American Water Works Company, Inc. (NYSE:AWK)
Bank of America Merrill Lynch Power and Gas Leaders Conference Call
September 20, 2011 10:30 am ET
Jeffry Sterba – President and Chief Executive Officer, American Water Works Company, Inc.
Kevin Burke - Chairman, President, and Chief Executive Officer, Consolidated Edison, Inc.
Steve Fleishman – Bank of America/Merrill Lynch
Steve Fleishman – Bank of America/Merrill Lynch
The next panel is titled rate based growth stories, all these companies, that’s the key part of their investment case. We are going to kick it off with American Water Works with Jeff Sterba, who is the President and Chief Executive Officer and then we’re going to go to Con Ed with Kevin Burke, who is the Chairman, President and CEO. We will then move on to Northeast Utilities with Dave McHale, who is an EVP and CFO. And then finally to NSTAR with Phil Lembo who is the Treasurer.
Just one logistical thing, the American Water Works, they gave new guidance last night and since we’re not webcasting the Q&A at the end of this, if you do have a question on the guidance please feel free to ask Jeff that at the end of his presentation.
So without further ado, let me turn it over to Jeff. Thank you.
Thanks, Steve. Well, thank you all very much for being with us today and Steve for running another great program as you always do. As you now and as Steve mentioned we did issue revised guidance last night, which effectively moved our guidance from the high end of $1.75 to $1.85 per adjusted earnings per share to $1.75 to $1.82 per share. And the primary drivers for this were, it may seem a little strange to those of us that have weathered Hurricane Irene and Leah in the Northeast over the recent weeks, you clearly saw that New Jersey and Pennsylvania had very severe weather, a lot of rain and fairly mild temperatures in the month of August. But one of the advantages of our system is that since we’re so geographically spread we had offset in our midwestern areas, help to offset the reduction in load that we experienced in August. And then in July we saw a good, hot, fairly dry weather frankly across our system.
So weather and then having gotten through the summer, weather was a part of the reason why we increased guidance but only a part. We also have seen the cost initiatives and our operating excellence initiatives take a little firmer control, and then I think that for all of us that access the short-term debt market, short-term debt interest rates have been very low. Not one of those three items is the majority of the driver in guidance; it’s really the combination of those three items relative to adjusted EPS. So with that statement, I assume you have read and studied and you can call back to us.
Let me just give a little bit of an overview of American Water for those of you that may not know us quite as well. We’re the largest publicly traded water business in the United States. We operate in over 30 states and two Canadian provinces. We have a number of phases of the water business that we’re in from the treatment and delivery of portable water to the collection and treatment of waste water to the processing of that waste water for reuse, to the design, build and construct the facilities for the benefit of other utilities, and then on into what I will call a consumer services focus where we provide value added products to our customers. It’s about 90% regulated and it’s all state regulation and about 10% is market-based, and you can see the states that we operate in on both the regulated and the market-based side.
On the regulated side of the business, there are two states that account for about 45% of our business that’s Pennsylvania and New Jersey, but we’re relatively spread out after that in terms of the other states that we have. We serve about 1,600 communities in those 19 states. And I think you can see just from the geography that we benefit from both the spread and the hedge against weather changes that tend to be more localized as well as to the changes that happen through the regulatory cycles.
We just mentioned that I think the track record that we’re demonstrating in American Water is starting to be recognized by investors. For the last 12 months our total shareholder return is up over 30% compared to about 10% for the Dow Jones Utility, then just about 6.5%, 7% for the market at large. And we’re doing this with a risk or beta that’s basically half that of the market place. And you will notice on the beta chart that there is a blip up in the last, so it’s probably about 6, 7 weeks. This is when the market has gotten a bit more volatile.
Frankly, this kind of an increase in beta, I don’t mind because what’s really happening is the market declined about 6% over the last six, seven weeks and we have increased – our stock prices increased by about 6% over that same period of time. So that drives an increase in beta but it’s still at about half the rates of the marketplace.
Let me give you a few bullets around an overview of the industry. This is an infrastructure industry by definition, and it’s a little bit different than a lot of other infrastructure industry than that you don’t see most of our infrastructure, it’s kind of out of sight and out of mind. And because of that there has been a tendency to under invest in this infrastructure.
