As filed with the Securities and Exchange Commission on August 27, 2007.
Registration No. 333-
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form S-1
REGISTRATION STATEMENT UNDER
THE SECURITIES ACT OF 1933
AMERICAN WATER WORKS COMPANY, INC.
(Exact name of registrant as specified in its charter)
Delaware | 4941 | 51-0063696 | ||
(State or other jurisdiction of incorporation or organization) |
(Primary Standard Industrial Classification Code Number) |
(I.R.S. Employer Identification Number) |
1025 Laurel Oak Road
Voorhees, NJ 08043
(856) 346-8200
(Address, including zip code, and telephone number, including area code, of registrants principal executive offices)
Donald L. Correll
President and Chief Executive Officer
American Water Works Company, Inc.
1025 Laurel Oak Road
Voorhees, NJ 08043
(856) 346-8200
(Name and address, including zip code, and telephone number, including area code, of agent for service)
Copies to:
William V. Fogg, Esq. Cravath, Swaine & Moore LLP Worldwide Plaza 825 Eighth Avenue New York, NY 10019 (212) 474-1000 |
George W. Patrick, Esq. Vice President and General Counsel American Water Works Company, Inc. 1025 Laurel Oak Road Voorhees, NJ 08043 (856) 346-8200 |
Robert E. Buckholz, Jr., Esq. Sullivan & Cromwell LLP 125 Broad Street New York, NY 10004 (212) 558-4000 |
Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.
If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. ¨
If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ¨
If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ¨
If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration number of the earlier effective registration statement for the same offering. ¨
CALCULATION OF REGISTRATION FEE
Title of Each Class of Securities to be Registered |
Proposed Maximum Aggregate Offering Price(1)(2) |
Amount of Registration Fee | ||
Common Stock, par value $1.00 per share |
$1,500,000,000 | $46,050.00 | ||
(1) | Includes shares to be sold upon exercise of the underwriters option to purchase additional shares. See Underwriting. |
(2) | Estimated solely for the purposes of calculating the registration fee pursuant to Rule 457(o) of Regulation C under the Securities Act of 1933, as amended. |
The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.
The information in this preliminary prospectus is not complete and may be changed. The selling stockholder may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities, and we and the selling stockholder are not soliciting an offer to buy these securities, in any state where the offer or sale is not permitted.
Subject to Completion, dated August 27 , 2007.
(Preliminary Prospectus)
Shares
American Water Works Company, Inc.
Common Stock
This is an initial public offering of common stock of American Water Works Company, Inc. The selling stockholder is selling all of the shares in the offering. We will not receive any of the proceeds from the sale of shares by the selling stockholder.
Concurrently with this offering, we are offering by separate prospectus $ million of our equity units. This offering of common stock is not contingent upon the consummation of our offering of equity units.
The initial public offering price per share of the common stock is currently estimated to be between $ and $ . We intend to apply to list our common stock for trading on the New York Stock Exchange under the symbol AWK.
Investing in our common stock involves risks. See Risk Factors beginning on page 11 to read about factors you should consider before buying shares of our common stock.
Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed on the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.
Per share | Total | |||||
Initial public offering price |
$ | $ | ||||
Underwriting discount |
$ | $ | ||||
Proceeds, before expenses, to the selling stockholder |
$ | $ |
The underwriters may also purchase up to an additional shares of common stock from the selling stockholder at the public offering price, less the underwriting discount, within 30 days from the date of this prospectus.
The underwriters expect to deliver the shares against payment in New York, New York on , 2007.
Goldman, Sachs & Co. | Citi | Merrill Lynch & Co. |
Prospectus dated , 2007.
Page | ||
1 | ||
11 | ||
26 | ||
27 | ||
28 | ||
28 | ||
28 | ||
29 | ||
Unaudited Pro Forma Condensed Consolidated Financial Information |
30 | |
36 | ||
Managements Discussion and Analysis of Financial Condition and Results of Operations |
38 | |
71 | ||
98 | ||
132 | ||
134 | ||
136 | ||
139 | ||
143 | ||
Material United States Federal Tax Consequences to Non-United States Stockholders |
145 | |
148 | ||
152 | ||
152 | ||
152 | ||
G-1 | ||
F-1 |
You should rely only on the information contained in this prospectus or any free writing prospectus prepared by or on behalf of us. We have not authorized anyone to provide you with information that is different. We are not making an offer of our common stock in any state where the offer is not permitted. You should not assume that the information contained in this prospectus is accurate as of any date other than the date on the front cover of this prospectus.
As used in this prospectus, and unless otherwise indicated or unless the context otherwise requires:
| American Water, our, us, we or the Company means American Water Works Company, Inc. and its subsidiaries after giving effect to the Restructuring, as defined below; |
| AWCC means American Water Capital Corp., our finance subsidiary, which is a wholly owned subsidiary of American Water Works Company, Inc.; |
| customer means a connection to our water or wastewater networks; as in the case of apartment complexes, businesses and many homes, multiple individuals may be served by a single connection; |
| population means the estimated number of people served by our water and wastewater services; see Industry and Market Data for the methodology we employ to estimate population served; |
| RWE means RWE Aktiengesellschaft, a stock corporation incorporated in the Federal Republic of Germany whose shares are publicly listed on the Frankfurt and Düsseldorf stock exchanges and other German stock exchanges as well as on the Zurich stock exchange; |
(i)
| selling stockholder means Thames Water Aqua Holdings GmbH, a limited liability company organized under the laws of the Federal Republic of Germany and a direct wholly owned subsidiary of RWE, and not any of its subsidiaries; |
| state PUC means a state commission or other entity engaged in economic regulation of public utilities; and |
| Thames US Holdings means Thames Water Aqua US Holdings, Inc., a Delaware corporation, a direct wholly owned subsidiary of the selling stockholder and an indirect wholly owned subsidiary of RWE, and not any of its subsidiaries. Thames US Holdings will be merged with and into American Water in the Merger described herein, with American Water as the surviving entity. |
American Water and its logos are our trademarks. Other service marks, trademarks and trade names referred to in this prospectus are the property of their respective owners.
Our regulated subsidiaries are subject to economic regulation by state PUCs in Arizona, California, Hawaii, Illinois, Indiana, Iowa, Kentucky, Maryland, Missouri, New Jersey, New Mexico, New York, Ohio, Pennsylvania, Tennessee, Texas, Virginia and West Virginia. Some of these states have enacted laws that require regulatory approval for the acquisition of control of any regulated utility. In those states, obtaining control of the parent or any other company that controls a regulated utility also requires prior regulatory approval. The threshold for a change of control is a fact-specific inquiry that varies by state. For example, in several states, a presumption of control will arise when an acquiring party acquires more than 9.9% of the voting securities of the regulated utility or the controlling entity. In addition to ownership, other states may analyze the degree of influence or control an acquiror may exert over the company. Any person acquiring our common stock in this offering, through the concurrent offering of our equity units or in any other purchase of our common stock in a quantity sufficient to trigger a change of control under state law would need the prior approval of the applicable state PUC.
Dealer Prospectus Delivery Obligation
Through and including , 2007 (the 25th day after the date of this prospectus), all dealers that effect transactions in our common stock, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers obligation to deliver a prospectus when acting as an underwriter and with respect to unsold allotments or subscriptions.
(ii)
This summary highlights information contained elsewhere in this prospectus. It may not contain all the information that is important to you. You should carefully read this entire prospectus, including the section captioned Risk Factors and the consolidated financial statements and notes to the consolidated financial statements, before making an investment decision. For the definition of certain terms used in this prospectus, please refer to the definitions set forth above and under Glossary.
Our Company
Founded in 1886, American Water is the largest investor-owned United States water and wastewater utility company, as measured both by operating revenue and population served. Our nearly 6,900 employees provide approximately 16.2 million people with drinking water, wastewater and other water-related services in 32 states and Ontario, Canada. In 2006, we generated $2,093.1 million in operating revenue, representing approximately four times the operating revenue of the next largest investor-owned company in the United States water and wastewater business, and $252.5 million in operating income, which includes $221.7 million of impairment charges relating to continuing operations.
Our primary business involves the ownership of water and wastewater utilities that provide water and wastewater services to residential, commercial and industrial customers. Our subsidiaries that provide these services are generally subject to economic regulation by state Public Utility Commissions, referred to as state PUCs, in the states in which they operate. The federal government and the states also regulate environmental, health and safety and water quality matters. We report the results of this business in our Regulated Businesses segment. Our Regulated Businesses currently provide services in 20 states within the United States and in 2006 served approximately 3.3 million customers, or connections to our water and wastewater networks. In 2006, our Regulated Businesses generated $1,854.6 million in operating revenue, prior to inter-segment eliminations, representing 88.6% of our consolidated operating revenue.
We also provide services that are not subject to economic regulation by state PUCs. We report the results of this business in our Non-Regulated Businesses segment. Our Non-Regulated Businesses include our Contract Operations Group, our Applied Water Management Group and our Homeowner Services Group. In 2006, our Non-Regulated Businesses generated $248.5 million in operating revenue, prior to inter-segment eliminations.
Our Industry
The United States water and wastewater industry has two main segments: (i) utility, which involves supplying water and wastewater services to customers, and (ii) general services, which involves providing water and wastewater-related services, including engineering, consulting and sales of water infrastructure and distribution products, such as pipes, to water and wastewater utilities and other consumers on a fee-for-service contract basis.
The utility segment includes municipal systems, which are owned and operated by local governments, and investor-owned systems. Government-owned systems make up the vast majority of the United States water and wastewater utility segment, accounting for approximately 85% of all United States community water systems and approximately 95% of all United States community wastewater systems.
The utility segment is characterized by high barriers to entry, including high capital spending requirements. Investor-owned water and wastewater utilities also face regulatory approval processes in order to do business, which may involve obtaining relevant operating approvals, including certificates of public convenience and
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necessity (or similar authorizations), pursuant to which state PUCs grant investor-owned utilities the right to provide service within an authorized service area. The utility segment of the United States water and wastewater industry is highly fragmented, with approximately 53,000 community water systems and approximately 16,000 community wastewater facilities, according to the United States Environmental Protection Agency, or EPA, and therefore presents opportunities for consolidation. Larger utilities, such as ours, that have greater access to capital are generally more capable of making mandated and other necessary infrastructure upgrades to water and wastewater systems.
Our Strengths
We believe that we are distinguished by the following key competitive strengths:
Market leader with broad national footprint and strong local presence. We are the largest and most geographically diversified investor-owned water and wastewater utility company in the United States. With operations in 32 states and Ontario, Canada, we serve a population of approximately 16.2 million people, which we estimate is approximately five times the population served by the next largest investor-owned water and wastewater company in the United States. Our scale and geographic scope enable us to capitalize effectively on growth opportunities across our service areas, while helping to insulate us from adverse conditions in any one geographic area.
| Regulatory, weather and economic diversity. Our presence in numerous jurisdictions and localities across the United States promotes more stable and predictable financial performance across our overall business. |
| Economies of scale. As the largest investor-owned water and wastewater utility company in the United States, our scale and long-standing history with suppliers provide us with a competitive advantage in procuring goods and services reliably and economically, which enables us to provide high quality, cost-effective service to our customers and allows us to economically employ industry experts to serve all our systems. |
| Active community involvement supports customer satisfaction. We establish an active presence in the local communities we serve, supported by strong, ongoing community relations and corporate responsibility. We work closely with these communities to help create detailed water development plans, collaborate on growth initiatives and implement various water infrastructure and conservation projects. |
Regulated Businesses provide financial stability. Our core Regulated Businesses, which consist of locally managed utility subsidiaries that generally are economically regulated by the states in which they operate, accounted for approximately 88.6% of our consolidated operating revenue in 2006. Our Regulated Businesses provide a high degree of financial stability because (i) high barriers to entry insulate us from competitive pressures, (ii) economic regulation promotes predictability in financial planning and long-term performance through the rate-setting process and (iii) our largely residential customer base promotes consistent operating results.
| Barriers to entry. The requirement to hold or to obtain government authorizations, along with high capital costs, generally inhibit competitive entry into our markets, including by municipal or government-owned utilities, which must either construct new systems or convert our assets to public ownership in order to compete directly with us in our authorized areas. Both of these factors provide a framework that allows us to operate our Regulated Businesses on a predictable and consistent basis. |
| Economic regulation. Economic regulation in the water and wastewater utility industry exists as a substitute for competition. The primary regulatory model used by state PUCs involves a determination of an applicable rate base (consisting of allowed investments made in infrastructure), the recovery of prudently incurred operating expenses and an opportunity to earn an appropriate rate of return of and |
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on invested capital. This model allows us to project our returns of and on investment and recovery of expenses and promotes predictability in financial planning and long-term performance of our Regulated Businesses. |
| Residential customer base. Residential customers accounted for approximately 91% of the total customers served by our Regulated Businesses and approximately 61% of total operating revenue for our Regulated Businesses in 2006. Residential customers represent a stable customer platform, generating consistent operating results for our company over time and across our geographic service areas. |
Experience in securing appropriate rates of return and promoting constructive regulatory frameworks. We seek appropriate rates of return of and on investments and recovery of prudently incurred operating expenses from state PUCs in the form of rate increases, referred to as rate relief. We have a strong track record of providing reliable service at cost-effective rates, which has typically resulted in high customer satisfaction and has generally allowed us to maintain positive relations with local communities and regulators. We have generally been granted rate relief in a timely manner after application, and prior to our acquisition by RWE, we often were successful in securing appropriate rate relief when we filed rate cases. In the period following RWEs acquisition of the Company, as a condition to the approval of the acquisition, we agreed with some state PUCs that we would not file rate cases for specified periods of time, also known as rate stay-outs. As of June 30, 2007, all rate stay-out provisions had expired.
A number of states in which our Regulated Businesses operate have adopted efficient rate policies, including some form of single tariff pricing, forward-looking test years and infrastructure surcharges. These constructive regulatory mechanisms encourage us to maintain a steady capital expenditure program to repair and improve water and wastewater systems as needed by reducing the regulatory lag on the recovery of prudent expenditures.
Significant growth opportunities with a low risk business profile. We believe we are well positioned to benefit from favorable industry dynamics in the water and wastewater sectors, which provide significant opportunities for future growth in both our Regulated Businesses and complementary Non-Regulated Businesses.
| Replacement of aging infrastructure. We intend to invest capital prudently to enable us to continue to provide essential services to our regulated water and wastewater utility customers and to assist municipalities in meeting the capital challenges of making substantial required infrastructure upgrades. We have successfully developed expertise in managing large capital investment projects and programs as an owner-operator and have an established track record of investing to upgrade, replace and add new pipes, treatment and pumping facilities and other water system infrastructure. In addition, we have experience designing, building and operating water treatment plants, which treat water from major rivers as well as lakes, reservoirs and groundwater sources within the United States. |
| Fragmented industry provides consolidation opportunities. With approximately 53,000 community water systems and roughly 16,000 community wastewater systems in the United States, the water and wastewater industry is significantly more fragmented than the other major utility industries. With the presence of our Regulated Businesses in 20 states, we have a large platform on which to grow both organically and through consolidation of this fragmented market. |
| Opportunities for non-regulated growth. Our expertise and geographic diversity increases our ability to make opportunistic investments in non-regulated businesses that are complementary to our Regulated Businesses. Our national footprint and public/private partnership experience, including operation and maintenance contracts, referred to as O&M contracts, position us to participate in existing and emerging non-regulated water businesses. These include contracting for the supply and treatment of water and collection and treatment of wastewater with the United States military. |
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Experienced senior management team. Our three senior managers have an average of 27 years of experience in the utilities industry. Donald L. Correll, our President and Chief Executive Officer, Ellen C. Wolf, our Senior Vice President and Chief Financial Officer, and John S. Young, our Chief Operating Officer, have all held senior management positions at publicly traded companies. Our 12 state presidents have an average of 19 years of experience in the utilities industry.
