American Water Works Company, Inc.: Form 10-Q for the period ended Mar 31, 2016

The following discussion should be read together with the unaudited consolidated financial statements and the notes thereto included elsewhere in this Form 10-Q. This discussion contains forward-looking statements that are based on management’s current expectations, estimates and projections about our business, operations and financial performance. The cautionary statements made in this Form 10-Q should be read as applying to all related forward-looking statements whenever they appear in this Form 10-Q. Our actual results may differ materially from those currently anticipated and expressed in such forward-looking statements as result of a number of factors, including those we discuss under “Forward Looking Statements,” Part II, Item 1A—Risk Factors, and elsewhere in this Form 10-Q.

General

American Water Works Company, Inc. (“American Water” or the “Company”) is the largest and most geographically diverse investor-owned publicly-traded water and wastewater utility company in the United States, as measured both by operating revenue and population served. Our primary business involves the ownership of water and wastewater utilities that provide water and wastewater services to residential, commercial, industrial and other customers. Our utilities are generally subject to economic regulation by state regulatory agencies in the states in which they operate. We report the financial results of our utilities in our Regulated Businesses segment. We also provide other services through businesses that are not subject to economic regulation by state regulatory agencies. We present the results of these businesses as our “Market-Based Businesses”. For further description of our businesses, see Part I, Item 1—Business in our Form 10-K.

You should read the following discussion in conjunction with our Consolidated Financial Statements and related Notes included elsewhere in this Form 10-Q and in our Form 10-K.

Financial Results

Income attributable to common stockholders increased 2 cents per diluted share, or 4.5%, to $0.46 cents per diluted share in the first three months of 2016 from $0.44 cents per diluted share for the same period in 2015. This increase was primarily due to continued growth in our Regulated Businesses segment largely attributable to additional authorized revenue driven by investment growth and acquisitions.

See “Comparison of Consolidated Results of Operations” and “Segment Results of Operations” below for further discussion on the consolidated results of operations, as well as our business segments.

Regulatory Matters

The table below provides rate authorizations by state, which became effective during the three months ended March 31, 2016. The table depicts annualized incremental revenues resulting from general rate cases, assuming a constant water sales volume, and infrastructure surcharge mechanisms that became effective during the period:

(In millions)

Our Pennsylvania subsidiary was authorized additional annualized revenues from infrastructure surcharges of $2 million effective on April 1, 2016.

On April 6, 2016, the Missouri Public Service Commission (the “MoPSC”) approved two stipulations in the general rate case of our Missouri subsidiary. One stipulation includes an agreement providing for approximately $5 million in additional annualized revenues. The stipulations also resolve a number of issues associated with the Missouri general rate case. However, certain key policy issues of the rate case, such as rate design, rate consolidation and low income tariffs, remain outstanding. A final order of the MoPSC to resolve these policy issues is expected no later than June 30, 2016. Approval of the stipulation is subject to the MoPSC final order.

On April 29, 2016, our New York subsidiary filed a general rate case requesting an additional $8 million in annualized revenues. On April 29, 2016, our Iowa subsidiary filed a general rate case requesting an additional $5 million in annualized revenues. On May 2, 2016, our California subsidiary filed a preliminary application, in advance of our general rate case, requesting an additional $35 million in annualized revenues.

On April 15, 2016, our New Jersey subsidiary filed for additional annualized revenues from infrastructure surcharges in the amount of $9 million. On April 29, 2016, our West Virginia subsidiary filed for additional annualized revenues from infrastructure surcharges in the amount of $3 million.

As of May 3, 2016, including the filings discussed above, we are awaiting final general rate case orders in seven states requesting additional annualized revenue of $115 million. We are also awaiting approval from three states for additional annualized surcharges of $15 million. There is no assurance that all or any portion of these requests will be granted.