For example, on average across the country, less than one half of 1% of the infrastructure is replaced every year. Think about that. That translates into an assumed average life of 200 to 300 years. Now, I used to be in the energy industry, in fact I’m still in to an extent, but on the energy side we used to say, well, you know, it used to be that we have some equipment that would look very familiar to Thomas Edison because he would recognize that we did because the turnover was fairly slow.
For us in the water industry it goes back more to Thomas Jefferson. The rate of investment or change in renewal of systems has been slow and that places the service to customers and the quality frankly at risk, that’s why the society of civil engineers have given the water and waste water systems the B minus grade and it’s something that we are actively focused on changing. We invest $800 million to a $1 billion a year in fundamental infrastructure in our states; we’re striving to get to about 1% replacement rates and but that ageing infrastructure that creates an opportunity for us as we go forward both in our footprint as well as to be able to help others that are struggling to be able to finance that on their own.
It’s also a very fragmented industry. There are over 50,000 water companies, only 1% of them serve more than 100,000 customers, over 70% of them serve less than 10,000 customers. What does that scream? Consolidation, not so fast. We don't – we're not of the mind that fundamental consolidation will take place in the industry because frankly water is very local and it has the set of politics around it that make it very unique. So we do see consolidation opportunities and we’ll talk a little bit about that but we don't necessarily see this as an industry that is going to go from 50,000 to 500 in any short period of time.
Like the rest of the utility industry, it’s also heavily regulated on the environmental front. We have over 90 contaminants that are regulated with specific levels at the state and federal level and over 100 emerging contaminants for which there are guidelines.
Our approach on this is to be a leader. We don't believe in just following and meeting regs, we believe in doing the best we can to provide greater value to our customers. Let me just keep you an example. In any given year there are about 11,000 violations of clean drinking water standards across the country. That’s a shocking figure frankly. We’re about 5% of that market, so you could say, okay, American Water, you should have about 550, last year we had three. If you think about notices the violations for reporting or monitoring violation, there is over almost 30,000 of those a year. Again we're about 5% of the market that should be 1,500 last year, we had 10%. So while we’re not happy with that. We want to drive those to zero, but I think that shows the standard that we set for quality of the products and services that we provide our customers.
Last and let me just touch on technology. This is an area where we put a fair amount of effort and are lucky enough to have some great scientists who really are the kind of on the leading edge of both developing new treatment technologies and perfecting new technologies that can help us meet these criteria at an increasingly lower cost. For example our second largest cost after labor is power and it’s because water is heavy. We deliver a ton of water to every residential consumer every day. You got to move a ton of water. That’s not easy to do. That takes a lot of pumps, so we use an awful lot of electricity. Every chance that we have to increase the efficiencies by which we move water or process water is the savings for us and our customers. And the way we think about improving the efficiency and excellence of our operations is when we remove $1 of O&M out of our cost structure, we can replace that with $6 of capital have the same impact on customers that earn $0.30 a share. So that’s an equation that we like and it’s an equation that our regulators also like because it makes sense for them to have a renewal and replacement of the infrastructure of the business.
Water as you probably seen, it’s hard to pick up a newspaper today and not have something about water. It used to be only in the west where I came from that water was front and center, and we had the slogan of whiskey is for drinking and water is for fighting. That’s increasingly true frankly in other areas of the country whether it would be Atlanta three years ago where they almost ran dry, whether it would be the drought that hit parts of the northeast last year or the impacts that have occurred in the Great Lakes area back about three or four years ago.
And so comes customers in a Gallup poll recently said that their number one environment issue wasn’t air, it was water. That’s why my friends in the electric utility industry recently identified in a Black's Beach Survey that their number one issue of concern is water. Electricity generation diverts 40% of all water supplies in our country and consumes about 3.5% of all water supplies. As we face increasing risks of scarcity of water, the challenges that we will have about managing that both in the energy-water in excess but elsewhere will increase.
Going back to the regulatory side, I mentioned that we serve in 19 states. We’ve been going over the last year through what I will call it process of rationalization, in which we’ve really looked hard at where do we have scale? Where can we, do we have good regulatory environment and where can we earn the appropriate return on the capital that we invest in those states and have good growth prospects. As a result of that we exited Texas earlier this year, not because we don’t want to be in Texas, but because the business we had did not provide us the platform for growth, it was very small and scattered.
