submitted a cost of service that uses 9.75%. They get to the same revenue requirement, so it gets to the same rate levels, they just go about it in a different way. So I think it's -- we believe it's 9.9%, but it's in that range.

Heike M. Doerr - Robert W. Baird & Co. Incorporated, Research Division

Okay. Can you give us an update on where you are on portfolio optimization? Are there still states you're weighing whether or not it makes sense to be in, and where on the contract operations side are we on that process?

Jeffry E. Sterba

Well, on a regulated side, as we said before, the lion share of any optimization has been done. We will remain open to looking at whether it's inter-state or intra-state opportunities. I can't tell you that there's the state -- we're not in the process of saying there's a state we want to exit. We're comfortable with what we've got, but we will always look at opportunities to optimize that. On the Contract Operations side, by and large, most of it has been accomplished, moving us into a set of contract that we can operate in a much more profitable way, starting to shift the way that we're thinking. We're looking at how that business expands and being very specific and focused about what we won't go back into. We had to work -- our people did a heck of a job in extracting ourselves out of some contracts and arrangements that just were not profitable and the last thing we'll do is go back into those.

Heike M. Doerr - Robert W. Baird & Co. Incorporated, Research Division

Okay, that's helpful. How should we think about your CapEx budget and this Monterey Peninsula water supply project? Will that project -- I know it's spread over a longer time period. Will it just push you up within that band or may there be some years that you'll need to spend above that $1 billion that we've been talking about at the top end?

Susan N. Story

Heike, this is Susan. The expenditures for those projects are included in our forecast for -- we, this year, have said we will spend about $950 million in CapEx. We are looking -- and there is range you saw based on some things. It hadn't been decided yet the size of the plant, how we're going to approach, I believe it's 6.4 million gallons per day versus 9.6 million, and the 6.4 million would have bigger groundwater replenishment. So we're really working through right now what that will be, based on some of the final decisions on that project, but we anticipate those will be rolled in to our CapEx guidance for each year.

Operator

Our next question comes from Jonathan Reeder from Wells Fargo.

Jonathan Reeder - Wells Fargo Securities, LLC, Research Division

Following up on Heike's question there a little bit. So on a going-forward basis, I mean, is $950 million, is that going to be the bottom end of the range or can we get above the $1 billion, especially when, I guess, you're looking at the rate cases that are driven more on the CapEx side and the O&M side, do you have room to get more aggressive with the CapEx budget?

Edward D. Vallejo

Jonathan, I guess, the answer I want to give you is, we're certainly looking at the level of CapEx given what we think our future expenditures level will be, that we can put in and maintain the kind of rate levels that we think we can sell with our commissioners and customers. We'll talk more about that in December in terms of what that really looks like. But is there a potential for an $800 million, the $800 million to $1 billion that we've used for the couple of years that shift over the next 5 years? The answer to that is yes. When it might shift to, and how much it shifts, if it shifts at all, we'll talk more about it in December. Right now, we've got a plan that, as Susan said, has got California included in it. Remember, one of the things that's happening is we've been spending about $100 million a year on BT. That disappears this year. So there's $100 million there that was going to that project which now is going to be available to go into hard infrastructure on the regulated side. And so that's still at the current -- at the same current level. But we are -- we're still not spending for 100-year replacement cycle, for example, and that's our goal, it's to get to 100-year replacement cycle. Because that's really kind of the outer limits of what we think the life of most of these systems are.

Susan N. Story

And there's a lot of things we look at, Jonathan, part of it, and not just a flat amount, but what does that mean in terms of our equity needs. We've gone on the record that we do not anticipate issuing equity under normal business operations for the foreseeable future. So we run a lot of scenario now. We also are looking, for example, to Jeff's point, of next year not having the BT expenditures. What does it mean in terms of our distribution system infrastructure charge, which reduces regulatory lag? This year, about 39% of our CapEx will be DSIC, just as a matter of the B2 rolling off which isn't eligible, that percent could go up next year. So when we run the analysis of the overall target, we look at a lot of factors including both the reg side and the market bases.

Jonathan Reeder - Wells Fargo Securities, LLC, Research Division

Okay. And then I guess, as we're kind of looking out, the cash flows continue to improve if CapEx doesn't meaningfully increase. What's kind of the balance you're looking at between, I guess, equity -- appropriate equity ratio at the consolidated level, dividend increases, redeploying the cash, everything like that?