Focusing on Central Themes

For 2016, our focus continues to be anchored on the five central themes noted in 2015: 1) Safety, 2) Customers, 3) People, 4) Growth and 5) Technology and Operational Efficiency. We will continue our focus on operating our business responsibly and managing our operating and capital costs in a manner that benefits our customers and produces long-term value for our stockholders. Additionally, we will continue our ongoing strategy that ensures a safe workplace for our employees, emphasizes public safety for our customers and communities, and leverages our human resources, processes and technology innovation to make our business more effective and efficient. The progress that we have made in the first three months of 2016 with respect to growth and improvement in our operational efficiency ratio is described below.

Growth—Infrastructure improvements, acquisitions and strategic capital investments

During the three months of 2016, we made capital investments of approximately $236 million, focused in two key areas:

• $214 million primarily to improve infrastructure in our Regulated Businesses; and
• $22 million for acquisitions in our Regulated Businesses, which added approximately 7,000 water and wastewater customers.

For the full-year of 2016, our total capital investment, including acquisitions, is expected to be in the range of $1.3 billion to $1.4 billion, most of which is allocated to improving infrastructure in our Regulated Businesses. Included in this range is our net capital investment by Pennsylvania-American Water Company in substantially all of the wastewater collection and treatment assets of Sewer Authority of the City of Scranton (the “SSA”). The SSA currently serves approximately 31,000 wastewater customers in the City of Scranton and Dunmore Borough, Pennsylvania. We expect this acquisition to close in the second half of 2016.

In April 2016, legislation in Pennsylvania was signed into law which authorizes water and wastewater companies to pay for and earn on municipal water and wastewater systems at appraised value rather than at depreciated original cost. Also, in Indiana two pieces of legislation were signed into law. Act 257, the Distressed Water and Wastewater Utilities Act, allows for water and wastewater systems of any size to qualify as distressed. Additionally it opens the appraisal process to a simple agreement between a municipality and a prospective buyer. The second piece of legislation, the System Integrity Adjustment Act, creates the first water and wastewater revenue stability mechanism in the state and allows for recovery of any difference between authorized revenue and actual revenue.

Technology & Operational Efficiency—Continuing Improvement in Adjusted O&M Efficiency Ratio for our Regulated Businesses

We continued to improve on our adjusted O&M efficiency ratio (a non-GAAP measure). Our adjusted O&M efficiency ratio for the twelve months ended March 31, 2016 was 35.6%, compared to 36.3% for the twelve months ended March 31, 2015. The improvement in the 2016 O&M efficiency ratio over this period was attributable to an increase in revenue coupled with a decline in O&M expenses.

We evaluate our operating performance using this measure because management believes it is a direct measure of the efficiency of our Regulated Businesses’ operations. This information is intended to enhance an investor’s overall understanding of our operating performance. The O&M efficiency ratio is not a GAAP financial measure and may not be comparable to other companies’ operating measures and should not be used in place of the GAAP information provided elsewhere in this report.

Our adjusted O&M efficiency ratio is defined as our regulated O&M expense divided by regulated operating revenues, where both O&M expense and operating revenues were adjusted to eliminate purchased water expenses. Additionally, from the O&M expenses, we excluded the allocable portion of non-O&M support services cost, mainly depreciation and general taxes that are reflected in the Regulated Businesses segment as O&M costs but for consolidated financial reporting purposes are categorized within other line items in the accompanying Consolidated Statement of Operations.

The following table provides the calculation and reconciliation that compares O&M and operating revenues, as determined in accordance with GAAP, and to those amounts utilized in the calculation of our adjusted O&M efficiency ratio for the twelve months ended March 31, 2016 as compared to the same period in 2015.

(In millions)

* Calculation assumes purchased water revenues approximate purchased water expenses.