We also entered into a transaction that we believe will close about the end of the year at about a 40% premium to equity for the sale of our Arizona and the Mexico properties. And we have more recently entered into a transaction to sell our properties in Ohio that we’ll probably close in the first quarter of next year. And along with that we’ve expanded our operations in Missouri, which we believe to be a good state with great opportunities and prospects. And we’ve added about 60% to our business in the State of New York where we have long-standing good, performance and results.
The driver of our performance in our regulated operations is fundamentally capital investment. And as you can see we invest $800 million to $1 billion a year. One way to think about that is take the average of $900 million. We have depreciation of about $300 million, so we’re investing about three times our depreciation rate. We’ve got a net rate base of around $8 billion, so that $600 million is increasing the earnings power for the business every year as we go forward. Also of that $800 to a $1 billion, about 20% of that capital has recovered through automatic adjustment mechanism where we don’t have to go through rate cases, and we expect that percent to go up for a reason I’ll talk about in a moment.
American Water is a business where obviously if you operate on a regulated basis, the 19 states going to 16 you’ve got rate cases, and yes we have to have rate cases. And a lot of the growth in our earnings over the last couple of years has been frankly regulatory catch up. And while we’ve increased our guidance, we’re having a reasonably good year; we are not by any means where we need to be or where we expect to be. Our return on equity for this year will be somewhere around 7.2% to 7.4% inclusive of the debt at the parent company and that’s not where we expect to be as we move forward. But on the rate case front, we will continue to file rate cases. So far this year we’ve resolved six rate cases worth about $78 million of increased revenue and at this stage we have nine cases that are outstanding with a phase value of about $315 million.
But increasingly what you’ll find is this important stats is not the value of the dollars and that’s obviously critical, but amount of increases that we will be asking for will decline over time, but it’s the structure. It’s dealing with the more strategic policy issues. And so for example developing mechanisms to more fully recognize the fact that residential use per customer is declining somewhere between 1% and 2% a year. We’re making sure that we’ve got mechanism that will recover that so we don’t have to wait for another rate case.
Enhancing our automatic recovery mechanisms of new capital investment that is being used to renew and replace our distribution systems. I mentioned to you that those today recover about 20% of our investment every year. We do believe and are hopeful that we’ll get a good order probably in the early part of next year from the state of New Jersey to put in place a distribution surcharge which will increase about 20%.
So one of the other takeaways that I urge you to take from this chart is that we don’t believe in a one-size result, we tailor our regulatory strategy to meet the unique circumstances of that state, what their policies are and what are our objectives within that state are. So we don’t have, we’re not trying to put the same standards in place in every state although we’re obviously trying to push the same standard principles.
Let me just spend one last minute on our market-based operation. This is really not subjected to state regulation and I can break it up into three buckets, in total it’s about 10% of our business. The first piece is where we operate sometimes design and construct facilities for others. And one of our really strong businesses in that is that we’re the largest privatizer of water and wastewater infrastructure on military basis.
We have 10 contracts these are regulated like contracts meaning that they are 50 year agreements that have three year repricing openers. So we’re able to reach or up our costs every three years for the operation under those contracts. There is only a small percentage of the basis that have privatized with the Army leading the way, we see this is something that will go forward and grow. Today we have about $2 billion of revenue backlog in that business.
Our Homeowner Services is really a consumer product service, that’s where we help ensure help them be comfortable about the risk of a water or sewer line break either from the curve to the gutter, curve to that meter to the house or in some instances in the building itself in their home, and these provide peace of mind products that we found to be very, very well received by our customers. We have about 870,000 contracts today that business is growing at about 12% a year or so.
And the last one is our Emerging Technologies piece and this is where we’re focusing a lot more on water reuse, when you think about it all the waters that we produce for you, you consume 1% of it. The other 99% of treated water that you could drink is put on ground, that you use to flush a toilet, that you use to take shower, it isn’t ingested.
As we go forward into a world of higher water scarcity does that really makes sense, when we could take reused water and use that for irrigation, these are things that in the west, we’ve done for years, we use reused water, treated waste water to cool power plants. These are the kinds of things that I think we’ll see more and more deployed throughout the country.