Industry leader in water quality, testing and research. As the largest investor-owned United States water and wastewater utility company, we are experts in water quality testing, compliance and treatment and have established and own industry-leading water testing facilities. Our technologically advanced quality control and testing laboratory in Belleville, Illinois is certified in 24 states through the EPA Unregulated Contaminant Monitoring program. Our laboratories and other facilities perform more than one million water quality tests per year.
Our Strategy
Our goal is to consistently provide customers with safe, high quality drinking water and reliable water and wastewater services. Our business strategies include:
| continuing to prudently invest in regulated water and wastewater infrastructure projects; |
| earning an appropriate rate of return on our investments from state PUCs; |
| growing our Regulated Businesses through acquisitions; and |
| continuing to pursue public/private partnerships, including O&M and military contracts and services, and other non-regulated businesses that are complementary to our Regulated Businesses. |
The Transactions
American Water is currently an indirect wholly owned subsidiary of RWE. RWE is one of Europes leading electricity and gas companies and supplies 20 million customers with electricity and 10 million customers with gas in Germany, the United Kingdom and Central and Eastern Europe. On November 4, 2005, RWE announced its intention to exit its water activities in the United States and the United Kingdom to focus on its core European electricity and gas business and has since then completed the divestiture of its water business in the United Kingdom. As a part of this strategy, RWE intends to fully divest its ownership of American Water through the consummation of one or more public offerings of common stock of American Water as soon as reasonably practicable, subject to market conditions, referred to as the RWE Divestiture. In anticipation of the RWE Divestiture, effective December 31, 2006, the businesses of Thames Water Holdings Incorporated and its subsidiaries were contributed by Thames US Holdings to American Water, referred to as the Contribution. In addition, prior to the consummation of this offering, Thames US Holdings will be merged with and into American Water with American Water being the surviving entity, referred to as the Merger. The Contribution and the Merger are referred to collectively in this prospectus as the Restructuring.
Prior to this offering we will effect a -for- stock split.
In addition, prior to the consummation of this offering, we intend to use the proceeds from the issuance of approximately $1,500.0 million aggregate principal amount of senior notes, referred to as the new senior notes, and approximately $450.0 million of commercial paper, together with approximately $20.0 million of cash on hand, to fund the early redemption of $1,750.0 million of preferred stock held by RWE and the repayment of $222.0 million aggregate principal amount of debt owed to RWE, which we refer to as the RWE notes. The new senior notes will not be registered under the Securities Act and will be offered in reliance on an exemption from the registration requirements of the Securities Act. Concurrently with the offering, we intend to use a portion of the proceeds from the issuance of approximately $500.0 million of equity units to fund the repayment of
4
approximately $450.0 million of commercial paper, with the balance of the net cash proceeds of approximately $34.5 million used for general corporate purposes. These transactions, together with the non-cash equity contribution to the Company by RWE of $1,194.5 million of debt of our subsidiaries held by RWE on December 15, 2006, the non-cash equity contribution to the Company by RWE of $100.0 million of debt of our subsidiaries held by RWE on March 29, 2007, and the $550.0 million cash equity contribution to the Company by RWE on March 29, 2007, which was used to pay down $232.5 million of short-term debt and the remainder used for general working capital purposes, are collectively referred to as the Refinancing. The Restructuring, the Refinancing, the Merger and the -for- split of common stock referred to above are collectively referred to in this prospectus as the Transactions.
Organizational Structure
The following chart sets forth our current organizational structure:
The following chart sets forth our organizational structure after giving effect to the consummation of the Transactions:
* | Assumes that RWE, through its subsidiary Thames Water Aqua Holdings GmbH, will sell its shares of our common stock in more than one offering. |
5
The Selling Stockholder
All of our issued and outstanding common stock is currently owned by the selling stockholder, Thames Water Aqua Holdings GmbH, a limited liability company organized under the laws of the Federal Republic of Germany and a direct wholly owned subsidiary of RWE. Upon consummation of this offering, the selling stockholder will continue to own % of our outstanding common stock. RWE intends to fully divest its ownership of American Water as soon as reasonably practicable, subject to market conditions.
Our Executive Offices
We are a corporation incorporated under the laws of Delaware. Our principal executive offices are located at 1025 Laurel Oak Road, Voorhees, NJ 08043. Our telephone number is (856) 346-8200. Our internet address is www.amwater.com. The information contained on or accessible from our website does not constitute a part of this prospectus and is not incorporated by reference herein.
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THE OFFERING
Common stock offered by the selling stockholder |
shares |
Common stock to be outstanding after this offering |
shares |
Option to purchase additional shares |
The underwriters have an option to purchase a maximum of additional shares from the selling stockholder. |
Use of proceeds |
We will not receive any proceeds from this offering. See Use of Proceeds. |
Equity units offering |
We are also offering in a concurrent offering by separate prospectus $ million of our equity units. Each equity unit will have a stated amount of $50 and will consist of a contract obligating the purchaser to purchase shares of common stock and a fixed-rate senior note initially due . We will only proceed with our sale of equity units if market conditions are attractive to us. Therefore, you should not assume that we will consummate our offering of equity units. This offering of common stock is not contingent on our offering of equity units. |
Listing |
We will apply to list our common stock and our equity units, or certain components thereof, on the New York Stock Exchange, or NYSE, under the symbols AWK and , respectively. |
Dividend policy |
We intend to pay quarterly cash dividends at an initial rate of approximately $ per share per annum on our common stock commencing in the first quarter following the completion of this offering. The declaration, payment and amount of future dividends to holders of our common stock will be at the discretion of our board of directors and will depend on many factors, including our financial condition and results of operations, liquidity requirements, capital requirements of our subsidiaries, legal requirements, regulatory constraints and other factors our board of directors deems relevant. |
Risk factors |
See Risk Factors for a discussion of factors you should consider before investing in our common stock. |
All information in this prospectus, unless otherwise indicated or the context otherwise requires:
| assumes the common stock will be sold at $ per share (the midpoint of the price range set forth on the cover of this prospectus); |
| assumes no exercise of the underwriters option to purchase additional shares; |
| gives effect to the for stock split to be effected prior to the offering; and |
| excludes, (i) shares of common stock issuable in connection with the concurrent equity units offering, (ii) shares of common stock reserved for issuance under our 2007 Omnibus Equity Compensation Plan ( of which and of which will be granted to key employees upon the consummation of the offering in the form of restricted stock and stock options, respectively) and (iii) shares reserved for issuance under an employee stock purchase plan that the Company is considering establishing following the consummation of this offering. |
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SUMMARY HISTORICAL CONSOLIDATED AND UNAUDITED PRO FORMA FINANCIAL DATA
The following table presents our summary historical consolidated financial data and summary unaudited pro forma consolidated financial data, at the dates and for the periods indicated. The historical data as of December 31, 2005 and 2006 and for the years ended December 31, 2004, 2005 and 2006 have been derived from our audited historical consolidated financial statements and the notes to those statements included elsewhere in this prospectus. See footnote 1 to the table below. The historical data as of June 30, 2007 and for the six months ended June 30, 2006 and 2007 have been derived from our unaudited historical consolidated financial statements and the notes to those statements included elsewhere in this prospectus. Operating results for the six months ended June 30, 2006 and 2007 have been prepared on a basis consistent with our audited consolidated financial statements and reflect all adjustments, consisting of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the periods presented. The results of any interim period are not necessarily indicative of the results that may be expected for any other interim period or for the entire fiscal year.
The summary unaudited pro forma financial data have been derived from our historical financial statements and adjusted to give effect to the Transactions. The summary unaudited pro forma financial data have been prepared to give effect to the Transactions as if they had occurred on January 1, 2006, in the case of the summary unaudited pro forma statement of operations data, and on June 30, 2007, in the case of the summary unaudited pro forma balance sheet data. The pro forma adjustments are based upon available information and certain assumptions that we believe are reasonable. The summary unaudited pro forma financial data are for informational purposes only and do not purport to represent what our results of operations or financial position actually would have been if the Transactions had occurred at any date, and such data do not purport to project the results of operations for any future period. See Unaudited Pro Forma Condensed Consolidated Financial Information.
Our historical financial data are not necessarily indicative of our future performance or what our financial position and results of operations would have been if we had operated as a separate, stand-alone entity during the periods shown. Because the data in this table is only a summary and does not provide all of the data contained in our financial statements, the information should be read in conjunction with Use of Proceeds, Capitalization, Unaudited Pro Forma Condensed Consolidated Financial Information, Selected Historical Consolidated Financial Data, Managements Discussion and Analysis of Financial Condition and Results of Operations and the financial statements and related notes thereto appearing elsewhere in this prospectus.
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For the years ended December 31, |
For the six months ended June 30, |
Pro forma for the year ended December 31, |
Pro forma for the six months ended June 30, |
|||||||||||||||||||||||||
2004 | 2005 | 2006 | 2006 | 2007 | 2006 | 2007 | ||||||||||||||||||||||
(unaudited) | (unaudited) | (unaudited) | (unaudited) | |||||||||||||||||||||||||
(dollars in thousands, except for share and per share data) | ||||||||||||||||||||||||||||
Statement of operations data(1): |
||||||||||||||||||||||||||||
Operating revenues |
$ | 2,017,871 | $ | 2,136,746 | $ | 2,093,067 | $ | 1,007,691 | $ | 1,027,277 | $ | 2,093,067 | $ | 1,027,277 | ||||||||||||||
Operating expenses |
||||||||||||||||||||||||||||
Operation and maintenance |
1,121,970 | 1,201,566 | 1,174,544 | 562,072 | 581,999 | 1,176,244 | 582,509 | |||||||||||||||||||||
Depreciation and amortization |
225,260 | 261,364 | 259,181 | 128,728 | 132,764 | 259,181 | 132,764 | |||||||||||||||||||||
General taxes |
170,165 | 183,324 | 185,065 | 94,756 | 93,819 | 185,065 | 93,819 | |||||||||||||||||||||
Loss (gain) on sale of assets(2) |
(8,611 | ) | (6,517 | ) | 79 | (1,795 | ) | (6,113 | ) | 79 | (6,113 | ) | ||||||||||||||||
Impairment charges |
78,688 | 385,434 | 221,685 | | | 221,685 | | |||||||||||||||||||||
Total operating expenses, net |
1,587,472 | 2,025,171 | 1,840,554 | 783,761 | 802,469 | 1,842,254 | 802,979 | |||||||||||||||||||||
Operating income (loss) |
430,399 | 111,575 | 252,513 | 223,930 | 224,808 | 250,813 | 224,298 | |||||||||||||||||||||
Other income (deductions) |
||||||||||||||||||||||||||||
Interest |
(315,944 | ) | (345,257 | ) | (365,970 | ) | (178,968 | ) | (142,970 | ) | (296,913 | ) | (141,682 | ) | ||||||||||||||
Amortization of debt expense |
(3,377 | ) | (4,367 | ) | (5,062 | ) | (1,678 | ) | (2,397 | ) | (5,932 | ) | (2,832 | ) | ||||||||||||||
Other, net(3) |
14,350 | 13,898 | 9,581 | 4,927 | 7,351 | 9,581 | 7,351 | |||||||||||||||||||||
Total other income (deductions) |
(304,971 | ) | (335,726 | ) | (361,451 | ) | (175,719 | ) | (138,016 | ) | (293,264 | ) | (137,163 | ) | ||||||||||||||
Income (loss) from continuing operations before income taxes |
125,428 | (224,151 | ) | (108,938 | ) | 48,211 | 86,792 | (42,451 | ) | 87,135 | ||||||||||||||||||
Provision for income taxes |
66,328 | 50,979 | 46,912 | 20,056 | 34,378 | 73,208 | 34,514 | |||||||||||||||||||||
Income (loss) from continuing operations |
$ | 59,100 | $ | (275,130 | ) | $ | (155,850 | ) | $ | 28,155 | $ | 52,414 | $ | (115,659 | ) | $ | 52,621 | |||||||||||
Income (loss) from continuing operations per basic common share(4)(5) |
$ | 59,100 | $ | (275,130 | ) | $ | (155,850 | ) | $ | 28,155 | $ | 52,414 | ||||||||||||||||
Income (loss) from continuing operations per diluted common share(4)(5) |
$ | 59,100 | $ | (275,130 | ) | $ | (155,850 | ) | $ | 28,155 | $ | 52,414 | ||||||||||||||||
Basic weighted average common shares |
1,000 | 1,000 | 1,000 | 1,000 | 1,000 | |||||||||||||||||||||||
Diluted weighted average common shares |
1,000 | 1,000 | 1,000 | 1,000 | 1,000 | |||||||||||||||||||||||
Other data(1): |
||||||||||||||||||||||||||||
Cash flows provided by (used in): |
||||||||||||||||||||||||||||
Operating activities |
$ | 458,408 | $ | 525,435 | $ | 323,748 | $ | 66,723 | $ | 136,181 | ||||||||||||||||||
Investing activities |
(545,903 | ) | (530,165 | ) | (691,438 | ) | (241,724 | ) | (279,441 | ) | ||||||||||||||||||
Financing activities |
95,254 | (9,049 | ) | 332,367 | 133,391 | 164,951 | ||||||||||||||||||||||
Construction expenditures |
(546,241 | ) | (558,446 | ) | (688,843 | ) | (235,818 | ) | (307,726 | ) |
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As of December 31, | As of June 30, | Pro forma as of June 30, | ||||||||||
2005 | 2006 | 2007 | 2007 | |||||||||
(unaudited) | (unaudited) | |||||||||||
(dollars in thousands) | ||||||||||||
Balance sheet data(1): |
||||||||||||
Cash and cash equivalents |
$ | 65,077 | $ | 29,754 | $ | 51,445 | $ | 66,012 | ||||
Utility plant at original cost, net of accumulated depreciation |
8,101,769 | 8,605,341 | 8,806,066 | 8,806,066 | ||||||||
Goodwill |
3,181,570 | 2,962,493 | 2,962,564 | 2,962,564 | ||||||||
Total assets |
12,542,029 | 12,783,059 | 13,071,585 | 13,097,388 | ||||||||
Redeemable preferred stock at redemption value(6) |
1,774,691 | 1,774,475 | 1,774,299 | 24,299 | ||||||||
Other long-term debt |
3,011,827 | 3,096,404 | 3,335,579 | 5,254,579 | ||||||||
Other short-term and current portion of long-term debt |
2,018,251 | 1,007,128 | 253,242 | 112,242 | ||||||||
Total debt |
6,804,769 | 5,878,007 | 5,363,120 | 5,391,120 | ||||||||
Common stockholders equity |
2,804,716 | 3,817,397 | 4,520,149 | 4,491,275 | ||||||||
Preferred stock without mandatory redemption requirements(6) |
4,571 | 4,568 | 4,568 | 4,568 |
(1) | Prior to the consummation of this offering, Thames US Holdings will be merged with and into American Water, with American Water as the surviving entity. Both American Water and Thames US Holdings are wholly owned subsidiaries of RWE. The audited historical consolidated financial statements of American Water represent the consolidated results of the Company, formerly issued under the name Thames Water Aqua US Holdings, Inc. and Subsidiary Companies for 2005 and 2006. |
(2) | Represents primarily losses (gains) on sales of publicly traded securities and dispositions of assets not needed in utility operations. |
(3) | Includes allowance for other funds used during construction, allowance for borrowed funds used during construction and preferred dividends of subsidiaries. |
(4) | The number of common shares used to compute net income per basic share and net income per diluted share for the fiscal years ended December 31, 2004, 2005 and 2006 and the six months ended June 30, 2006 and 2007 is 1,000 (the number of shares outstanding during such period) as no dilutive options or instruments were outstanding during these periods. |
(5) | The number of common shares used to compute net income per basic share is , which gives effect to the -for- stock split to be effected prior to the offering. Net income per diluted share also gives effect to all restricted stock units and stock options to be granted under our 2007 Omnibus Equity Compensation Plan to our executive officers and certain key employees upon the consummation of this offering as if they were exercised or converted into common stock using the treasury method. Incremental common shares included in diluted earnings per share are . |
(6) | Includes preferred stock held by RWE and other preferred stock issued by subsidiaries of the Company. |
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An investment in our common stock involves risk. Before you decide to purchase our common stock, you should carefully consider these risk factors together with all of the other information included in this prospectus, including the information contained in the section entitled Managements Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements included elsewhere in this prospectus and the notes thereto. If any of the following risks actually occurs, our business, financial condition, operating results and prospects could be adversely affected, which in turn could adversely affect the value of our common stock.