Consolidated Results of Operations

(In millions)%

Comparison of Consolidated Results of Operations

Operating revenues. In the first three months of 2016, operating revenues increased due to a:

• $19 million increase in our Regulated Businesses segment due to authorized rate increases to fund investment growth, acquisitions and incremental revenues from surcharges and balancing accounts, partially offset by lower consumption when compared to the same period in 2015;
• $15 million increase in our Market-Based Businesses primarily due to incremental revenue from our Military Services Group and contract growth in our Homeowner Services Group; and
• $12 million increase attributable to Keystone, which was acquired in the third quarter of 2015 and is included in our Market-Based Businesses.

Operation and maintenance. In the first three months of 2016, operation and maintenance expense increased primarily due to a:

• $13 million increase in our Market-Based Businesses primarily due to incremental costs in our Military Services Group and Homeowner Services Group corresponding with the increases in operating revenues discussed above, as well as the acceleration of marketing expenses into the first quarter; and
• $12 million increase attributable to Keystone.

Depreciation and amortization. In the first three months of 2016, depreciation and amortization expense increased primarily as a result of additional utility plant placed in service and the acquisition of Keystone.

Other income (expenses). In the first three months of 2016, other expenses increased primarily due to a $5 million increase in interest expense from the issuance of incremental long-term debt in the last six months of 2015.

Segment Results of Operations

Our segments are determined based on how we assess our performance and allocate our resources. We evaluate the performance of our segments and allocate resources based on several factors, with the primary measure being net income attributable to common stockholders.

We conduct our business primarily through one reportable segment, our Regulated Businesses segment. We also operate businesses that provide a broad range of related and complementary water and wastewater services in non-regulated markets, which includes four operating segments that individually do not meet the criteria of a reportable segment. These four non-reportable segments are presented as our “Market-Based Businesses”.

Regulated Businesses Segment

The following table summarizes certain financial information for our Regulated Businesses segment:

(In millions)%

Operating revenues. The following tables and discussions provide explanation of the variances related to the three components of operating revenues—water services revenues, wastewater services revenues and other revenues:

(In millions)

(In millions)

In the first three months of 2016, operating revenues increased primarily due to a:

• $16 million increase from authorized rate increases primarily to fund investment growth in various states;
• $4 million attributable to recent water and wastewater acquisitions;
• $4 million incremental revenues from balancing accounts and infrastructure surcharges; partially offset by a
• $7 million decline in consumption in 2016 compared to the same period in 2015 primarily due to declining usage from milder weather in certain states.

Operation and maintenance. The following table and discussions provide a detailed explanation of the variances related to the major components of operation and maintenance.

(In millions)%

In the first three months of 2016, operation and maintenance decreased primarily due to a:

• $4 million decrease in maintenance services and supplies primarily due to lower main breaks as a result of milder weather in 2016 compared to the same period in 2015; partially offset by a
• $3 million credit adjustment included in operating supplies and services in 2015, which was related to authorized recovery in the California rate case of previously expensed business transformation costs.

Operating expenses, net. This increase is principally due to higher depreciation and amortization expense of $8 million partially offset by the decrease in operation and maintenance expense as explained above. The increase in depreciation and amortization expense is primarily due to additional utility plant placed in service.

Market-Based Businesses

The following table summarizes certain financial information for our Market-Based Businesses:

(In millions)%

Operating revenues. In the first three months of 2016, operating revenues increased primarily due to a:

• $12 million increase resulting from Keystone;
• $9 million increase in our Military Services Group revenues primarily due to ongoing construction project activities; and
• $4 million increase in our Homeowner Services Group revenues primarily due to contract growth and the expansion into other geographic areas.

Operation and maintenance. The following table summarizes information regarding components of operation and maintenance:

(In millions)%

25

In the first three months of 2016, operation and maintenance expense increased primarily due to a:

• $12 million increase resulting from Keystone, including $5 million in employee-related costs, $6 million in operating supplies and services and $1 million in maintenance materials and supplies;
• $8 million increase in operating supplies and services primarily due to increased construction project activities in our Military Services Group, as well as additional marketing expenses in Homeowner Services Group; and
• $3 million increase in employee-related costs in our Military Services Group, Contract Operations Group and Homeowner Services Group, including the addition of two military contracts that started operations in late 2014 and the transition phase of the Vandernberg Air Force Base.