One of the things that we have said to our investors is that we expect to grow 7% to 10% per year, obviously in the recent past we’ve grown more rapidly than that in 2010 again in 2011, but we do continue to believe that our long-term earnings per share growth rate is in the 7% to 10%.
What will drive that will change. So for example it is largely been driven by rate case catch up. It will increasingly been driven over the next four years or so by this focus on efficiency and effectiveness where we ask our people three basic questions. Is what you do add value? If not, stop doing it. If it adds value, is it being done through an effective process? If not let’s redesign the process. If it’s being done through an effective process where are the errors? And let’s find ways to drive those errors to zero. It’s very fundamental blocking and tackling, but it drives continuous improvement.
The fundamental engine will continue to be investments in our regulated operations by that $800 billion and increasingly they will in the longer-term it will be continually to be fueled by acquisitions and new products and services.
So that’s our story in a nutshell. We think that we provide a dividend, a good dividend, it’s a little over 3% today, we provide a 7% to 10% growth, we do all that at a risk that’s half of what the market is and we very much appreciate your interest in our company.
So with that Steve, I guess I would take any questions, if there is a specific question related to guidance, we’ll defer the other questions later. Any questions?
Great. Thank you very much.
Okay. Well, thank you, and thank you for all coming today, and thanks for coming to New York City. I mean just being around the streets of Times Square you can see the density, the vitality of New York City. It’s a place of opportunity and challenges and in Con Edison we’re used to both of them. But today, I want to talk about the investments in New York City and the other regions that we serve.
Here is our forward-looking statements, sure you’re going to see it, a lot of them today. Let me first focus a little bit on some general information about the company. We are the largest among the few publicly traded electric utility companies, that’s really focused on transmission and distribution. Our utilities have very limited commodity exposure. We have earnings visibility with multiyear rate plans in effect.
In addition, we’ve reduced some regulatory lag giving some of the following features of our rate plan. The forward-looking text here, finally commodity cost recovery and adjustment mechanisms where a couple of other major corporate expenses such as pensions and environmental costs. We have a strong dividend track record having increased the dividend over 37 consecutive years. We have the ability to invest for customer benefit and that ability is a result of that strong balance sheet and the liquidity that is available to us.
And finally, we have the highest electric reliability in the United States. What is that business model? It’s pretty straightforward. We’re really an energy deliver business providing electricity, gas and steam delivery service to the most densely populated city in the U.S.
Energy delivery is the core of our business activity and it is aware of senior management’s time is focused and the company’s resources are concentrated. Our Con Edison Company of New York subsidiary, which I will refer to as CECONY provides electric and gas delivery service to customers in New York City and Westchester and steam service to customers in Manhattan.
Our Orange & Rockland utilities subsidiary provides electric and gas delivery service in contiguous counties to the North and West of the CECONY service territory.
We also have three complementary and modestly sized competitive businesses that provide retail electric commodity supply, traditional energy services, energy management services to third party plant owners, solar energy projects and gas storage services.
The breakout of earnings and equity for year-end 2010 demonstrates the predominance of energy delivery in our business mix. 96% of ongoing earnings come from the regulated delivery business, which have received 95% of accumulative equity investment.
As I said, CECONY delivers electricity, gas and steam to customers in New York City and Westchester. More than half of that customer’s electricity and gas commodity is purchased from competitive retail energy suppliers and the New York Power Authority, we make no profit on commodity procurement in the regulated utilities. Orange & Rockland delivers electricity and gas to suburban customers in New York, New Jersey and a small portion of Pennsylvania.
Taking a look at our capital expenditures, I really want to focus the rest of my time on the investment in our delivery system and our competitive businesses. Over the next three years, we’ve budgeted about $2.1 billion in annual capital expenditures. The lion’s share of that investment is focused on energy delivery, a small portion of that spend is year marked to the competitive business.
Our utility construction expenditures are designed to support emission to provide energy services safely, reliably, efficiently, and in an environmentally sound manner. The modest investments for our competitive businesses are focused on renewable generation and energy infrastructure projects.
CECONY specifically our electric business dominates our capital investment. Our 2011 capital program for CECONY includes $1.4 billion of investment in electric operations, $335 million for gas operations and about $100 million for steam operations. I think you can see from this chart depreciation for CECONY is less than half of our annual capital expenditure. Meaning we will continue to add the rate base as we invest for customer benefit. Those rate base additions will grow the earning space of the company.