Risks Related to Our Industry and Business
Our operations are heavily regulated. Decisions by regulators and changes in laws and regulations over which we have no control can significantly affect our business and results of operations.
Our operations are subject to extensive regulation by state PUCs and environmental, health and safety and water quality regulation by federal, state and local governments.
Economic Regulation
Our Regulated Businesses provide water and wastewater services to our customers through subsidiaries economically regulated by state PUCs. Economic regulation affects the rates we charge our customers and has a significant effect on our business and results of operations. Generally, the state PUCs authorize us to charge rates that they determine are sufficient to recover our prudently incurred operating expenses, to enable us to finance the addition of new, or the replacement of existing, water and wastewater infrastructure and to allow us the opportunity to earn what they determine to be an appropriate rate of return of and on our invested capital.
Our ability to meet our financial objectives depends upon the rates authorized by the various state PUCs. We periodically file rate increase applications with state PUCs. The ensuing administrative process may be lengthy and costly. We can provide no assurances that our rate increase requests will be granted. Even if approved, there is no guarantee that approval will be given in a timely manner or at a sufficient level to cover our expenses, the recovery of our investment and/or provide us an opportunity to earn an appropriate rate of return of and on our investment. If the authorized rates are insufficient to cover operating expenses, to allow for the recovery of our investment and to provide an appropriate return on invested capital, or if the rate increase decisions are delayed, our financial condition, results of operations, cash flow and liquidity may be adversely affected. Even if rates are sufficient, we face the risk that we will not achieve the rates of return of and on our invested capital that are permitted by the state PUC.
Environmental, Health and Safety and Water Quality Regulation
Our water and wastewater operations are subject to extensive United States federal, state and local and, in the case of our Canadian operations, Canadian laws and regulations, that govern the protection of the environment, health and safety, the quality of the water we deliver to our customers, water allocation rights, and the manner in which we collect, treat and discharge wastewater. These requirements include the United States Clean Water Act of 1972, referred to as the Clean Water Act, and the United States Safe Drinking Water Act of 1974, referred to as the Safe Drinking Water Act, and similar state and Canadian laws and regulations. We are also required to obtain various environmental permits from regulatory agencies for our operations. State PUCs also set conditions and standards for the water and wastewater services we deliver. If we deliver water or wastewater services to our customers that do not comply with regulatory standards, or otherwise violate environmental laws, regulations or permits, or other health and safety and water quality regulations, we could incur substantial fines, penalties or other sanctions or costs or damage to our reputation. In the most serious cases, regulators could force us to discontinue operations and sell our operating assets to another utility or municipality.
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We incur substantial operating and capital costs on an ongoing basis to comply with environmental laws and regulations and other health and safety and water quality regulations. These laws and regulations, and their enforcement, have tended to become more stringent over time, and new or stricter requirements could increase our costs. Although we may seek to recover ongoing compliance costs in our rates, there can be no guarantee that the various state PUCs or similar regulatory bodies that govern our Regulated Businesses would approve rate increases to recover such costs or that such costs will not adversely and materially affect our financial condition, results of operations, cash flow and liquidity.
In addition, we operate a number of water and wastewater systems under O&M contracts. Pursuant to these contracts, we operate the system according to the standards set forth in the applicable contract, but it is generally the responsibility of the owner to undertake capital improvements. In some cases, we may not be able to convince the owner to make needed improvements in order to maintain compliance with applicable regulations. Although violations and fines incurred by water and wastewater systems may be the responsibility of the owner of the system under these contracts, such non-compliance events may reflect poorly on us as the operator of the system and damage our reputation, and in some cases, may result in liability to the same extent as if we were the owner.
We may also incur liabilities under environmental laws and regulations requiring us to investigate and clean up environmental contamination at our properties or at off-site locations where we have disposed of waste or caused adverse environmental impacts. The discovery of previously unknown conditions, or the imposition of cleanup obligations in the future, could result in significant costs, and could adversely affect our financial condition, results of operations, cash flow and liquidity. Such remediation losses may not be covered by our insurance policies and may make it difficult for us to secure insurance in the future at acceptable rates.
Regulatory Changes
Any governmental entity that regulates our operations may enact new legislation or adopt new regulations or policies at any time, and new judicial decisions may change the interpretation of existing legislation or regulations at any time. The individuals who serve as regulators are elected or are political appointees. Therefore, elections which result in a change of political administration or new appointments may also result in changes in the individuals who serve as regulators and the policies of the regulatory agencies that they serve. New laws, or regulations, new interpretations of existing laws or regulations, or changes in agency policy, including as a response to shifts in public opinion, or conditions imposed during the regulatory hearing process may affect our business in a number of ways, including the following:
| making it more difficult for us to raise our rates and, as a consequence, to recover our costs or earn our expected rates of return; |
| changing the determination of the costs, or the amount of costs, that would be considered recoverable in rate cases; |
| changing water quality or delivery service standards or wastewater collection, treatment and discharge standards with which we must comply; |
| restricting our ability to terminate our services to customers who owe us money for services previously provided; |
| requiring us to provide water services at reduced rates to certain customers; |
| restricting our ability to sell assets or issue securities; |
| changing regulatory benefits that we expected to receive when we began offering services in a particular area; |
| changing or placing additional limitations on change of control requirements relating to any concentration of ownership of our common stock; |
| making it easier for governmental entities to convert our assets to public ownership via eminent domain; |
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| restricting or prohibiting our extraction of water from rivers, streams, reservoirs or aquifers; and |
| revoking or altering the terms of the certificates of public convenience and necessity (or similar authorizations) issued to us by state PUCs. |
Any of these changes or any other changes in laws, regulations, judicial decisions or agency policies applicable to us may have an adverse effect on our business, financial condition, results of operations, cash flow and liquidity.
Weather conditions, natural hazards, overuse of water supplies and competing uses may interfere with our sources of water, demand for water services and our ability to supply water to customers.
Our ability to meet the existing and future water demands of our customers depends on an adequate supply of water. In many states, the availability of our water supply is established through allocation rights and passing-flow requirements set by governmental entities. These requirements can change from time to time and adversely impact our water supply. Drought, overuse of sources of water, the protection of threatened species or habitats or other factors may limit the availability of ground and surface water. Governmental restrictions on water use during drought conditions may also result in decreased use of water services, even if our water supplies are sufficient to serve our customers, which may adversely affect our financial condition and results of operations. Following drought conditions, water demand may not return to pre-drought levels even after restrictions are lifted. Cool and wet weather may also reduce demand for water, thereby adversely affecting our financial condition, results of operations, cash flow and liquidity.
Earthquakes and other natural hazards may affect the condition or operability of our facilities, limiting or preventing us from delivering water or wastewater services to our customers, which may adversely affect our financial condition, results of operations, cash flow and liquidity. Furthermore, damage to our facilities might not be covered by our insurance policies and such losses may make it difficult for us to secure insurance in the future at acceptable rates.
In addition, freezing weather may contribute to water and wastewater transmission interruptions caused by pipe and main breakage, which may be costly to repair. Extreme weather events may also have a material adverse effect on our results of operations. If an extreme weather event, such as a hurricane or flood, were to damage the physical plant of one or more of our operating subsidiaries, the delivery of water to our customers could be interrupted and we could be required to make significant capital expenditures to repair the damage. Extreme weather events may also affect demand for water services. We may not be able to recover such costs through rates. Any interruption in our ability to supply water or to collect, treat and properly dispose of wastewater, or any costs associated with restoring service, could adversely affect our financial condition and results of operations. Furthermore, losses from business interruptions might not be covered by our insurance policies, and such losses may make it difficult for us to secure insurance in the future at acceptable rates.
Declining residential per customer water usage may reduce our long-term revenues, financial condition and results of operations.
Increased water conservation, including through the use of more efficient household fixtures and appliances among residential consumers, combined with declining household sizes in the United States, has contributed to a trend of declining residential per customer water usage. Our Regulated Businesses are heavily dependent upon revenue generated from rates we charge to our residential customers for the volume of water they use. The rate we charge for our water is regulated by state PUCs and we may not unilaterally adjust our rates to reflect demand. If rate increases authorized by state PUCs or growth in our residential customer base are not sufficient to offset declining revenue caused by this declining usage, our long-term revenues, financial condition and results of operations may be materially adversely affected.
Due to overlaps in regulatory oversight, parallel regulatory regimes may impose inconsistent obligations on us, and we may be subject to fines and penalties under one regulatory regime for actions that are compulsory under another regulatory regime.
We are subject to environmental, economic and other regulation at the state level and environmental and other regulation at the federal level. In many cases, state agencies adopt and enforce federal regulations.
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Although state regulations frequently overlap with federal regulations, state regulations in some instances may be stricter or broader in scope than applicable federal standards or inconsistent with other federal regulations. For example, in California, our extraction of water from certain surface water sources to meet the requirement by the state PUC to provide water to the population we serve can result in fines under federal environmental laws for damage caused to steelhead trout stock. The fines and penalties we may incur as a result of inconsistent regulatory regimes may adversely affect our financial condition and results of operations, cash flow and liquidity.
Risks associated with the collection, treatment and disposal of wastewater may impose significant costs.
The wastewater collection, treatment and disposal operations of our subsidiaries are subject to substantial regulation and involve significant environmental risks. If collection or sewage systems fail or do not operate properly, untreated wastewater or other contaminants could spill onto nearby properties or into nearby streams and rivers, causing damage to persons or property, injury to aquatic life and economic damages, which may not be recoverable in rates. Liabilities resulting from such damage could adversely and materially affect our business, results of operations and financial condition. Moreover, in the event that we are deemed liable for any damage caused by overflow, our losses might not be covered by insurance policies, and such losses may make it difficult for us to secure insurance in the future at acceptable rates.
Our Regulated Businesses require significant capital expenditures to maintain infrastructure and expand our rate base and may suffer if we fail to secure appropriate funding to make investments, or if we suffer delays in completing major capital expenditure projects.
The water and wastewater utility business is capital intensive. In addition to our acquisition strategy, we invest significant amounts of capital to add, replace and maintain property, plant and equipment. In 2006, we invested $688.8 million in capital improvements and we expect to invest approximately $740 to $780 million in capital improvements in 2007. We expect the level of capital expenditures necessary to maintain the integrity of our systems to increase in the future. We fund these projects from cash generated from operations, borrowings under our revolving credit facility and commercial paper programs and the issuance of long-term debt and equity securities. We can provide no assurances that we will be able to access the debt and equity capital markets or do so on favorable terms.
RWE will have certain registration rights with respect to future issuances of our equity securities and, subject to the lock-up provision described in this prospectus, intends to fully divest its ownership of American Water as soon as reasonably practicable, subject to market conditions. The registration rights agreement to be entered into with RWE will impose certain restrictions on our ability to issue equity securities in amounts beyond specified thresholds without RWEs consent. Future sales of our common stock by RWE, as well as the restrictions in the registration rights agreement, may make it more difficult or costly for us to raise additional equity in the future. Furthermore, if we are unable to raise sufficient equity, we can provide no assurances that we will be able to access the debt capital markets, or do so on favorable terms.
If we are unable to obtain sufficient capital, we may fail to maintain our existing property, plant and equipment, realize our capital investment strategies, meet our growth targets and successfully expand the rate base upon which we are able to earn future returns of and on our investment. Even if we have adequate resources to make required capital expenditures, we face the additional risk that we will not complete our major capital expenditures on time, as a result of construction delays or other obstacles. Each of these outcomes could adversely affect our financial condition and results of operations. We also face the risk that after we make substantial capital expenditures, the rate increases granted to us by state PUCs may not be sufficient to recover our prudently incurred operating expenses and to allow us the opportunity to earn an appropriate rate of return of and on our invested capital.
Our business may suffer if we receive a downgrade in our corporate or issuer credit ratings from the credit ratings agencies.
Moodys Investors Service, Inc., referred to as Moodys, and Standard & Poors Ratings Services, referred to as S&P, issue ratings on our ability to repay our debt obligations. The credit ratings agencies could downgrade our credit rating based on reviews of our financial performance and projections or upon the occurrence of other
14
events that could impact our business outlook. A downgrade could cause our lenders to seek a higher rate of interest for future borrowings and thus increase our cost of capital. A downgrade could also limit our access to further equity and debt capital. The ratings agencies might not maintain ratings that allow us to obtain further capital for our business on reasonable terms, and we might not be able to recover any increases in our cost of capital through rates. The inability to recover these higher costs or regulatory lag in the recovery of such costs can affect our financial condition, results of operations, cash flow and liquidity. At June 30, 2007, S&P had its ratings of the Company and AWCC on CreditWatch with negative implication, and Moodys had its ratings of AWCC on negative outlook.
The failure of, or the requirement to repair, upgrade or dismantle, any of our dams may adversely affect our financial condition and results of operations.
We own a total of 99 dams. A failure of any of those dams could result in injuries and property damage downstream for which we may be liable. The failure of a dam would also adversely affect our ability to supply water in sufficient quantities to our customers and could adversely affect our financial condition and results of operations. Any losses or liabilities incurred due to a failure of one of our dams might not be covered by insurance policies or be recoverable in rates, and such losses may make it difficult for us to secure insurance in the future at acceptable rates.
We also are required from time to time to repair or upgrade the dams that we own. The cost of such repairs can be and has been material. We might not be able to recover such costs through rates. The inability to recover these higher costs or regulatory lag in the recovery of such costs can affect our financial condition, results of operations, cash flow and liquidity.
The federal and state agencies that regulate our operations may adopt rules and regulations requiring us to dismantle our dams. Federal and state agencies are currently considering rules and regulations that could require us to strengthen or dismantle one of our dams on the Carmel River in California due to safety concerns related to seismic activity. Any requirement to strengthen or dismantle this dam could result in substantial costs that may adversely affect our financial condition and results of operations. We are currently engaged in negotiations with federal and state agencies and local stakeholders on a plan to maintain our existing Carmel River dams or to share the costs of dismantling one of them with those federal and state agencies and local stakeholders. These negotiations could be delayed or abandoned.
Any failure of our network of water and wastewater pipes and water reservoirs could result in losses and damages that may affect our financial condition and reputation.
Our operating subsidiaries distribute water and wastewater through an extensive network of pipes and store water in reservoirs located across the United States. A failure of major pipes or reservoirs could result in injuries and property damage for which we may be liable. The failure of major pipes and reservoirs may also result in the need to shut down some facilities or parts of our network in order to conduct repairs. Such failures and shutdowns may limit our ability to supply water in sufficient quantities to our customers and to meet the water and wastewater delivery requirements prescribed by governmental regulators, including state PUCs with jurisdiction over our operations, and adversely affect our financial condition, results of operations, cash flow, liquidity and reputation. Any business interruption or other losses might not be covered by insurance policies or be recoverable in rates, and such losses may make it difficult for us to secure insurance in the future at acceptable rates.
Contamination of our sources of water could result in service interruptions and human exposure to hazardous substances and subject our subsidiaries to civil or criminal enforcement actions, private litigation and clean-up obligations.
Our water supplies are subject to contamination, including contamination from naturally-occurring compounds, chemicals in groundwater systems, pollution resulting from man-made sources, such as perchlorate
15
and methyl tertiary butyl ether (MTBE), and possible terrorist attacks. In the event that our water supply is contaminated, we may have to interrupt the use of that water supply until we are able to substitute the supply of water from another water source, including, in some cases, through the purchase of water from a third-party supplier. In addition, we may incur significant costs in order to treat the contaminated source through expansion of our current treatment facilities, or development of new treatment methods. If we are unable to substitute water supply in a cost-effective manner, our financial condition, results of operations, cash flow, liquidity and reputation may be adversely affected. We might not be able to recover costs associated with treating or decontaminating water supplies through rates, or such recovery may not occur in a timely manner. Moreover, we could be held liable for environmental damage as well as damages arising from toxic tort or other lawsuits or criminal enforcement actions or other consequences arising out of human exposure to hazardous substances in our drinking water supplies.