Jeffry E. Sterba

Well, you kind of gave what the basket of opportunities are. I mean, we are clearly not going to weaken our cap structure, but as we've talked about before, we don't necessarily see an overriding need to strengthen it necessarily either. So the 44% equity that we're at today, will by nature, go up a bit. But it's just we've got room to issue debt to the extent that our total CapEx or other expenditures, for example, with the kinds of acquisitions like the one we're doing in Virginia, that's a little larger, more of those. So we've got headroom to do that. If you're poking around, so is there a stock buyback on the horizon, those are things we do not have a stock buyback plan at this stage. Those are things that is an ongoing part of the business. We're focused on the right amount of capital first to invest in the business. And that's a function of both what we can afford through the rate-making process and the amount of free cash flow that we have in our headroom on the debt side. So I kind of leave it there. We'll give you more color about a forward look on the 5 years as we hit December.

Susan N. Story

And that's on the 17th Analyst Day.

Jonathan Reeder - Wells Fargo Securities, LLC, Research Division

Okay, Jeff, you're right. And then I guess last question, maybe more for Susan. As we look at, I guess, the operating expenses and everything, why weren't production costs may be down a little more than they were given more the large decrease in customer demand?

Susan N. Story

Most of our biggest expenses in production is in energy and chemicals. And we did see a decrease in both of those. Chemicals, we did have, in some areas, a little bit of an increase due to just some of the operations, but they were consistent. Production cost decreases were relatively consistent with the sales decrease. And remember, on the revenue, the $15.8 million makeup in the revenue, we only showed $8.6 million on the slide because that netted out the $7.2 million from 2012 from the California retro. So in terms of -- anything else on the production?

Jonathan Reeder - Wells Fargo Securities, LLC, Research Division

Okay. So, I mean, you're saying the production costs are down in line with the decreased customer demand, as you would have expected?

Susan N. Story

They were down in line mostly energy chemicals. Chemicals may not have gone down as much on a straight-line correlation because we did have some chemical increased cost in a few areas, but energy was, and chemicals were down. And those are the 2 predominant components of those expenses.

Operator

Our next question comes from Spencer Joyce with Hilliard Lyons.

David A. Paz - BofA Merrill Lynch, Research Division

Two, hopefully, pretty concise questions for you. One, on the New Jersey DSIC that we had going into effect in July, how often should be looking for reops on that? Is it going to be a little bump every 3 months, kind of like PA or maybe semiannually like the eastwest and Missouri, just how often can we look for a bump there?

Susan N. Story

That's a great question. I'm glad you asked. The regulations say that we can file up to twice a year in New Jersey for the DSIC. Some of you may have noticed there were some earlier material that we filed for $6.3 million. And I just noted that we have annualized increase to $4 million. Because of the way that the regulation is worded, it appeared that we could go in. And so we had anticipated during 7 months on our first filing, 5 months in our second, the staff really and rate counts, so really preferred that we do 6 and 6. So that accounts for the difference in the $6.3 million and the $4 million. But rather than being effective August 1, it was effective July 1. So short answer, it's twice a year, up to twice in 12 months. And we have further guidance that the preference is every 6 months.

Spencer E. Joyce - Hilliard Lyons, Research Division

Okay, fantastic. Second other question, totally switching gears. What's kind of the rollout time on those? How soon can we -- or should we be expecting some material revenue impact from those?

Edward D. Vallejo

Well, Nashville, we've got to go through the formal contract, and so that can take 30, 60 days, something like that. So it takes a little while. And then we have to put together the plan with the city because in that instance, this is an exclusive arrangement and it will go on their bill. So that -- it won't be until close to the end of the year before it could get rolled out. On Houston, frankly, I think that's already out there. We are starting to take customers into it. We've had advertisements and releases that have gone out and it's hit the newspapers in Houston. It is nonexclusive and so it's a little easier. They're basically just endorsing a couple of programs, so that one is moving forward. The Nashville one, because it is exclusive, has more potential, probably it won't really be out and customers are signing up until the end of the year.

Spencer E. Joyce - Hilliard Lyons, Research Division

Okay. Another question just kind of popped up. On the exclusive or nonexclusive, looking over some of the historical places you've serviced, what's the penetration rate difference between places you serve exclusively and non-exclusively?