I will explore where the investments are being deployed, and first I’ll start with the CECONY electric system, most of the electric investments are of replacements and upgrading of existing assets. System expansion is driven by the local economy, in the last few years that slowed up a bit, we’re starting to see some signs of an uptick, but it’s still a lot slower than it had been.
Our capital program Electric System this year includes over $800 million for distribution systems, $63 million for transmission upgrades and system reliability, little over $200 million for new transmission substations, which completes the transmission line that we brought from Westchester into New York City, and the remainder is year marked for Smart Grid, IT and some other areas.
This summer we established a new record for electric peak usage on July 22, the new record is 13,189 megawatts, the prior record was 13,141 megawatts set five years ago. Our summer preparation program for the year included installing and replacing about 1,200 miles a cable establishing 26 new high voltage distribution cables, relieving another 97 cables and installing quite a few underground transformers. 1,200 miles a cable may not sound like a lot to be realized that kind of about 94,000 miles of underground cables.
Turning to CECONY gas you can see a similar investment being emerging, capital investments in our gas business is driven predominantly by the need to upgrade and replace existing assets. We have over 4000 miles of mains in our gas distribution system.
Our 2011 capital program includes a $79 million investment to replace 50 miles of cast iron and unprotected steel mains. Main replacement is the kind of word you’d expect on a system that’s been evolving over like almost two centuries.
Another area of investment worth noting is municipal infrastructure upgrades. We have $63 million in this year’s budget to relocate our facilities to accommodate public improvements such as the ongoing expansion of the subway lines, and some new connections to the water system. Supporting New York City project helps facilitate the growth in our service area. And more investment is invested for customer addition.
Climate change initiatives at the local level are also impacting capital investment than I guessed, New York City Clean Air rules are transforming CECONY into one of the nations most compelling growth stories for natural gas.
In April, Mayor Bloomberg put into place new rules that phase out the use of No.6 and No.4 heating oil in New York City. No.6 heating oil is going to be phased out by 2015 and No.4 by 2030. After those dates, no permits for existing boilers will be issued as they will be required to burn No.2 oil or natural gas. Effective immediately, no new permits are being issued for new boilers for either No.6 or No.4 oil.
We’ve identified more than 7,000 potential buildings with in-house service territory, most of those in Manhattan and the Bronx that could convert to natural gas over time. If all 7,000 were to convert to natural gas, it would mean a 90% increase in our peak hour load. It would also require a significant capital investment to reinforce that system.
We’ve already begun to see a surge in request to convert from oil to gas. We had 558 requests for oil to gas conversion in all of 2010 and through August of this year, we have nearly 1,500 significant change. The big increases are coming from buildings using No.6 oil, but also from No.2 oil where people are seeing a significant change in the price gap between No.2 oil and natural gas.
This year we created a dedicated department, working on the conversion opportunities. We do expect the conversions to drive a need for more capital investments in future years. In 2012 for instance we anticipate a real need to invest in additional almost $60 million for new regulator states, just to support the conversion of No.4 and No.6 oil. The incremental investment will provide customers with a cleaner energy alternative and will benefit shareholders as the earnings base in the gas business continues to go.
Climate change regulations are also impacting investments in our CECONY Steam business. We plan to invest about $350 million in our steam business over three years. Part of that investment is earmarked for converting two plants to gas burning capability. Converting the plant at 59th Street and 74th Street will significantly reduce emissions. The retrofitted plants will meet New York state Department of Environmental Conversation 2014 NOx requirements. Adding fuel diversity will also provide some savings to our customers. And the lowering cost for the customers is a fact that we weigh in all of our investment decisions.
Another cost savings initiative in our steam business is the retirement of two boilers at the Hudson Avenue station in Brooklyn, the capacity of which we no longer need. The retirement will reduce bills for steam system customers by 3%. The savings coming from avoid capital expenditures, lower operating cost and some fuel savings.
And now I’d like to turn briefly to our other regulated subsidiary, Orange & Rockland. The variance between capital expenditures and depreciation is even more pronounced at O&R than in CECONY. Depreciation is about one-third of total capital investment. And again that means we continue to benefit from an increase in rate base based upon our investments for customer benefit.