The necessity for increased security has resulted, and may continue to result, in increased operating costs.
Following the events of September 11, 2001, we have taken steps to increase security measures at our facilities and heighten employee awareness of threats to our water supply and infrastructure. We have also increased our security measures regarding the delivery and handling of some chemicals used in our business. We have and will continue to bear increased costs for security precautions to protect our facilities, operations and supplies. These costs may be significant. We might not be able to recover these increased costs or any other costs that may be incurred as a result of terrorist attacks or other security breaches through rates or applicable insurance policies.
Our liquidity and earnings could be adversely affected by increases in our production costs, including the cost of chemicals, electricity, fuel or other significant materials used in the water and wastewater treatment process.
We incur significant production costs in connection with the delivery of our water and wastewater services. Our production costs are driven by inputs such as chemicals used to treat water and wastewater as well as electricity and fuel, which are used to operate pumps and other equipment used in water treatment and delivery and wastewater collection, treatment and disposal. We also incur production costs for waste disposal. For 2006, production costs accounted for 14.4% of our total operating costs. These costs can and do increase unexpectedly and in substantial amounts, as occurred in California during 2001 when the cost of electricity rose substantially.
Our Regulated Businesses might not be able to recover increases in the costs of chemicals, electricity, fuel, other significant inputs or waste disposal through rates, or such recovery may not occur in a timely manner. Our Non-Regulated Businesses may not be able to recover these costs in contract prices or other terms. The inability to recover these higher costs can affect our financial condition, results of operations, cash flow and liquidity.
Our reliance on third-party suppliers poses significant risks to our business and prospects.
We contract with third parties for goods and services that are essential to our operations, such as maintenance services, pipes, chemicals, electricity, water, gasoline, diesel and other materials. We are subject to substantial risks because of our reliance on these suppliers. For example:
| our suppliers may not provide raw materials that meet our specifications in sufficient quantities; |
| our suppliers may provide us with water that does not meet applicable quality standards or is contaminated; |
| our suppliers may face a reduction in or an interruption of supply; |
| our suppliers may face production delays due to natural disasters or strikes, lock-outs or other such actions; |
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| one or more suppliers could make strategic changes in the lines of products and services they offer; and |
| some of our suppliers are small companies which are more likely to experience financial and operational difficulties than larger, well-established companies, because of their limited financial and other resources. |
As a result of any of these factors, we may be required to find alternative suppliers for the raw materials and services on which we rely. Accordingly, we may experience delays in obtaining appropriate raw materials and services on a timely basis and in sufficient quantities from such alternative suppliers at a reasonable price, which could interrupt services to our customers and adversely affect our revenues, financial condition, results of operations, cash flow and liquidity.
Risks associated with potential acquisitions or investments may adversely affect us.
We will continue to seek to acquire or invest in additional regulated water or wastewater systems, including by acquiring systems in markets in the United States, where we do not currently operate our Regulated Businesses, and through tuck-ins. We will also continue to seek to enter into public/private partnerships, including O&M, military and design, build and operate, referred to as DBO, contracts and services that complement our businesses. These transactions may result in:
| incurrence of debt and contingent liabilities; |
| failure to have or to maintain effective internal control over financial reporting; |
| fluctuations in quarterly results; |
| exposure to unknown risk and liabilities, such as environmental liabilities; and |
| other acquisition-related expenses. |
We may also experience difficulty in obtaining required regulatory approvals for acquisitions, and any regulatory approvals we obtain may require us to agree to costly and restrictive conditions imposed by regulators. Future sales of our common stock by RWE, as well as the restrictions in the registration rights agreement to be entered into with RWE, may make it more difficult or costly for us to raise additional equity to fund an acquisition or to issue shares as consideration in connection with an acquisition. We may not identify all significant risks when conducting due diligence for the transaction, and we could be exposed to potential liabilities for which we will not be indemnified. There may be difficulties integrating new businesses, including bringing newly acquired businesses up to the necessary level of regulatory compliance. The demands of identifying and transitioning newly acquired businesses or pursuing investment opportunities may also divert managements attention from other business concerns and otherwise disrupt our business. Any of these risks may adversely affect our financial condition, results of operations and cash flows.
We have recorded a significant amount of goodwill, and we may never realize the full value of our intangible assets.
Our total assets include substantial goodwill. At June 30, 2007, our goodwill totaled $2,962.6 million. The goodwill is associated primarily with the acquisition by an affiliate of RWE of American Water in 2003 and ETown Corporation in 2001, representing the excess of the purchase price the purchaser paid over the fair value of the net tangible and intangible assets acquired. Goodwill is recorded at fair value on the date of an acquisition and, in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, or SFAS No. 142, is reviewed annually or more frequently if changes in circumstances indicate the carrying value may not be recoverable. Annual impairment reviews are performed in the fourth quarter. We have been required to reflect, as required by SFAS No. 142 and other applicable accounting rules, a non-cash charge to operating results for goodwill impairment in the amounts of $192.9 million in 2004, $396.3 million in 2005 and $227.8 million in 2006. These amounts include impairments relating to discontinued operations.
There are a number of significant assumptions reflected in our valuation analyses. These include market interest rates used for discounting future cash flows, market value assumptions using market valuation multiples of comparable water utilities and revenue and operating income growth assumptions in our business plan. We
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base these assumptions on our best estimates of the Companys future performance and available market information at the time. It is reasonably possible that we will be required to recognize additional impairments in the future, depending on, among other factors, a decline over a period of time in the valuation multiples of comparable water utilities, a decline in the market value of our common stock and its value relative to our book equity at the consummation of this offering or a decline over a period of time of our stock price following the consummation of this offering. A decline in our forecasted results in our business plan, such as changes in rate case results or capital investment budgets or changes in our interest rates may also result in an incremental impairment charge. Further recognition of impairments of a significant portion of goodwill would negatively affect our results of operations and total capitalization, the effect of which could be material and could make it more difficult for us to secure financing on attractive terms and maintain compliance with our debt covenants.
Our Regulated Businesses compete with other regulated utilities, as well as strategic and financial buyers, for acquisition opportunities, which may hinder our ability to grow our business.
We compete with other regulated utilities, as well as strategic and financial buyers, for acquisition opportunities, including tuck-ins. Our competitors may impede our growth by purchasing water utilities near our existing operations, thereby preventing us from acquiring them. Competing utilities and strategic and financial buyers have challenged, and may in the future challenge, our applications for new service territories. Our growth could be hindered if we are not able to compete effectively for new territories with other companies or strategic and financial buyers that have lower costs of operations or that can submit more attractive bids.
The assets of our Regulated Businesses are subject to condemnation through eminent domain.
Municipalities and other government subdivisions have historically been involved in the provision of water and wastewater services in the United States, and organized movements may arise from time to time in one or more of the service areas in which our Regulated Businesses operate to convert our assets to public ownership and operation through the governmental power of eminent domain. Should a municipality or other government subdivision seek to acquire our assets through eminent domain, we may resist the acquisition. Contesting an exercise of condemnation through eminent domain may result in costly legal proceedings and may divert the attention of the affected Regulated Businesss management from the operation of its business.
The last sale of one of our water and wastewater systems under threat of condemnation occurred in 2003 in California. On March 1, 2007, our subsidiary, California American Water Company, was served by the San Lorenzo Valley Water District with court papers seeking to condemn our water and wastewater system in Felton, California, which serves approximately 1,300 customers. While we are contesting the condemnation, we might not prevail. If a municipality or other government subdivision succeeds in acquiring the assets of one or more of our Regulated Businesses through eminent domain, there is a risk that we will not receive adequate compensation for the business, that we will not be able to keep the compensation, or that we will not be able to divest the business without incurring significant one-time charges.
In order to consummate the proposed RWE Divestiture, we and RWE were required to obtain approvals from thirteen state PUCs. There can be no guarantee that we will obtain the remaining final Pennsylvania approval in a timely manner or that some state PUC approvals already granted to us will not be appealed, withdrawn, modified or stayed. In addition, to obtain the approvals we were required to accept certain conditions and restrictions that could increase our costs and adversely affect our business.
To consummate the proposed RWE Divestiture, we and RWE obtained regulatory approvals from state PUCs in 13 states. While the RWE Divestiture was approved in writing on August 23, 2007 by the Pennsylvania state PUC, a final and non-appealable order, referred to as the PA Final Order, has yet to be issued. Therefore, we may not be able to obtain all necessary final state PUC approvals in a timely fashion. In addition, the appeal period to challenge our state PUC approvals remains open in California, Illinois, New York, New Jersey and Pennsylvania. Thus, there can be no guarantee that our state PUC approvals in those states will not be appealed. Moreover, some of our existing state PUC approvals may be withdrawn or altered in the future by the
18
state PUCs since they retain authority to withdraw or modify their prior decisions. There also can be no guarantee that, in conjunction with an appeal or otherwise, a stay or other form of injunctive relief will not be granted by a state PUC or reviewing court.
Some of the regulatory approvals contain conditions and restrictions that could increase our costs and adversely affect our business, including reporting obligations; obligations to maintain appropriate credit worthiness; restrictions on changes of control; prohibitions on the pass-through of our initial Sarbanes-Oxley Act compliance costs; prohibitions on the pass-through of costs of the Transactions; service and staffing level requirements; and the maintenance of collective bargaining agreements and retirement and other post employment benefit programs.
In addition, one of the regulatory approvals that we and RWE obtained expires 24 months from the date of effectiveness of this registration statement and another such approval expires 36 months from that date. If RWE does not fully divest its ownership of American Water within 24 or 36 months of the effectiveness of this registration statement, then we and RWE may be required to seek an extension of such approvals, as applicable, which process may result in delays, costs and the imposition of additional conditions on us or on RWE.
Our Non-Regulated Businesses, through American Water (excluding its regulated subsidiaries), provide performance guarantees and other forms of financial security to our public-sector clients that could be claimed by our clients or potential clients if we do not meet certain obligations.
Under the terms of some of our indebtedness and some of our agreements with the municipalities and other governmental entities, which we serve pursuant to O&M contracts, American Water (excluding its regulated subsidiaries) provides guarantees of the performance of our Non-Regulated Businesses, including financial guarantees or deposits to ensure performance of certain obligations. At June 30, 2007, we had guarantees and deposits totaling approximately $511.0 million, and this amount is likely to increase if our Non-Regulated Businesses grow. The presence of these contingent liabilities on our balance sheet may adversely affect our financial condition and make it more difficult for us to secure financing on attractive terms. In addition, if the obligor on the guaranteed instrument fails to perform certain obligations to the satisfaction of the party that holds the guarantee, that party may seek to enforce the guarantee against us or proceed against the deposit. In that event, our financial condition, results of operations, cash flow and liquidity could be adversely affected.
Our Non-Regulated Businesses are party to long-term contracts to operate and maintain water and wastewater systems under which we may incur costs in excess of payments received.
Some of our Non-Regulated Businesses enter into long-term contracts pursuant to which they agree to operate and maintain a municipalitys or other partys water or wastewater treatment and delivery facilities in exchange for an annual fee. Our Non-Regulated Businesses are generally subject to the risk that costs associated with operating and maintaining the facilities may exceed the fees received from the municipality or other contracting party. In addition, directly or through our non-regulated subsidiaries, we often guarantee our Non-Regulated Businesses obligations under those contracts. Losses under these contracts or guarantees may adversely affect our financial condition, results of operations, cash flow and liquidity.
Our Non-Regulated Businesses expose us to product liability, warranty and other claims.
Our Non-Regulated Businesses design, build, operate and maintain water and wastewater systems at which accidents or system failures can cause personal injury and property damage. Any such failures could result in product liability, warranty and other claims against us.
We rely on our IT systems to assist with the management of our business and customer and supplier relationships, and a disruption of these systems could adversely affect our business.
Our IT systems are an integral part of our business, and a serious disruption of our IT systems could significantly limit our ability to manage and operate our business efficiently, which in turn could cause our business and competitive position to suffer and cause our results of operations to be reduced. We depend on our
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IT systems to bill customers, process orders, provide customer service, manage construction projects, manage our financial records, track assets, remotely monitor certain of our plants and facilities and manage human resources, inventory and accounts receivable collections. Our IT systems also allow us to purchase products from our suppliers and bill customers on a timely basis, maintain cost-effective operations and provide service to our customers. Our IT systems are vulnerable to damage or interruption from:
| power loss, computer systems failures and internet, telecommunications or data network failures; |
| operator negligence or improper operation by, or supervision of, employees; |
| physical and electronic loss of customer data or security breaches, misappropriation and similar events; |
| computer viruses; |
| intentional acts of vandalism and similar events; and |
| hurricanes, fires, floods, earthquakes and other natural disasters. |
Such damages or interruptions may result in physical and electronic loss of customer or financial data, security breaches, misappropriation and similar events.
In addition, we may not be successful in developing or acquiring technology that is competitive and responsive to the needs of our business and we might lack sufficient resources to make the necessary investments in technology to allow us to continue to operate at our current level of efficiency.
Our indebtedness could affect our business adversely and limit our ability to plan for or respond to changes in our business, and we may be unable to generate sufficient cash flow to satisfy our liquidity needs.
As of June 30, 2007, after giving effect to the Transactions, our pro forma indebtedness of $5,391.1 million, and our working capital, defined as current assets less current liabilities, was in a deficit position. Our indebtedness could have important consequences, including:
| limiting our ability to obtain additional financing to fund future working capital or capital expenditures; |
| exposing us to interest rate risk with respect to the portion of our indebtedness that bears interest at a variable rate; |
| limiting our ability to pay dividends on our common stock or make payments in connection with our other obligations; |
| likely requiring that a portion of our cash flow from operations be dedicated to the payment of the principal of and interest on our debt, thereby reducing funds available for future operations, acquisitions, dividends on our common stock or capital expenditures; |
| increasing our vulnerability to economic and industry downturns and conditions; |
| limiting our ability to take advantage of significant business opportunities, such as acquisition opportunities, and to react to changes in market or industry conditions; and |
| placing us at a competitive disadvantage compared to those of our competitors that have less debt. |
The terms of our credit facilities permit additional borrowings, subject to certain conditions. In order to meet our capital expenditure needs, we may be required to make such additional borrowings under our credit facilities or be required to issue new debt securities in the capital markets. We can provide no assurances that we will be able to access the debt capital markets or do so on favorable terms. If new debt is added to our current debt levels, the related risks we now face could intensify limiting our ability to refinance existing debt on favorable terms.
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We will depend primarily on operations to fund our expenses and to pay the principal and interest on our outstanding debt. Our ability to meet our expenses thus depends on our future performance, which will be affected by financial, business, economic, competitive, legislative, regulatory and other factors. We are not able to control many of these factors, such as economic conditions in the markets where we operate and pressure from competitors. The money we earn may not be sufficient to allow us to pay principal and interest on our outstanding debt obligations. If we do not have enough money, we may be required to refinance all or part of our existing debt, sell assets, borrow additional funds or sell additional equity. We may not be able to take such actions on terms that are acceptable to us, if at all. In addition, the terms of our existing or future debt agreements, including our credit facilities, may restrict us from adopting any of these alternatives. If our business does not generate sufficient cash flow from operations or if we are unable to incur indebtedness sufficient to enable us to fund our liquidity needs, we may be unable to plan for or respond to changes in our business that would prevent us from maintaining or increasing our business and cause our operating results and prospects to be affected adversely.
Our failure to comply with restrictive covenants under our credit facilities could trigger prepayment obligations.