Operating expenses, net. This increase is principally due to the increase in operation and maintenance expense explained above as well as higher depreciation and amortization expense as a result of Keystone.

Liquidity and Capital Resources

For a general overview of our sources and uses of capital resources, see the introductory discussion under in Part II, Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources contained in our Form 10-K.

We fund liquidity needs for capital investment, working capital and other financial commitments through cash flows from operations, public and private debt offerings, commercial paper markets and, to the extent necessary, American Water Capital Corp. (“AWCC”) revolving credit facility. We regularly evaluate the capital markets and closely monitor the financial condition of the financial institutions with contractual commitments in our revolving credit facility.

In order to meet our short-term liquidity needs, we, through AWCC, our wholly owned financing subsidiary, issue commercial paper, which is supported by our revolving credit facility. Effective as of March 22, 2016 and under the terms of the revolving credit agreement dated June 30, 2015, AWCC exercised its right to increase its borrowing capacity available under our revolving credit facility from an aggregate maximum of $1.25 billion to $1.75 billion. All other terms, conditions and covenants with respect to the existing facility remained unchanged. The Company incurred $1 million of issuance costs in connection with the increased lending commitments, which will be amortized over the remaining life of the credit facility. Also on March 22, 2016, AWCC increased the commercial paper program from $1.0 billion to $1.6 billion.

On March 24, 2016, we entered into three forward starting swap agreements with an aggregate notional amount of $225 million to reduce interest rate exposure for a portion of the expected refinancing of our 6.085% fixed-rate long-term debt maturing in 2017. The forward starting swap agreements terminate in December 2017 and have an average fixed interest rate of 2.30%.

As of March 31, 2016, AWCC had no outstanding borrowings and $89 million of outstanding letters of credit under the revolving credit facility. As of March 31, 2016, AWCC had $1.66 billion available under the revolving credit facility to fulfill our short-term liquidity needs and to issue letters of credits, which supported $839 million in outstanding commercial paper. We believe that our ability to access the capital markets, our revolving credit facility and our cash flows from operations will generate sufficient cash to fund our short-term requirements. However, we can provide no assurances that the lenders will meet their existing commitments to AWCC under the credit facility or that we will be able to access the commercial paper or loan markets in the future on terms acceptable to us or at all.

Cash Flows Provided by Operating Activities

Cash flows provided by operating activities primarily result from the sale of water and wastewater services and, due to the seasonality of demand, are generally greater during the third quarter of each fiscal year. The following table provides a summary of the major items affecting cash flows provided by our operating activities:

(In millions)

(a) Includes depreciation and amortization, deferred income taxes and amortization of deferred investment tax credits, provision for losses on accounts receivable, gain on asset dispositions and purchases, pension and non-pension postretirement benefits expense and other non-cash, net. Details of each component can be found in the Consolidated Statements of Cash Flows.

(b) Changes in working capital include changes to receivables and unbilled revenues, pension and non-pension postretirement benefit contributions, accounts payable and accrued liabilities, and other current assets and liabilities, net.

In the first three months of 2016, the increase in cash flows from operating activities, as compared to the same period in 2015, is primarily due to changes in non-cash activities and working capital. Most of the change in the non-cash activities is associated with an increase in deferred taxes, mainly as a result of infrastructure investment combined with the tax effect of electing bonus depreciation which is also a component of the change in other assets and liabilities. The changes in working capital were principally driven by three components: a change in accounts receivable and unbilled revenues resulting from continuous improvement in our Regulated Businesses’ collection efforts, as well as increased collection of outstanding receivables in our Military Services Group in 2016; a change in accounts payable and accrued liabilities mainly associated with incremental accrued interest in 2016 partially offset by the timing of payments; and lastly, a change in other assets and liabilities, net as a result of a change in the book overdraft liability from the timing of accounts payable and the timing of electing bonus depreciation as described above.