You see on the slide a breakdown of this year’s capital investment for O&R Electric and Gas. What is apparent is the consistent theme of replacement and upgrade of assets with system reliability. Our efforts are focused on being more cost effective with new technologies and other efficiencies. Our pursuit of efficiencies is one reason our smart grid effort is more concentrated on increasing the intelligence and monitoring capability of the grid but on devices like smart meters.
The electric business is where the bulk of O&R’s capital expenditure is directed. About $170 investment this year for electric compared to $35 million investment for gas. O&R’s five-year annualized growth in weather-adjusted electric peak usage is predicted to be more than double CECONY’s electric peak usage. Accordingly O&R needs to invest more heavily in substations to meet that growth.
I want to wrap up my discussion on investments in our energy delivery business by emphasizing two points, cost control and regulatory treatment of the investments. CECONY operates the largest underground electric system in the world as well as the largest district steam system, maintaining our sophisticated and extensive networks beneath the streets of New York City is an expensive proposition. Over the long-term, cost management and implementation of new technologies will be critical to hold the capital expenditures at levels acceptable to our regulators. That is where much of our 392 million smart grid investment is targeted. About half of that investment is government grants under the stimulus programs and the other half goes into rate base.
Our smart grid initiative involves a combination of enhanced monitoring and control capabilities along with intelligent, analytical and decision aid tools. The additional intelligence that we are installing in our electric transmission and distribution system can reduce the cost of monitoring, maintaining and expanding our systems.
The enhanced monitoring and controlled capabilities will also enable us over time to more cost effectively manage that network and should lead to greater efficiencies in our infrastructure investment. We expect the smart grid of the future to help us achieve long-term cost controls while meeting increasing customer usage and increasing customer expectations reliability. But we’re also vigilant about our near-term prospects. The effort to achieve cost efficiency is part of a long tradition of cost consciousness as a company.
The management’s attention to sustainability and cost reflects an effort to deliver to investors the value of the investments we make on behalf of our customers. The value is expressed in the earnings power of the business, which is the rate base. That investment gets rolled into rate base, which is the earnings driver for the company.
Rate base has grown by a compounded annual growth rate of 6% over the past 10 years. It's important to note that our rate base growth has been concurrent with our investment. The forward-looking testier approach used by the New York Public Service Commission is studying rates allows current recovery of investment, the current recovery means there is no lag in the return on those investments.
Final area we’re making some infrastructure investment is on the competitive businesses. We forecast capital investments of nearly $500 million over three years for our competitive energy businesses. We will pursue opportunities to invest in renewable generation and energy-related infrastructure projects. An example of the latter is an investment we made last year to acquire the remaining interest in a gas storage project that we didn’t own.
Our focus in renewable energy has been on solar energy. We will also explore future natural gas infrastructure opportunities as new supplies to our region increases to meet customer needs. Our largest solar project, the 20 megawatt photovoltaic project in Pilesgrove, New Jersey is now complete and online. We have a 50% interest in that project. We have three small projects that are complete bringing the total megawatts in-service and owned by Con Edison development of the 14 megawatt and we have another 18 megawatts under construction. The total investment for those projects is $128 million. We expect through these investments to deliver equity returns that are modestly above those we achieved in our delivery business.
Looking at the totality of our capital program, we invest for the customer benefit to deliver energy safely and reliably. As we execute that charge, we are ever mindful of our responsibility as stewards of the environment. This month we’re notified that Con Edison had once again been selected for the Dow Jones Sustainability Index for North America. Sustainability is important to us as it is to our plan and to our investors. We consider sustainability to be one of our guiding principles.
We are also mindful of our duties for our shareholders. 58% are individuals to whom the dividend is paramount. In January, we increased their dividend for the 37th consecutive year. We are the only utility in the S&P 500 with 30 or more consecutive years of dividend increases.
In closing, I want to return to our business model. We are a company focused on our customer. What we try to provide is safe reliable service with attention to cost efficiently. We also try to partner with our customers in shaping our business in our community along sustainability lines. Our business model calls for constant investment in our employees and our infrastructure. For our customers and for our investors, we think our business model is a sound proposition. We’re stable, conservative in our management’s bio and determined in the pursuit of our vision.
So I thank you for your time and I’ll await some questions later on. Thank you.