Our failure to comply with the restrictive covenants under our credit facilities could result in an event of default, which, if not cured or waived, could result in us being required to repay or refinance (on less favorable terms) these borrowings before their due date. If we are forced to repay or refinance (on less favorable terms) these borrowings, our results of operations and financial condition could be adversely affected by increased costs and rates. In 2007, we were not in compliance with reporting covenants contained in some of the debt agreements of our subsidiaries. Such defaults under the reporting covenants were caused by our delay in producing our quarterly and audited annual consolidated financial statements. We have obtained all necessary waivers under the agreements, and we expect that prior to the effectiveness of the registration statement we will deliver the required financial statements and no longer be in default under any debt agreements. We can provide no assurance that we will comply in the future with all our reporting covenants and will not face an event of default under our debt agreements, or that such default will be cured or waived.
Our inability to adequately replace members of our local and corporate management team could adversely affect our results of operations.
Our operations are dependent on the continued efforts of our officers and employees. The loss of key officers who have acquired significant experience in operating an integrated water company on a national level may cause a significant disruption to our business. In addition, the operations of the individual utilities we own are dependent on the performance and productivity of the local managers in charge of those utilities and on other skilled employees. The success of the water utilities we own is significantly affected by local relationships (including relationships with local regulatory bodies) and the quality of services the utilities offer. Our inability to adequately replace key local managers and other skilled employees may jeopardize those relationships and the quality of services offered by those utilities. In addition, management and other skilled employees are in high demand. We cannot assure you that we will be able to identify, attract and retain sufficient managers and other skilled employees to continue to operate our businesses at their current levels of performance in the future.
Work stoppages and other labor relations matters could adversely affect our results of operations.
Currently, approximately 3,400 employees, or approximately 50% of our total workforce, are unionized and represented by 14 different unions. Approximately one-third of our 75 union collective bargaining agreements expire annually, with 23 agreements covering 783 employees scheduled to expire before the end of 2007. We might not be able to renegotiate labor contracts on terms that are favorable to us and negotiations or dispute resolutions undertaken in connection with our labor contracts could be delayed or become subject to the risk of labor actions or work stoppages. Labor actions, work stoppages or the threat of work stoppages and our failure to obtain favorable labor contract terms during renegotiations may all adversely affect our financial condition, results of operations, cash flow and liquidity.
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We currently have material weaknesses in internal control over financial reporting. If we fail to remedy our material weaknesses or otherwise maintain effective internal control over financial reporting, we may not be able to report our financial results accurately or on a timely basis. Any inability to report and file our financial results in an accurate and timely manner could harm our business and adversely impact the trading price of our common stock.
After the consummation of this offering, we will become a public company. As a public company, we will be required to comply with the Sarbanes-Oxley Act and other rules and regulations that govern public companies. In particular, we will be required to certify our compliance with Section 404 of the Sarbanes-Oxley Act for the year ended December 31, 2008, which will require us to perform system and process evaluation and testing of our internal control over financial reporting to allow management and our registered public accounting firm to report on the effectiveness of our internal control over financial reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles. However, since 2003, we have been a wholly owned subsidiary of RWE, a stock corporation incorporated in the Federal Republic of Germany, and were not required to maintain a system of internal control consistent with the requirements of the SEC and the Sarbanes-Oxley Act, nor to prepare our own financial statements. As a public reporting company, we will be required, among other things, to maintain a system of effective internal control over financial reporting suitable to prepare our publicly reported financial statements in a timely and accurate manner, and also to evaluate and report on such system of internal control.
A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Companys annual or interim financial statements will not be prevented or detected on a timely basis. In connection with the preparation of our consolidated financial statements as of December 31, 2006, we and our independent registered public accountants have identified the following material weaknesses in our internal control over financial reporting:
| Inadequate internal staffing and skills; |
| Inadequate controls over financial reporting processes; |
| Inadequate controls over month-end closing processes, including account reconciliations; |
| Inadequate controls over maintenance of contracts and agreements; |
| Inadequate controls over segregation of duties and restriction of access to key accounting applications; and |
| Inadequate controls over tax accounting and accruals. |
We have allocated, and will continue to allocate, significant additional resources, including hiring of additional staff, to remediate the deficiencies in our internal control listed above. However, elements of our remediation plan can only be accomplished over time, and we can provide no assurances that our initiatives will result in an effective internal control environment.
Each of these weaknesses could result in a material misstatement of our annual or interim consolidated financial statements. Moreover, we cannot assure you that we have identified all, or that we will not in the future have additional, material weaknesses, any of which may subject us to additional regulatory scrutiny, and cause future delays in filing our financial statements and periodic reports with the SEC. Any such delays in the filing of our financial statements and periodic reports may result in a loss of public confidence in the reliability of our financial statements and sanctions imposed on us by the SEC. We believe that such misstatements or delays could negatively impact our liquidity, access to capital markets, financial condition and the market value of our common stock or cause a downgrade in the credit ratings of American Water or AWCC. These material weaknesses contributed to our inability to comply with reporting covenants in our debt agreements and those of our subsidiaries, and could hinder our ability to comply with such covenants in the future if we are not successful in remediating such weaknesses.
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Risks Related to this Offering
There has been no prior public trading market for shares of our common stock since our acquisition by RWE, and an active trading market may not develop following the completion of this offering.
Since our acquisition by RWE in 2003, there has been no public market for our shares. It is likely that the initial public offering price for our shares will differ from the market price for our shares after the initial public offering. We cannot assure you that an active trading market for our shares will develop. A significant portion of our shares may not trade following the offering because RWE will own approximately % of our shares after the offering (or approximately % of our shares if the underwriters option to purchase additional shares is exercised in full). If no trading market develops, securities analysts may not initiate or maintain research coverage of us, which could further depress the market for our shares. The price of our shares could decline if one or more equity analysts downgrade our shares or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business. Furthermore, our operating results and prospects from time to time may be below the expectations of market analysts and investors. As a result, investors may not be able to sell their shares at or above the initial public offering price or at the time that they would like to sell.
The market price of our common stock may be volatile, which could cause the value of your investment to decline.
There has historically been significant volatility in the market price and trading volume of equity securities. This volatility is often unrelated to the financial performance of the companies issuing the securities. These broad market fluctuations may negatively affect the market price of our common stock. The initial public offering price for the shares of common stock being sold in this offering will be determined by negotiations between the representatives of the underwriters and the selling stockholder and may not be indicative of prices that will prevail in the open market following this offering. You may not be able to resell your shares at or above the initial public offering price due to fluctuations in the market price of our common stock caused by changes in our operating performance or prospects and other factors. Some specific factors that may have a significant effect on the market price of our common stock include:
| actual or anticipated fluctuations in our operating results or future prospects; |
| the publics reaction to our press releases, our other public announcements and our filings with the SEC; |
| strategic actions by us or our competitors, such as acquisitions or restructurings; |
| new laws or regulations or new interpretations of existing laws or regulations applicable to our business; |
| changes in accounting standards, policies, guidance, interpretations or principles; |
| adverse conditions in the financial markets or general economic conditions, including those resulting from war, incidents of terrorism and responses to such events; |
| sales of common stock by us, the selling stockholder or members of our management team; and |
| changes in stock market analyst recommendations or earnings estimates regarding our common stock, other comparable companies or the water services industry generally. |
There has not been a public market for our common stock since our acquisition by RWE in 2003. We cannot predict the extent to which investor interest in our company will lead to the development of an active trading market on the New York Stock Exchange or otherwise or how liquid that market might become. If an active trading market does not develop, you may have difficulty selling any of our common stock that you buy. Consequently, you may not be able to sell our common stock at prices equal to or greater than the price you paid in this offering.
Future sales of our shares, or the perception by the market that future sales of our shares may occur, could depress the market price of our common stock.
Future sales, or the perception of the availability for sale in the public market, of substantial amounts of our common stock could adversely affect the prevailing market price of our common stock and could impair our
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ability to raise capital through future sales of equity securities at a time and price that we deem appropriate. Following the Transactions, there will be shares of our common stock outstanding.
The shares of common stock sold by RWE in this offering will be freely transferable without restriction or further registration under the Securities Act. The remaining shares of common stock owned by RWE will be restricted securities within the meaning of Rule 144 under the Securities Act but will be eligible for resale subject to applicable volume, manner of sale, holding period and other limitations of Rule 144 and the lock-up provisions described below. RWE has registration rights with respect to the common stock that they will retain following this offering and, subject to the lock-up provisions described in this prospectus, intends to fully divest its ownership of American Water as soon as reasonably practicable, subject to market conditions.
In addition, the equity units to be issued pursuant to a separate prospectus concurrently with this offering are effectively exchangeable into up to freely tradable shares of our common stock on the third anniversary of that offering. Following the consummation of this offering, we intend to grant restricted stock units and stock options under our 2007 Omnibus Equity Compensation Plan, and are considering establishing an employee stock purchase plan, for which we would reserve shares of our common stock to be issued and sold thereunder.
We, our executive officers and directors and the selling stockholder have agreed to a lock-up, meaning that, subject to specified exceptions, neither we nor they will sell any shares or engage in any hedging transactions without the prior consent of the representatives of the underwriters for 180 days after the date of this prospectus. Following the expiration of this 180-day lock-up period, all of the shares of our common stock held by our executive officers and directors and by the selling stockholder will be eligible for future sale, subject to the applicable volume, manner of sale, holding period and other limitations of Rule 144.
We may issue shares of our common stock, or other securities, from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our common stock or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. We may also grant registration rights covering those shares or other securities in connection with any such acquisitions and investments. Any additional capital raised through the sale of our equity securities may dilute your percentage ownership in us. See Shares Eligible for Future Sale for a discussion of the shares of common stock that may be sold into the public market in the future.
You may never receive dividends on your investment in our common stock, which may limit your returns.
We currently intend to declare and pay regular quarterly cash dividends on our common stock. See Dividend Policy. However, we are not legally or contractually required to pay dividends, and our board of directors may revise or discontinue our dividend policy at any time. In particular, our dividend policy may change upon a change of control. In addition, any payment of cash dividends will depend upon our financial condition and results of operations, liquidity requirements, capital requirements of our subsidiaries, legal requirements, regulatory constraints, restrictions in our debt agreements and other factors deemed relevant by our board of directors. Some of our debt agreements restrict our ability, subject to specified exceptions, to pay dividends. Furthermore, any additional indebtedness that we incur may severely restrict or prohibit the payment of dividends. We cannot assure you that the agreements governing our future indebtedness will permit us to pay dividends on our common stock. See Description of Certain Indebtedness.
To pay dividends at intended levels, we will require a significant amount of cash. Our ability to generate cash depends on many factors beyond our control, including the ability to receive cash distributions from our subsidiaries. We may not receive sufficient distributions from our subsidiaries to pay dividends with respect to shares of our common stock.
Our ability to pay dividends will depend on our ability to generate cash flow from operations in the future. This ability, to an extent, is subject to general economic, financial, competitive, regulatory and other factors that
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are beyond our control. We cannot assure you, however, that our subsidiaries will generate sufficient cash flow from operations, or have sufficient surplus or net profits, as the case may be, to make cash contributions to us in an amount sufficient to enable us to pay our indebtedness, pay dividends or to fund our other liquidity needs.
In addition, we are a holding company with no substantial assets. Because substantially all of our operations are conducted through our subsidiaries, we will not be able to pay dividends unless we receive sufficient cash distributions from our operating subsidiaries. Our operating subsidiaries are subject to regulation by applicable state PUCs which may limit the ability of these subsidiaries to make distributions to us. If we do not have sufficient cash to fund dividend payments, we would either reduce or eliminate dividends or rely on cash provided by financing activities to fund dividend payments, and such financing may or may not be available.
Our principal stockholder is in a position to affect our ongoing operations, corporate transactions and other matters, and its interests may conflict with or differ from your interests as a stockholder.
Upon the consummation of this offering, RWE will own approximately % of our common stock (or approximately % if the underwriters option to purchase additional shares is exercised in full). As a result, RWE effectively will be able to significantly influence the outcome on virtually all matters submitted to a vote of our stockholders, including the election of directors. So long as RWE continues to own a significant portion of the outstanding shares of our common stock, it will continue to be able to significantly influence the election of our directors, subject to compliance with applicable NYSE requirements, our decisions, policies, management and affairs and corporate actions requiring stockholder approval, including the approval of transactions involving a change of control. The interests of RWE and its affiliates may not coincide with the interests of our other stockholders.
Provisions in our amended and restated certificate of incorporation, our bylaws, Delaware law and the laws of the states in which we operate may inhibit or discourage a takeover attempt and negatively affect the value of your shares.
Provisions of our charter documents, the General Corporation Law of the State of Delaware, the state in which we are organized, and the laws of the states in which we operate, could discourage potential acquisition proposals or make it more difficult for a third party to acquire control of our company, even if doing so might be beneficial to our stockholders. See Description of Capital Stock. Upon the consummation of the offering, our amended and restated certificate of incorporation and bylaws will provide for various procedural and other requirements that could make it more difficult for stockholders to effect some corporate actions, or may deter, delay or prevent a third party from acquiring us. These provisions will include:
| limitations on who may call special meetings of stockholders; |
| the inability of stockholders to act by written consent; |
| advance notice requirements for nominations for election to the board of directors and for stockholder proposals; and |
| the authority of our board of directors to issue, without stockholder approval, shares of preferred stock with such terms as our board of directors may determine and to issue additional shares of our common stock. |
In addition, some of the states in which we operate have enacted laws that require regulatory approval for the acquisition of control of regulated utilities. The threshold for a change of control is a fact specific inquiry that varies by state. For instance, in some states, any person acquiring more than 9.9% of our common stock would need the prior approval of the applicable state PUC or a determination from such state PUC that control has not been acquired. In addition to ownership, other states may analyze the degree of influence or control an acquiror may exert over the company. Any person acquiring our common stock in this offering, through the concurrent offering of our equity units or in any other purchase of our common stock in a quantity sufficient to trigger a change of control under state law would need the prior approval of the applicable state PUC.
These provisions may discourage acquisition proposals and may make it more difficult or expensive for a third party to acquire a majority of our outstanding voting stock or may delay, prevent or deter a merger, acquisition, tender offer or proxy contest, which may negatively affect our stock price.
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We have made statements under the captions Summary, Risk Factors, Managements Discussion and Analysis of Financial Condition and Results of Operations, Business and in other sections of this prospectus that are forward-looking statements. In some cases, these forward-looking statements can be identified by words with prospective meanings such as intend, plan, estimate, believe, anticipate, expect, predict, project, forecast, outlook, future, potential, continue, may, can, should and could and similar expressions. Forward-looking statements may relate to, among other things, our future financial performance, our growth strategies, our ability to repay debt, our ability to finance current operations and growth initiatives, trends in our industry, regulatory or legal developments or rate adjustments.
Forward-looking statements are predictions based on our current expectations and assumptions regarding future events. They are not guarantees of any outcomes, financial results or levels of performance, and you are cautioned not to place undue reliance upon them. These forward-looking statements are subject to a number of risks and uncertainties, and new risks and uncertainties of which we are not currently aware or which we do not currently perceive may arise in the future from time to time. Should any of these risks or uncertainties materialize, or should any of our expectations or assumptions prove incorrect, then our results may vary materially from those discussed in the forward-looking statements herein. Factors that could cause actual results to differ from those discussed in forward-looking statements include, but are not limited to, the factors discussed under the caption Risk Factors and the following factors:
| weather conditions, patterns or events, including drought or abnormally high rainfall; |
| changes in general economic, business and financial market conditions; |
| changes in laws, governmental regulations and policies, including environmental, health and water quality and public utility regulations and policies; |
| the decisions of governmental and regulatory bodies, including decisions to raise or lower rates; |
| the timeliness of regulatory commissions actions concerning rates; |
| migration into or out of our service territories; |
| our ability to obtain permits for expansion projects; |
| changes in customer demand for, and patterns of use of, water, such as may result from conservation efforts; |
| the availability of adequate and cost-effective supplies of chemicals, electricity, fuel, water and other raw materials that are needed for our operations; |
| our ability to successfully acquire and integrate water and wastewater systems that are complementary to our operations and the growth of our business; |
| our ability to manage the expansion of our business; |
| our ability to control operating expenses and to achieve efficiencies in our operations; |
| access to sufficient capital on satisfactory terms; |
| fluctuations in interest rates; |
| restrictive covenants in or changes to the credit ratings on our current or future debt that could increase our financing costs or affect our ability to borrow, make payments on debt or pay dividends; |
| changes in our credit rating; |
| changes in capital requirements; |
| difficulty in obtaining insurance at acceptable rates and on acceptable terms and conditions; |
| ability to retain and attract qualified employees; |
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| cost overruns relating to improvements or the expansion of our operations; and |
| civil disturbance or terrorist threats or acts or public apprehension about future disturbances or terrorist threats or acts. |
Any forward-looking statements we make speak only as of the date of this prospectus. Except as required by law, we do not have any obligation, and we specifically disclaim any undertaking or intention, to update any forward-looking statements, whether as a result of new information, future events or otherwise.