Jeffry E. Sterba

In those areas where we are on the bill, so we're on the water or wastewater bill, we see penetration rates that are up into the 30s. And we have disclosed that before. So in the low-30s kind of range. When you're not on a bill, it noticeably drops off, but we don't get specific penetration.

Operator

Your next question comes from Angie Storozynski from Macquarie.

Angie Storozynski - Macquarie Research

I wanted to talk about 2 things about your enhanced growth. So first of all, the military contracts. I know that you are awaiting a number of them to be announced. Do you see an impacts from the federal sequestration on the timing of those tenders being announced?

Jeffry E. Sterba

Well, it's always hard to tell on the timing. The schedule -- the optimistic schedule is 18 months from the time first bids are made to the time that awards are made. And that hasn't necessarily ever happen. So honestly, we are still seeing strong activity. In fact, it's picked up. The challenge is, now, there's a 20% sequestration in the number of areas that we work with, so -- because they didn't do it unto the second half. So they're having -- they're a little higher on the furlough side. And so we are seeing a little bit of a slowdown, but it doesn't seem like it's significant. Things are still moving forward and we're seeing a pickup of activity particularly in the airports. So in one sense, I wish I could tell you, we're still seeing strong response, but we keep the eye out about -- are they really going to be able to keep the schedule?

Angie Storozynski - Macquarie Research

Okay. And secondly, you've mentioned potentially larger acquisitions as the way to the enhanced growth of earnings going forward. Could you put a bit of a context, you mean, we have some sour memories from the large acquisitions and how dilutive they used to be, equity needs, regulatory lag, how can you avoid these, and also, how can you convince the big sellers to give you their assets at book value without any goodwill issues and things like that?

Jeffry E. Sterba

It is a very good question and it has a couple of pieces to it. The example I would give is the Dale services. In the sense of how big our company is, it doesn't seem large, but 20,000 customers is a large acquisition in this world. Those kind -- these acquisitions, we're very disciplined about the ability to get what we pay in rates. If we don't think we can get it into rates, we are not paying it. Now that does not mean there won't be a premium because there are some states that allow a premium under certain circumstances. So if we're able, by virtue of that acquisition, to avoid a capital investment or 2 lower overall cost, then acquisitions can be allowed. Now we're still sitting on acquisition premiums made with citizens, for example. You're not going to see something like that and neither Susan or I or anybody else in this company has any appetite for paying major premiums that you're just, you're basically going to be accepting a lower return on. That's just not our philosophy about this. But things you are seeing certain communities that get into, they get challenged and we have a very disciplined approach about what is it that, that state will specifically allow. If they want more than that, well that's interesting, we're not going to pay more than that.

Angie Storozynski - Macquarie Research

Is it easier for you to buy large wastewater systems as opposed to fresh water?

Jeffry E. Sterba

Easier, none of the stuff is easy because it's got politics wrapped around it and all sorts of other stuff. To me and I think to us, wastewater is much more of an area that's got greater growth potential because wherever we serve water, someone's providing wastewater. And so we're already known in those communities. And that, most of the time, is not us. So we think that provides a market particularly given that wastewater is not necessarily held as dear on the municipal side as drinking water is, even though it's all one water. So we think that wastewater has significant potential for us.

Operator

Your final question comes from Mr. Brian Chin from Merrill Lynch.

Brian Chin - BofA Merrill Lynch, Research Division

I just have a quick one. On the Monterey Peninsula water supply project, obviously, this has been sort of a long-running project. Could you give us a sense on the settlement, to what extent you have cost overrun protections and/or are there monitoring requirements as the project is underway that help give regulators and yourself a sense of how expensive the project costs is projected to be?

Jeffry E. Sterba

Yes. At this stage, we only have estimates and that's what's reflected in the agreements. And part of that is because there are some -- a couple of outstanding issues in terms of the recharge project. So there isn't the ability to have certainty on what those costs are yet. So once -- as we get those resolved, those kinds of significant issues resolved, then I would expect that we'll have much firmer, that's why we're giving you a range at this stage, so there isn't a number that someone can say, oh, well you can't exceed this because specifics of the projects are not yet fully resolved.

Operator

Thank you, sir. That was your final question.

Jeffry E. Sterba

Well, let me just thank you, all, very much for your questions and for your interest. And we look forward to talking to you next quarter and don't hesitate to call us if you got any questions in the interim. Thanks much.

Operator

Thank you. That concludes the American Water Second Quarter 2013 Results Conference Call. Thank you for participating. You may now disconnect.

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