Cash Flows Used in Investing Activities

The following table provides information regarding cash flows used in our investing activities:

(In millions)

(a) Includes removal costs from property, plant and equipment retirements, net, proceeds from sale of assets and net funds restricted.

In the first three months of 2016, net capital expenditures increased $58 million, or 25.7%, primarily due to continued investment across all infrastructure categories, mainly replacement and renewal of transmission and distribution infrastructure in our Regulated Businesses.

The increase in cash utilized for acquisitions during the first three months of 2016 compared to the same period in 2015 is principally due to the purchase of all of Environmental Disposal Corporation’s outstanding capital stock, an investor-owned wastewater utility in New Jersey.

As previously discussed, on March 29, 2016, Pennsylvania-American Water Company (“PAWC”) entered into an asset purchase agreement with the SSA to acquire substantially all of the wastewater collection and treatment system assets of the Sewer Authority of the City of Scranton (the “SSA”) system for a total transaction value of approximately $195 million, subject to certain adjustments as provided in the asset purchase agreement. Included in the agreement is a requirement that the SSA must transfer $38 million of cash at the time of closing, as well as other purchase price adjustments. The SSA is currently subject to a Consent Decree with the U.S. Environmental Protection Agency (the “EPA”) and the Pennsylvania Department of Environmental Protection (“PaDEP”), which requires the SSA to complete significant upgrades to its sewer system at an estimated cost of $140 million. As a part of the purchase, PAWC will be required to cause the Consent Decree to be amended to allow it to assume the obligations and liabilities of the SSA thereunder. The acquisition closing is subject to the approval of the Pennsylvania Public Utility Commission, and, with respect to the amendment of the Consent Decree, the consent of the EPA, PaDEP, the U.S. Department of Justice and the U.S. District Court for the Middle District of Pennsylvania. We expect to close the transaction by September 30, 2016.

Cash Flows Provided by Financing Activities

The following table provides information regarding cash flows provided by our financing activities:

(In millions)

(a) Includes proceeds from issuance of common stock under various employee stock plans and our dividend reinvestment plan, advances and contributions for construction, net of refunds, debt issuance costs and tax benefits realized from equity compensation.

The increase in proceeds from short-term borrowings in 2016 was primarily due to the use of short-term borrowings to fund a portion of the capital expenditures, acquisitions and anti-dilutive stock repurchases.

The following long-term debt was retired through sinking fund provisions, optional redemptions or payment at maturity during the first three months of 2016:

Credit Facilities and Short-Term Debt

The following table summarizes information as of March 31, 2016 regarding the Company’s aggregate credit facility commitments, letter of credit sub-limits and available funds under those revolving credit facilities, as well as outstanding amounts of commercial paper and outstanding borrowings under the respective facilities:

(In millions)

(a) Includes amounts related to Keystone’s revolving credit facility. The total commitment under the revolving credit facility was $16 million, all of which was available as of March 31, 2016.

The weighted-average interest rate on short-term borrowings for the three months ended March 31, 2016 and 2015 was approximately 0.74% and 0.47%, respectively.

Capital Structure

The following table provides certain information regarding our capital structure as of each of the dates set forth below:

Debt Covenants

Our debt agreements contain financial and non-financial covenants. To the extent that we are not in compliance with these covenants, such an event may create an event of default under the debt agreement and we, or our subsidiaries, may be restricted in the ability to pay dividends, issue new debt or access our revolving credit facility. For two of our smaller operating companies, we have informed our counterparties that we will provide only unaudited financial information at the subsidiary level, which resulted in technical non-compliance with certain of their reporting requirements under debt agreements with respect to $8 million of outstanding debt. We do not believe this event will materially impact us. Our long-term debt indentures also contain a number of covenants that, among other things, limit the Company from issuing debt secured by the Company’s assets, subject to certain exceptions. Our failure to comply with any of these covenants could accelerate repayment obligations.