Unless otherwise indicated, information contained in this prospectus concerning the water and wastewater industry, its segments and related markets and our general expectations concerning such industry and its segments and related markets are based on management estimates. Such estimates are derived from publicly available information released by third-party sources, as well as data from our internal research and on assumptions made by us based on such data and our knowledge of such industry and markets, which we believe to be reasonable. We have estimated the number of people served by our water and wastewater systems (i) by multiplying the number of residential water and wastewater connections by average people per household based on 2000 United States Census data by state (average people per household varies by state but is generally between 2.4 to 3.0 individuals per household); (ii) by adjusting for some other customer classes, including commercial customers, and for bulk water sales and (iii) by reconciling drinking water and wastewater connections to avoid double counting population served where the same user has both drinking water and wastewater service. In some instances, population estimates for our Non-Regulated Businesses are based on either (i) specific population estimates from the client or (ii) population estimates based on the average volume of water processed by the applicable facilities. Our internal research has not been verified by any independent source, and we have not independently verified any third party information and cannot assure you of its accuracy or completeness. In addition, while we believe the market share and market position information included herein is generally reliable, such information is inherently imprecise. While we are not aware of any misstatements regarding the industry or similar data presented herein, such data involve risks and uncertainties and are subject to change based on various factors, including those discussed under the heading Risk Factors in this prospectus.
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All of the shares of common stock offered by this prospectus are being sold by the selling stockholder. For information about the selling stockholder, see Principal and Selling Stockholder. We will not receive any of the proceeds from the shares of common stock sold by the selling stockholder.
Concurrently with this offering of common stock, we are offering, by means of a separate prospectus, $ million of our equity units. Each equity unit will have a stated amount of $50 and will consist of a contract obligating the purchaser to purchase shares of common stock and a fixed-rate senior note initially due . Pursuant to the purchase contracts, we will have an obligation to deliver, on or prior to , shares of common stock, subject to anti-dilution adjustments as provided in the purchase contracts.
We estimate that we will receive net proceeds from our sale of equity units of $ million, after deducting estimated expenses and underwriting discounts and commissions.
We intend to pay quarterly cash dividends on our common stock at an initial rate of $ per share per annum. The first such dividend will be declared and paid in the first quarter following the completion of this offering. The declaration, payment and amount of future dividends to holders of our common stock will be at the discretion of our board of directors and will depend on many factors, including our financial condition and results of operations, liquidity requirements, capital requirements of our subsidiaries, legal requirements, regulatory constraints and other factors deemed relevant by our board of directors.
We are a holding company with no significant business operations of our own. All of our business operations are conducted through our subsidiaries. Dividends and loans from, and cash generated by, our subsidiaries will be our principal sources of cash to repay indebtedness, fund operations and pay dividends. Accordingly, our ability to pay dividends to our stockholders will depend on the earnings and distributions of funds from our subsidiaries. See Risk FactorsRisks Related to this OfferingTo pay dividends at intended levels, we will require a significant amount of cash. Our ability to generate cash depends on many factors beyond our control, including the ability to receive cash distributions from our subsidiaries. We may not receive sufficient distributions from our subsidiaries to pay dividends with respect to shares of our common stock.
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The following table sets forth our cash and cash equivalents and capitalization as of June 30, 2007 on an actual basis and on a pro forma basis to give effect to the Transactions as if they had occurred on June 30, 2007.
You should read this table in conjunction with, and this table is qualified in its entirety by reference to, the sections in this prospectus entitled Summary Historical Consolidated and Unaudited Pro Forma Financial Data, Use of Proceeds, Unaudited Pro Forma Condensed Consolidated Financial Information, Selected Historical Consolidated Financial Data, Managements Discussion and Analysis of Financial Condition and Results of Operations, and our consolidated financial statements and the notes thereto included elsewhere in this prospectus.
As of June 30, 2007 | ||||||
(dollars in thousands) | ||||||
Historical | Pro forma | |||||
Cash and cash equivalents |
$ | 51,445 | $ | 66,012 | ||
Short-term debt |
||||||
RWE notes(1) |
141,000 | | ||||
Short-term debt |
167 | 167 | ||||
Total short-term debt |
141,167 | 167 | ||||
Long-term debt of American Water |
||||||
Redeemable preferred stock(2) |
1,750,000 | | ||||
Long-term debt of AWCC |
||||||
Private activity bonds and government funded debt |
86,860 | 86,860 | ||||
Senior notes |
1,212,000 | 1,212,000 | ||||
New senior notes(3) |
| 1,500,000 | ||||
RWE notes(4) |
81,000 | | ||||
Equity units (5) |
| 500,000 | ||||
Long-term debt of other subsidiaries |
||||||
Private activity bonds and government funded debt |
1,126,493 | 1,126,493 | ||||
Mortgage bonds |
802,840 | 802,840 | ||||
Senior notes |
53,500 | 53,500 | ||||
Redeemable preferred stock at redemption value (6) |
24,856 | 24,856 | ||||
Notes payable and other |
3,859 | 3,859 | ||||
Unamortized debt discount, net |
80,545 | 80,545 | ||||
Total long-term debt |
5,221,953 | 5,390,953 | ||||
Total debt |
5,363,120 | 5,391,120 | ||||
Equity |
||||||
Common stockholders equity(7) |
4,520,149 | 4,491,275 | ||||
Preferred stock without mandatory redemption requirements |
4,568 | 4,568 | ||||
Total equity |
4,524,717 | 4,495,843 | ||||
Total capitalization including short-term debt and current portion of long-term debt |
$ | 9,887,837 | $ | 9,886,963 | ||
(1) | In connection with the Refinancing, we will repay $141.0 million of short-term indebtedness owed to RWE. |
(2) | In connection with the Refinancing, we will redeem $1,750.0 million of our preferred stock. |
(3) | In connection with the Refinancing, AWCC will issue $1,500.0 million of new senior notes. |
(4) | In connection with the Refinancing, we will repay $81.0 million of long-term indebtedness owed to RWE. |
(5) | In connection with the Refinancing, AWCC will issue approximately $500.0 million of equity units by a separate prospectus concurrently herewith. |
(6) | Includes current portion of redeemable preferred stock. |
(7) | Does not include the common stock issuable upon settlement of the purchase contract included in the equity units being offered by a separate prospectus concurrently with this offering. |
29
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL INFORMATION
The following unaudited pro forma condensed consolidated financial information have been developed by applying pro forma adjustments to the historical audited and unaudited consolidated financial statements of American Water appearing elsewhere in this prospectus. See the explanatory note to the unaudited pro forma condensed consolidated financial statements. The unaudited pro forma condensed consolidated statements of operations give effect to the Transactions as if they had occurred on January 1, 2006. The unaudited pro forma condensed consolidated balance sheet gives effect to the Transactions as if they had occurred on June 30, 2007. The Transactions consist of the following:
| The Restructuring, comprising: |
| The contribution of the businesses of Thames Water Holdings Incorporated and its subsidiaries by Thames US Holdings to American Water; and |
| The merger of Thames US Holdings into American Water with American Water being the surviving entity. |
| The Refinancing, comprising: |
| The non-cash equity contribution to the Company by RWE of $1,194.5 million of debt of our subsidiaries held by RWE on December 15, 2006, the non-cash equity contribution to the Company by RWE of $100.0 million of debt of our subsidiaries held by RWE on March 29, 2007 and the $550.0 million cash equity contribution to the Company by RWE on March 29, 2007, which was used to pay down $232.5 million of short-term debt and the remainder used for general working capital purposes; |
| The issuance of approximately $1,500.0 million aggregate principal amount of new senior notes, together with approximately $450.0 million of commercial paper and approximately $20.0 million of cash, which will fund the early redemption of $1,750.0 million of preferred stock and the repayment of RWE notes in an aggregate principal amount of $222.0 million; and |
| The issuance of approximately $500.0 million of equity units, less issuance costs, to fund the repayment of approximately $450.0 million of commercial paper, with the balance of the net cash proceeds of approximately $34.5 million to be used for general corporate purposes. |
| The -for- split of common stock effected prior to this offering and the consummation of this offering of common stock of American Water. |
Assumptions underlying the pro forma adjustments are described in the accompanying notes, which should be read in conjunction with these unaudited pro forma condensed consolidated financial statements.
The unaudited pro forma adjustments and financial information:
| are based upon available information and certain assumptions that we believe are reasonable under the circumstances; |
| are presented for informational purposes only; |
| do not purport to represent what our results of operations or financial condition would have been had the Transactions actually occurred on the dates indicated; and |
| do not purport to project our results of operations or financial condition for any future period or as of any future date. |
The unaudited pro forma condensed consolidated financial statements should be read in conjunction with the information contained in Use of Proceeds, Capitalization, Selected Historical Consolidated Financial Data, Managements Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and related notes thereto appearing elsewhere in this prospectus. All pro forma adjustments and their underlying assumptions are described more fully in the notes to our unaudited pro forma condensed consolidated financial statements.
30
American Water Works Company, Inc. and Subsidiary Companies
Unaudited Pro Forma Condensed Consolidated Statement of Operations
For the Year Ended December 31, 2006
Historical | Pro forma adjustments |
Pro forma | ||||||||||
(dollars in thousands, except for share and per share amounts) |
||||||||||||
Operating revenues |
$ | 2,093,067 | $ | | $ | 2,093,067 | ||||||
Operating expenses |
||||||||||||
Operation and maintenance |
1,174,544 | 1,700 | (A) | 1,176,244 | ||||||||
Depreciation and amortization |
259,181 | | 259,181 | |||||||||
General taxes |
185,065 | | 185,065 | |||||||||
Loss (gain) on sale of assets |
79 | | 79 | |||||||||
Impairment charges |
221,685 | | 221,685 | |||||||||
Total operating expenses, net |
1,840,554 | 1,700 | 1,842,254 | |||||||||
Operating income (loss) |
252,513 | (1,700 | ) | 250,813 | ||||||||
Other income (deductions) |
||||||||||||
Interest |
(365,970 | ) | (4,239 | )(B) | (296,913 | ) | ||||||
74,676 | (C) | |||||||||||
(1,380 | )(H) | |||||||||||
Amortization of debt expense |
(5,062 | ) | (870 | )(B) | (5,932 | ) | ||||||
Other, net |
9,581 | | 9,581 | |||||||||
Total other income (deductions) |
(361,451 | ) | 68,187 | (293,264 | ) | |||||||
Income (loss) from continuing operations before income taxes |
(108,938 | ) | 66,487 | (42,451 | ) | |||||||
Provision for income taxes |
46,912 | 26,296 | (E) | 73,208 | ||||||||
Income (loss) from continuing operations |
$ | (155,850 | ) | $ | 40,191 | $ | (115,659 | ) | ||||
Unaudited pro forma earnings per share: |
||||||||||||
Basic |
$ | (155,850 | ) | |||||||||
Diluted |
$ | (155,850 | ) | |||||||||
Weighted average shares used in calculating earnings per share: |
||||||||||||
Basic |
1,000 | (F) | ||||||||||
Diluted |
1,000 | (G) | ||||||||||
See accompanying notes to the Unaudited Pro Forma Condensed Consolidated Financial Statements.
31
American Water Works Company, Inc. and Subsidiary Companies
Unaudited Pro Forma Condensed Consolidated Statement of Operations
For the Six Months Ended June 30, 2007
Historical | Pro forma adjustments |
Pro forma | ||||||||||
(dollars in thousands, except for share and per share amounts) |
||||||||||||
Operating revenues |
$ | 1,027,277 | $ | | $ | 1,027,277 | ||||||
Operating expenses |
||||||||||||
Operation and maintenance |
581,999 | 510 | (A) | 582,509 | ||||||||
Depreciation and amortization |
132,764 | | 132,764 | |||||||||
General taxes |
93,819 | | 93,819 | |||||||||
Loss (gain) on sale of assets |
(6,113 | ) | | (6,113 | ) | |||||||
Impairment charges |
| | | |||||||||
Total operating expenses, net |
802,469 | 510 | 802,979 | |||||||||
Operating income (loss) |
224,808 | (510 | ) | 224,298 | ||||||||
Other income (deductions) |
||||||||||||
Interest |
(142,970 | ) | (2,138 | )(B) | (141,682 | ) | ||||||
4,116 | (C) | |||||||||||
(690 | )(H) | |||||||||||
Amortization of debt expense |
(2,397 | ) | (435 | )(B) | (2,832 | ) | ||||||
Other, net |
7,351 | | 7,351 | |||||||||
Total other income (deductions) |
(138,016 | ) | 853 | (137,163 | ) | |||||||
Income (loss) from continuing operations before income taxes |
86,792 | 343 | 87,135 | |||||||||
Provision for income taxes |
34,378 | 136 | (E) | 34,514 | ||||||||
Income (loss) from continuing operations |
$ | 52,414 | $ | 207 | $ | 52,621 | ||||||
Unaudited pro forma earnings per share: |
||||||||||||
Basic |
$ | 52,414 | ||||||||||
Diluted |
$ | 52,414 | ||||||||||
Weighted average shares used in calculating earnings per share: |
||||||||||||
Basic |
1,000 | (F) | ||||||||||
Diluted |
1,000 | (G) | ||||||||||
See accompanying notes to the Unaudited Pro Forma Condensed Consolidated Financial Statements.
32
American Water Works Company, Inc. and Subsidiary Companies
Unaudited Pro Forma Condensed Consolidated Balance Sheet
June 30, 2007
Historical | Pro forma adjustments |
Pro forma | ||||||||
(dollars in thousands) | ||||||||||
ASSETS |
||||||||||
Property, plant and equipment |
||||||||||
Utility plantat original cost, net of accumulated depreciation |
$ | 8,806,066 | $ | | $ | 8,806,066 | ||||
Nonutility property, net of accumulated depreciation |
109,525 | | 109,525 | |||||||
Total property, plant and equipment |
8,915,591 | | 8,915,591 | |||||||
Current assets |
||||||||||
Cash and cash equivalents |
51,445 | 14,567 | (B) | 66,012 | ||||||
Other current assets |
440,550 | | 440,550 | |||||||
Total current assets |
491,995 | 14,567 | 506,562 | |||||||
Regulatory and other long-term assets |
||||||||||
Goodwill |
2,962,564 | | 2,962,564 | |||||||
Other regulatory and other long-term assets |
701,435 | 11,236 | (D) | 712,671 | ||||||
Total regulatory and other long-term assets |
3,663,999 | 11,236 | 3,675,235 | |||||||
TOTAL ASSETS |
$ | 13,071,585 | $ | 25,803 | $ | 13,097,388 | ||||
CAPITALIZATION & LIABILITIES |
||||||||||
Capitalization |
||||||||||
Common stockholders equity |
$ | 4,520,149 | $
|
790 6,500 (23,000) (13,504) 340 |
(I) (I) (H) (D) (J) |
$ | 4,491,275 | |||
Preferred stock without mandatory redemption requirements |
4,568 | | 4,568 | |||||||
Long-term debt |
||||||||||
Long-term debt |
3,335,579 | (81,000 | )(I) | 3,254,579 | ||||||
Redeemable preferred stock at redemption value |
1,774,299 | (1,750,000 | )(I) | 24,299 | ||||||
New senior notes |
| 1,500,000 | (B) | 1,500,000 | ||||||
Equity units |
| 500,000 | (B) | 500,000 | ||||||
Total capitalization |
9,634,595 | 140,126 | 9,774,721 | |||||||
Current liabilities |
||||||||||
Short-term debt and current portion of long-term debt |
253,242 | (141,000 | )(I) | 112,242 | ||||||
Other current liabilities |
|
373,216 |
|
4,017 4,425 |
(E) (E) |
|
381,658 | |||
Total current liabilities |
626,458 | (132,558 | )(I) | 493,900 | ||||||
Total regulatory and other long-term liabilities |
2,031,085 | 18,235 | (H) | 2,049,320 | ||||||
Contributions in aid of construction |
779,447 | | 779,447 | |||||||
TOTAL CAPITALIZATION AND LIABILITIES |
$ | 13,071,585 | $ | 25,803 | $ | 13,097,388 | ||||
See accompanying notes to the Unaudited Pro Forma Condensed Consolidated Financial Statements.
33
American Water Works Company, Inc. and Subsidiary Companies
Notes to the Unaudited Pro Forma Condensed Consolidated Financial Statements
Explanatory Note: Prior to the consummation of this offering, Thames US Holdings will be merged with and into American Water, with American Water as the surviving entity. Both American Water and Thames US Holdings are wholly owned subsidiaries of RWE. The historical consolidated financial statements of American Water represent the consolidated results of the Company, formerly issued under the name Thames Water Aqua US Holdings, Inc. and Subsidiary Companies.
(A) | Reflects the granting of unvested stock options and restricted stock units to our employees in conjunction with this offering. The awards will be issued under the American Water 2007 Omnibus Equity Compensation Plan. The Company is recording non-cash compensation charges in accordance with Statement of Financial Accounting Standards No. 123(R) Share-Based Payment. |
(B) | The sources and uses of funds in connection with the Refinancing and the related impact on interest expense related to the Transactions are summarized below, which are defined and further discussed elsewhere in this prospectus. |
Principal | Rate(1) | Interest 12 months |
Interest 6 months |
Debt expense amortization 12 months |
Debt expense amortization 6 months |
|||||||||||||||||
(dollars in thousands) | ||||||||||||||||||||||
SOURCES: |
||||||||||||||||||||||
New senior notes |
$ | 1,500,000 | ||||||||||||||||||||
Equity units |
500,000 | |||||||||||||||||||||
Total sources |
$ | 2,000,000 | 6.00 | % | $ | 120,000 | $ | 60,000 | ||||||||||||||
USES: |
||||||||||||||||||||||
Redeemable preferred stock |
$ | 1,740,000 | $ | (103,250 | ) | $ | (51,625 | ) | ||||||||||||||
RWE notes |
220,693 | (12,511 | ) | (6,237 | ) | |||||||||||||||||
Financing costs |
24,740 | ($ | 870 | ) | ($ | 435 | ) | |||||||||||||||
Total |
1,985,433 | (115,761 | ) | (57,862 | ) | (870 | ) | (435 | ) | |||||||||||||
Net source (use) |
$ | 14,567 | $ | 4,239 | $ | 2,138 | ($ | 870 | ) | ($ | 435 | ) |
(1) |
Reflects the assumed blended interest rates in the case of the new senior notes and the notes associated with the equity units. A 1/8% change to the assumed interest rates would impact earnings before tax by approximately $2.5 million for the year ended December 31, 2006 and $1.3 million for the six months ended June 30, 2007. |
(C) | Reflects the non-cash equity contribution to the Company by RWE of $1,194.5 million of 5.80% debt of our subsidiaries held by RWE on December 15, 2006, the non-cash equity contribution to the Company by RWE of $100.0 million of 4.0% debt of our subsidiaries held by RWE and the $550.0 million of cash equity contribution to the Company by RWE on March 29, 2007. The cash was used to pay down $232.5 million of short-term debt with the remainder used for general working capital purposes. |
(D) | Reflects issuance costs that are expected to total $24.7 million, of which $13.5 million relating to the equity units has been reflected as a reduction to additional paid-in capital, and $11.2 million associated with the new senior notes has been reflected as other assets and will be amortized over the term of each tranche of the new senior notes. |
(E) | Represents the reduction in income tax expense resulting from the Transactions at the estimated blended tax rate of 39.6%. A $10 million gain assumed on the early extinguishment of the redeemable preferred stock is not subject to state tax jurisdiction and therefore a rate of 35% was applied. The deferred tax liability of $4.4 million associated with the preferred stock dividend was reclassified from long-term to short-term |
34
liabilities, and the $4.0 million estimated tax expense on the gains from early extinguishment of redeemable preferred stock and debt is reflected as a current liability. |
(F) | The number of common shares used to compute pro forma basic earnings per common share is , which is the number of shares of our common stock assumed to be outstanding on the issuance date. |
(G) | The number of shares used to compute pro forma diluted earnings per share will be based on the number of shares of our common stock described in (F) above, plus the potential dilution that could occur if restricted stock units granted under the American Water 2007 Omnibus Equity Compensation Plan were exercised or converted into common stock. The number of shares used in computing pro forma diluted earnings per share have been adjusted to reflect number of restricted units assumed to have been issued. |
(H) | The equity units have an assumed overall annual payment rate of %. The assumed interest rate on the underlying notes is % and the remainder is attributable to the contract adjustment payments, which includes imputed interest of $1.4 million (which is not disclosed in footnote (B) above). The estimated present value of the obligation to make contract adjustment payments of $23.0 million is recorded as a long-term liability with a corresponding reduction of additional paid-in capital. |
(I) | Reflects the repurchase of RWE notes and early redemption of preferred stock. The proceeds from the new senior notes, together with the proceeds from the issuance of commercial paper and cash on hand, will be used to repurchase the RWE notes and to redeem the redeemable preferred stock. A portion of the net proceeds from the issuance of the equity units will be used to repay the commercial paper with the remaining net proceeds to be used for general corporate purposes. The gain of $0.8 million, after income taxes, on the early extinguishment of the RWE notes is calculated as the difference between the assumed interest rate of the 10-year tranche of the new senior notes and the weighted-average interest rate on the RWE notes. The gain has been recorded as a capital contribution from RWE. The difference of $6.5 million, after income taxes, between the carrying value of the preferred stock and the cash payment is recorded to additional paid-in-capital. |
(J) | The current liability of $0.3 million associated with restricted stock units granted under our 2007 Omnibus Equity Compensation Plan was reclassified to additional paid-in capital. |
35
SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA
The following table presents our selected historical consolidated financial data at the dates and for the periods indicated. The statements of operations data for the years ended December 31, 2004, 2005, and 2006 and the balance sheet data as of December 31, 2005 and 2006 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. The historical financial data as of December 31, 2004 have been derived from our audited consolidated financial statements not included in this prospectus. The financial data as of June 30, 2006 and 2007 and for the six months ended June 30, 2006 and 2007 have been derived from our unaudited interim consolidated financial statements included elsewhere in this prospectus. See footnote 1 to the table below. Operating results for the six months ended June 30, 2006 and 2007 have been prepared on a basis consistent with our audited consolidated financial statements and reflect all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the financial position and results for the periods presented. The results of any interim period are not necessarily indicative of the results that may be expected for any other interim period or for the entire fiscal year. The financial data as of and for the year ended December 31, 2002 have been derived from the consolidated financial statements of Thames Water Holdings, Incorporated, referred to as Predecessor, the statement of operation for the year ended December 31, 2003, and the financial data as of December 31, 2003 and 2004 have been derived from our historical financial statements, in each case, which are not included in this prospectus.
Our historical consolidated financial data are not necessarily indicative of our future performance or what our financial position and results of operations would have been if we had operated as a separate, stand-alone entity during the periods shown. This financial data should be read in conjunction with, and is qualified in its entirety by reference to, the information in the section in this prospectus entitled Summary Historical Consolidated and Unaudited Pro Forma Financial Data, Use of Proceeds, Capitalization, Unaudited Pro Forma Condensed Consolidated Financial Information, Managements Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and the notes thereto included elsewhere in this prospectus.
For the years ended December 31, |
For the six months ended |
|||||||||||||||||||||||||||
2002(1) | 2003 | 2004 | 2005 | 2006 | 2006 | 2007 | ||||||||||||||||||||||
(Predecessor) (unaudited) |
(unaudited) | (unaudited) | (unaudited) | |||||||||||||||||||||||||
(dollars in thousands, except for share and per share data) | ||||||||||||||||||||||||||||
Statement of operations data(2): |
||||||||||||||||||||||||||||
Operating revenues |
$ | 198,835 | $ | 1,890,291 | $ | 2,017,871 | $ | 2,136,746 | $ | 2,093,067 | $ | 1,007,691 | $ | 1,027,277 | ||||||||||||||
Operating expenses |
||||||||||||||||||||||||||||
Operation and maintenance |
99,571 | 1,089,071 | 1,121,970 | 1,201,566 | 1,174,544 | 562,072 | 581,999 | |||||||||||||||||||||
Depreciation and amortization |
20,659 | 210,588 | 225,260 | 261,364 | 259,181 | 128,728 | 132,764 | |||||||||||||||||||||
General taxes |
24,480 | 164,677 | 170,165 | 183,324 | 185,065 | 94,756 | 93,819 | |||||||||||||||||||||
Loss (gain) on sale of assets(3) |
| (16,771 | ) | (8,611 | ) | (6,517 | ) | 79 | (1,795 | ) | (6,113 | ) | ||||||||||||||||
Impairment charges |
182,256 | 3,555 | 78,688 | 385,434 | 221,685 | | | |||||||||||||||||||||
Total operating expenses, net |
326,966 | 1,451,120 | 1,587,472 | 2,025,171 | 1,840,554 | 783,761 | 802,469 | |||||||||||||||||||||
Operating income (loss) |
(128,131 | ) | 439,171 | 430,399 | 111,575 | 252,513 | 223,930 | 224,808 | ||||||||||||||||||||
Other income (deductions) |
||||||||||||||||||||||||||||
Interest |
(26,734 | ) | (280,501 | ) | (315,944 | ) | (345,257 | ) | (365,970 | ) | (178,968 | ) | (142,970 | ) | ||||||||||||||
Amortization of debt expense |
| (3,872 | ) | (3,377 | ) | (4,367 | ) | (5,062 | ) | (1,678 | ) | (2,397 | ) | |||||||||||||||
Other, net(4) |
5,343 | (52,387 | ) | 14,350 | 13,898 | 9,581 | 4,927 | 7,351 | ||||||||||||||||||||
Total other income (deductions) |
(21,391 | ) | (336,760 | ) | (304,971 | ) | (335,726 | ) | (361,451 | ) | (175,719 | ) | (138,016 | ) | ||||||||||||||
Income (loss) from continuing operations before income taxes |
(149,522 | ) | 102,411 | 125,428 | (224,151 | ) | (108,938 | ) | 48,211 | 86,792 | ||||||||||||||||||
Provision for income taxes |
8,895 | 60,271 | 66,328 | 50,979 | 46,912 | 20,056 | 34,378 | |||||||||||||||||||||
Income (loss) from continuing operations |
$ | (158,417 | ) | $ | 42,140 | $ | 59,100 | $ | (275,130 | ) | $ | (155,850 | ) | $ | 28,155 | $ | 52,414 | |||||||||||
Income (loss) from continuing operations per basic common share(5) |
$ | (158,417 | ) | $ | 42,140 | $ | 59,100 | $ | (275,130 | ) | $ | (155,850 | ) | $ | 28,155 | $ | 52,414 | |||||||||||
Income (loss) from continuing operations per common diluted share(5) |
$ | (158,417 | ) | $ | 42,140 | $ | 59,100 | $ | (275,130 | ) | $ | (155,850 | ) | $ | 28,155 | $ | 52,414 | |||||||||||
Basic weighted average common shares(5) |
1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | |||||||||||||||||||||
Diluted weighted average common shares(5) |
1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | |||||||||||||||||||||
36
For the years ended December 31, |
For the six months ended |
|||||||||||||||||||
2004 | 2005 | 2006 | 2006 | 2007 | ||||||||||||||||
(unaudited) | (unaudited) | |||||||||||||||||||
(dollars in thousands, except for share and per share data) | ||||||||||||||||||||
Other data: |
||||||||||||||||||||
Cash flows provided by (used in): |
||||||||||||||||||||
Operating activities |
$ | 458,408 | $ | 525,435 | $ | 323,748 | $ | 66,723 | $ | 136,181 | ||||||||||
Investing activities |
(545,903 | ) | (530,165 | ) | (691,438 | ) | (241,724 | ) | (279,441 | ) | ||||||||||
Financing activities |
95,254 | (9,049 | ) | 332,367 | 133,391 | 164,951 | ||||||||||||||
Construction expenditures |
(546,241 | ) | (558,446 | ) | (688,843 | ) | (235,818 | ) | (307,726 | ) |
As of December 31, | As of June 30, | |||||||||||||||||
2002(1) | 2003 | 2004 | 2005 | 2006 | 2007 | |||||||||||||
(Predecessor) (unaudited) |
(unaudited) | (unaudited) | ||||||||||||||||
Balance sheet data: |
||||||||||||||||||
Cash and cash equivalents |
$ | 24,232 | $ | 71,097 | $ | 78,856 | $ | 65,077 | $ | 29,754 | $ | 51,445 | ||||||
Utility plant and property, net of depreciation |
772,052 | 7,377,195 | 7,754,434 | 8,101,769 | 8,605,341 | 8,806,066 | ||||||||||||
Total assets |
1,297,587 | 12,629,354 | 12,728,410 | 12,542,029 | 12,783,059 | 13,071,585 | ||||||||||||
Other short term and long term debt |
806,770 | 5,063,344 | 5,101,891 | 5,030,078 | 4,103,532 | 3,588,821 | ||||||||||||
Redeemable preferred stock |
12,000 | 1,787,777 | 1,775,224 | 1,774,691 | 1,774,475 | 1,774,299 | ||||||||||||
Total debt |
818,770 | 6,851,121 | 6,877,115 | 6,804,769 | 5,878,007 | 5,363,120 | ||||||||||||
Common stockholder equity |
106,229 | 3,198,144 | 3,129,555 | 2,804,716 | 3,817,397 | 4,520,149 | ||||||||||||
Preferred stock without mandatory redemption requirements |
| 5,687 | 4,651 | 4,571 | 4,568 | 4,568 |
(1) | Principally reflects the historical financial data of Elizabethtown Water Company. |
(2) | Prior to the consummation of this offering, Thames US Holdings will be merged with and into American Water, with American Water as the surviving entity. Both American Water and Thames US Holdings are wholly owned subsidiaries of RWE. The historical consolidated financial statements of American Water represent the consolidated results of the Company formerly issued under the name Thames Water Aqua US Holdings, Inc. and Subsidiary Companies for 2003 to 2006 and Thames Water Holdings Incorporated for 2002. |
(3) | Represents primarily losses (gains) on sales of publicly traded securities and dispositions of assets not needed in utility operations. |
(4) | Includes allowance for other funds used during construction, allowance for borrowed funds used during construction and preferred dividends of subsidiaries. |
(5) | The number of shares used to compute income (loss) from continuing operations per basic share and income (loss) from continuing operations per diluted common share for the fiscal years ended December 31, 2004, 2005 and 2006 and the six months ended June 30, 2006 and 2007 is 1,000 (the number of common shares outstanding during such period) as no dilutive options or instruments were outstanding during these periods. |
37
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations covers periods prior to the consummation of the Transactions. Accordingly, the discussion and analysis of historical periods does not reflect the significant impact that the Transactions will have on us. You should read the following discussion together with the financial statements and the notes thereto included elsewhere in this prospectus. This discussion contains forward-looking statements that are based on managements current expectations, estimates and projections about our business and operations. The cautionary statements made in this prospectus should be read as applying to all related forward-looking statements whenever they appear in this prospectus. Our actual results may differ materially from those currently anticipated and expressed in such forward-looking statements as a result of a number of factors, including those we discuss under Risk Factors and elsewhere in this prospectus. You should read Risk Factors and Forward-Looking Statements.