Certain long-term notes and the AWCC revolving credit facility require us to maintain a ratio of consolidated debt to consolidated capitalization (as defined in the relevant documents) of not more than 0.70 to 1.00. As of March 31, 2016, our ratio was 0.57 to 1.00 and therefore we were in compliance with the covenant.

Security Ratings

Our access to the capital markets, including the commercial paper market, and respective financing costs in those markets, may be directly affected by our securities ratings. We primarily access the debt capital markets, including the commercial paper market, through AWCC. However, we have also issued debt through our regulated subsidiaries, primarily in the form of tax exempt securities or borrowings under state revolving funds, to lower our overall cost of debt.

The following table presents the Company’s securities ratings as of March 31, 2016:

A security rating is not a recommendation to buy, sell or hold securities and may be subject to revision or withdrawal at any time by the assigning rating agency, and each rating should be evaluated independently of any other rating. Security ratings are highly dependent upon our ability to generate cash flows in an amount sufficient to service our debt and meet our investment plans. We can provide no assurances that our ability to generate cash flows is sufficient to maintain our existing ratings. None of our borrowings are subject to default or prepayment as a result of a downgrading of these security ratings, although such a downgrading could increase fees and interest charges under our credit facility.

Dividends

On March 1, 2016, we paid a cash dividend of $0.34 per share to the Company’s shareholders of record as of February 8, 2016.

On April 22, 2016 our Board of Directors declared a quarterly cash dividend payment of $0.375 per share payable on June 1, 2016 to stockholders of record as of May 9, 2016. Future dividends, declared at the discretion of the Board of Directors, will be dependent upon future earnings, cash flows, financial and legal requirements and other factors.

Application of Critical Accounting Policies and Estimates

Our financial condition, results of operations and cash flows are impacted by the methods, assumptions and estimates used in the application of critical accounting policies. See Part II, Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates in our Form 10-K for a discussion of our critical accounting policies.

Recent Accounting Pronouncements

See Note 2—New Accounting Pronouncements to the Notes to Consolidated Financial Statements included in Part I, Item 1—Consolidated Financial Statements of this Quarterly Report on Form 10-Q for a description of new accounting standards recently adopted or pending adoption.

We are subject to market risks in the normal course of business, including changes in interest rates and equity prices. There have been no significant changes to our exposure to market risk since December 31, 2015. For a discussion of our exposure to market risk, refer to Part II, Item 7A—Quantitative and Qualitative Disclosures about Market Risk contained in our Form 10-K.

Evaluation of Disclosure Controls and Procedures

American Water maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.

Our management, including the Chief Executive Officer and the Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of March 31, 2016.

Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of March 31, 2016, our disclosure controls and procedures were effective at a reasonable level of assurance.

Changes in Internal Control over Financial Reporting

We concluded that there have been no changes in our internal control over financial reporting that occurred during the three months ended March 31, 2016, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act).

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, Item 1A—Risk Factors in our Form 10-K, and in our other public filings, which could materially affect our business, financial condition or future results. Other than as set forth below, there have been no material changes from risk factors previously disclosed in Part I, Item 1A—Risk Factors in our Form 10-K.

On April 1, 2016, we experienced a non-cybersecurity-related firmware failure of an information technology storage device utilized for our core business functions. Our water and wastewater systems were not impacted by this event. We implemented our disaster recovery activities and were able to utilize all financial systems and established internal control procedures for the quarter and month ended March 31, 2016. The foregoing should be read in conjunction with the risk factor set forth in Part I, Item 1A—Risk Factors in our Form 10-K entitled “We rely on technology to facilitate the management of our business and customer and supplier relationships, and a disruption of these systems could adversely affect our business.”