Overview
Founded in 1886, American Water is the largest investor-owned United States water and wastewater utility company, as measured both by operating revenue and population served. Our nearly 6,900 employees provide approximately 16.2 million people with drinking water, wastewater and other water-related services in 32 states and Ontario, Canada. In 2006, we generated $2,093.1 million in operating revenue, representing approximately four times the operating revenue of the next largest investor-owned company in the United States water and wastewater business, and $252.5 million in operating income, which includes $221.7 million of impairment charges relating to continuing operations.
Our primary business involves the ownership of water and wastewater utilities that provide water and wastewater services to residential, commercial and industrial customers. Our Regulated Businesses that provide these services are generally subject to economic regulation by state PUCs in the states in which they operate. The federal government and the states also regulate environmental, health and safety and water quality matters. We report the results of this business in our Regulated Businesses segment. Our Regulated Businesses currently provide services in 20 states and in 2006 served approximately 3.3 million customers, or connections to our water and wastewater networks. In 2006, our Regulated Businesses generated $1,854.6 million in operating revenue, prior to inter-segment eliminations, representing 88.6% of our consolidated operating revenue.
We also provide services that are not subject to economic regulation by state PUCs. We report the results of this business in our Non-Regulated Businesses segment. Our Non-Regulated Businesses include our:
| Contracts Operations Group, which enters into public/private partnerships, including O&M and DBO contracts for the provision of services to water and wastewater facilities for municipalities, the United States military and other customers; |
| Applied Water Management Group, which works with customers to design, build and operate small water and wastewater treatment plants; and |
| Homeowner Services Group, which provides services to domestic homeowners to protect against the cost of repairing broken or leaking pipes inside and outside their homes. |
In 2006, our Non-Regulated Businesses generated $248.5 million in operating revenue, prior to inter-segment eliminations.
History
Prior to being acquired by RWE in 2003, we were the largest publicly traded water utility company in the United States. In 2003, we were acquired by RWE and became a private company. Thames US Holdings,
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currently an indirect wholly owned subsidiary of RWE, is the holding company for us and our regulated and unregulated subsidiaries throughout the United States and Ontario, Canada. Our consolidated statements of operations, statements of cash flow and changes in common stockholders equity and comprehensive income (loss) for the years ended December 31, 2004, 2005 and 2006 and the six months ended June 30, 2006 and 2007 and consolidated balance sheets as of December 31, 2005 and 2006 and as of June 30, 2007 have been derived from the consolidated financial statements and accounting records of Thames US Holdings and its subsidiaries.
Our consolidated statements of operations for the years ended December 31, 2004, 2005 and 2006 and the six months ended June 30, 2006 and 2007 reflect expense allocations for some central corporate functions historically provided to us by RWE, including information systems, human resources, accounting and treasury activities and legal services. These allocations reflect expenses specifically identifiable as relating to our business as well as our share of expenses allocated to us based on capital employed, capital expenditures, headcount, revenues, production volumes, fixed costs, environmental accruals or other methods management considers to be reasonable. We and RWE consider these allocations to be a reasonable reflection of our utilization of the services provided by RWE. However, our expenses as a separate, stand-alone company may be higher or lower than the amounts reflected in our consolidated statements of operations.
The RWE acquisition resulted in certain changes in our business. For example, our operations and management were managed through Thames Water Plc, referred to as Thames Water, a former subsidiary of RWE. Also, we agreed not to file rate cases with some state PUCs for specified periods of time as a condition of the acquisition. As of June 30, 2007, all rate stay-out provisions had expired.
As a result of significantly increased costs, our inability to file rate cases and impairment charges, we recorded net losses in the amount of $64.9 million, $325.0 million and $162.2 million for the years ended December 31, 2004, 2005 and 2006, respectively.
In 2005, RWE decided to divest American Water through the sale of shares in one or more public offerings. In order to become a public company once again, we have had to incur substantial initial costs, including costs associated with ensuring adequate internal control over financial reporting in order to achieve compliance with the Sarbanes-Oxley Act. These substantial initial costs are not recoverable in rates charged to our customers. See Our Internal Control and Remediation Initiatives.
We performed valuations of our long-lived assets, investments and goodwill, as of December 31, 2004, 2005 and 2006. As a result of the valuation analyses, we recorded pretax charges of $216.0 million, $420.4 million and $227.8 million, including impairment charges from discontinued operations, for the years ended December 2004, 2005 and 2006, respectively. As a result, this reduced net income by $200.5 million, $388.6 million and $223.6 million in 2004, 2005 and 2006, respectively.
The Company estimates the fair value of our long-lived assets, investments and goodwill using available market values, discounted cash flow models from our business plan or a combination of market and discounted cash flow values. Annual impairment reviews are performed in the fourth quarter. There are a number of significant assumptions reflected in our valuation analyses. These include market interest rates used for discounting future cash flows, market value assumptions using market valuation multiples of comparable water utilities and revenue and operating income growth assumptions in our business plan. We base these assumptions on our best estimates of the Companys future performance and available market information at the time. Any decline over a period of time in the valuation multiples of comparable water utilities, a decline in the market value of our common stock and its value relative to our book equity at the consummation of this offering or a decline over a period of time of our stock price following the consummation of this offering could result in additional impairments. A decline in our forecasted results in our business plan, such as changes in rate case results or capital investment budgets or an increase in interest rates, may also result in an incremental impairment charge. In accordance with GAAP, the Company reviews goodwill annually, or more frequently, if changes in circumstances indicate the carrying value may not be recoverable. See Critical Accounting Policies and Estimates.
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Our Internal Control and Remediation Initiatives
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles. However, since 2003, we have been a wholly owned subsidiary of RWE, a stock corporation organized under the laws of the Federal Republic of Germany, and were not required to maintain a system of internal control consistent with the requirements of the SEC and the Sarbanes-Oxley Act, nor to prepare our own financial statements. As a public reporting company, we will be required, among other things, to maintain a system of effective internal control over financial reporting suitable to prepare our publicly reported financial statements in a timely and accurate manner, and also to evaluate and report on such system of internal control. In particular, we will be required to certify our compliance with Section 404 of the Sarbanes-Oxley Act for the year ended December 31, 2008, which will require us to perform system and process evaluation and testing of our internal control over financial reporting to allow management and our independent registered public accounting firm to report on the effectiveness of our internal control over financial reporting.
In connection with the preparation of our consolidated financial statements as of December 31, 2006, we and our independent registered public accountants have identified the following material weaknesses in our internal control over financial reporting:
| Inadequate internal staffing and skills; |
| Inadequate controls over financial reporting processes; |
| Inadequate controls over month-end closing processes, including account reconciliations; |
| Inadequate controls over maintenance of contracts and agreements; |
| Inadequate controls over segregation of duties and restriction of access to key accounting applications; and |
| Inadequate controls over tax accounting and accruals. |
Since joining the Company in 2006, Donald L. Correll, our Chief Executive Officer, and Ellen C. Wolf, our Chief Financial Officer, have assigned a high priority to the evaluation and remediation of our internal controls, and have taken numerous steps to remediate these material weaknesses and to evaluate and strengthen our other internal controls over financial reporting. Some of the actions taken include:
| Increasing our internal financial staff numbers and skill levels, and using external resources to supplement our internal staff where necessary; |
| Implementing detailed processes and procedures related to our period end financial closing processes, key accounting applications and our financial reporting processes; |
| Implementing or enhancing systems used in the financial reporting processes and month-end close processes; |
| Conducting extensive training on existing and newly developed processes and procedures as well as explaining to employees Sarbanes-Oxley Act requirements and the value of internal controls; |
| Enhancing our internal audit staff; |
| Hiring a director of internal control and a director of taxes; |
| Implementing a tracking mechanism and new policy and procedure for approval of all contracts and agreements; and |
| Retaining a nationally recognized accounting and auditing firm to assist management in developing policies and procedures surrounding internal controls over financial reporting, to evaluate and test these internal controls and to assist in the remediation of internal control deficiencies. |
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We have allocated, and will continue to allocate, significant additional resources, including the hiring of additional staff, to remediate the material weaknesses identified above. As of June 30, 2007, the Company has incurred $33.8 million to remediate these material weaknesses and to document and test key financial reporting controls. As a condition to state PUC approval of the RWE Divestiture, we agreed that costs incurred in connection with our initial internal control and remediation initiatives would not be recoverable in rates charged to our customers.
Elements of our remediation activities can only be accomplished over time, and our initiatives provide no assurances that they will result in an effective internal control environment. Our board of directors, in coordination with our audit committee, will continually assess the progress and sufficiency of these initiatives and make adjustments, as necessary.
Factors Affecting Our Results of Operations
Our financial condition and results of operations are influenced by a variety of factors, including the following:
| economic utility regulation; |
| infrastructure investment; |
| compliance with environmental, health and safety standards; |
| production costs; |
| customer growth; |
| declining water usage per customer; and |
| weather and seasonality. |
Economic Utility Regulation
Our subsidiaries in the states in which we operate our Regulated Businesses are generally subject to extensive economic regulation by their respective state PUCs. Although specific authority might differ from state to state, in most states, these state PUCs must approve rates, accounting treatments, long-term financing programs, significant capital expenditures and plant additions, transactions between the regulated subsidiary and affiliated entities, reorganizations and mergers and acquisitions, in many instances prior to their completion. Regulatory policies not only vary from state to state, they may change over time. These policies will affect the timing as well as the extent of recovery of expenses and the realized return on invested capital.
Our operating revenue is typically determined by reference to the volume of water supplied to a customer multiplied by a price-per-gallon set by a tariff approved by the relevant state PUC. The process to obtain approval for a change in rates, or rate case, involves filing a petition with the state PUC on a periodic basis as determined by our capital expenditures needs and our operating costs. Rate cases and other rate-related proceedings can take several months to a year or more to complete. Therefore, there is frequently a delay, or regulatory lag, between the time one of our regulated subsidiaries makes a capital investment or incurs an operating expense increase and when those costs are reflected in rates. The management team at each of our regulated subsidiaries works to minimize regulatory lag.
Our results of operations are significantly affected by rates authorized by the state PUCs in the states in which we operate. In addition to the formal rate case filings, we generate revenues through other cost recovery procedures. For example, some states in which we operate allow utility subsidiaries to recover system infrastructure replacement costs without the necessity of filing a full rate proceeding. Since infrastructure replacement is a significant element of capital expenditures made by our subsidiaries, such programs can reduce regulatory lag.
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Currently, Pennsylvania, Illinois, Missouri, Indiana, New York, California and Ohio have allowed the use of these infrastructure surcharges. These surcharges adjust periodically based on qualified capital expenditures being completed or anticipated in a future period. These surcharges are typically reset to zero when new base rates are effective and incorporate the costs of these infrastructure expenditures. We anticipate an increase in revenues of approximately $16.0 million in 2007, assuming constant sales volumes, as a result of these infrastructure surcharges.
Some states have permitted use of some form of forecast or forward looking test year instead of historical data to set rates. Examples of these states include Illinois, Kentucky, Ohio, New York and California. In addition, a number of states in which we operate have allowed the utility to update historical data for some changes that occur for some limited period of time subsequent to the historical test year. This allows the utility to take account of some more current costs or capital investments in the rate-setting process. Examples of these states include New Mexico, Texas, Missouri, Iowa, Virginia, Pennsylvania, Maryland, West Virginia, New Jersey and Arizona.
Another regulatory mechanism to address issues of regulatory lag includes the ability, in some circumstances, to recover in rates a return on utility plant before it is actually in service, instead of capitalizing an allowance for funds used during construction. Examples of states that have allowed such recovery include Iowa, Texas, Pennsylvania, Ohio, Kentucky and California.
As a condition to our acquisition by RWE in 2003, we agreed not to file rate cases in some of the states where our Regulated Businesses operate. As of June 30, 2007, all material rate stay-out provisions had expired. We have four general rate cases pending that were filed in 2006 that would provide $79.1 million in additional annualized revenues, assuming constant sales volumes, if approved as filed. During the first six months of 2007, our subsidiaries have filed general rate cases in seven states that would provide $125.5 million in additional annualized revenues, assuming constant sales volumes, if approved as filed. In the first six months of 2007 we received authorizations for additional annualized revenues from rates of $81.0 million, assuming constant sales volumes. We have filed (or soon will file) general rate cases in six additional states before the end of 2007 that would provide $52.6 million in additional annualized revenues, assuming constant sales volumes, if approved as filed. In addition, we expect to continue to receive additional revenues through infrastructure replacement surcharges. There is no assurance that the complete amount, or any portion thereof, of any requested increases will be granted.
Infrastructure Investment
Over the next five years, we estimate that Company-funded capital investment will total between $4,000 and $4,500 million. We anticipate spending between $700 and $900 million yearly on Company-funded capital investment for the foreseeable future, depending upon the timing of major capital projects. Our capital investment includes both infrastructure renewal programs, where we replace existing infrastructure, as needed, and construction of facilities to meet new customer growth. Over the next five years, we estimate we will invest approximately $1,800 million to replace aging infrastructure including mains, meters, and supply and treatment facilities. We estimate that we will invest approximately $1,300 million in facilities to serve new customer growth over this same period. In addition, we estimate that complying with water quality standards and other regulatory requirements will require approximately $750 million of investment. Projects to enhance system reliability, security and efficiency, or to meet other needs are projected to account for approximately an additional $400 million of investment over this same period.
These capital investments are needed on an ongoing basis to comply with existing and new regulations, renew aging treatment and network assets, provide capacity for new growth and enhance system reliability, security and quality of service. The need for continuous investment presents a challenge due to the potential for regulatory lag, or the delay in recovering our operating expenses and earning an appropriate rate of return of and on our invested capital. Because the decisions of state PUCs and the timing of those decisions can have a significant impact on the operations and earnings of our Regulated Businesses, we maintain a rate case
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management program guided by the goals of obtaining efficient recovery of costs of capital and utility operation and maintenance costs, including costs incurred for compliance with environmental, health and safety and water quality regulation. We pursue methods to minimize the adverse impact of regulatory lag and have worked with state PUCs and legislatures to implement a number of approaches to achieve this result, including promoting the implementation of forms of forward-looking test years and infrastructure surcharges.
Compliance with Environmental, Health and Safety Standards
Our water and wastewater operations are subject to extensive United States federal, state and local and, in the case of our Canadian operations, Canadian laws and regulations, governing the protection of the environment, health and safety, the quality of the water we deliver to our customers, water allocation rights, and the manner in which we collect, treat and discharge wastewater. These requirements include the Safe Drinking Water Act, the Clean Water Act and similar state and Canadian laws and regulations. We are also required to obtain various environmental permits from regulatory agencies for our operations. State PUCs also set conditions and standards for the water and wastewater services we deliver. We incur substantial costs associated with compliance with environmental, health and safety and water quality regulation to which our Regulated Businesses are subject.
Environmental, health and safety and water quality regulations are complex and change frequently, and they have tended to become more stringent over time. As newer or stricter standards are introduced, they could increase our operating expenses. In the past, we have generally been able to recover expenses associated with compliance for environmental, health and safety standards, but this recovery is affected by regulatory lag.
Production Costs
Our water and wastewater services require significant production inputs and result in significant production costs. These costs include fuel and power, which is used to operate pumps and other equipment, purchased water and chemicals used to treat water and wastewater. We also incur production costs for waste disposal. For 2006, production costs accounted for approximately 14.4% of our total operating costs.
Customer Growth
Customer growth in our Regulated Businesses is driven by (i) organic population growth within our authorized service areas and (ii) by adding new customers to our regulated customer base by acquiring water and wastewater utility systems through acquisitions. Generally, we add customers through tuck-ins of small water and/or wastewater systems, typically serving fewer than 10,000 customers, in close geographic proximity to where we currently operate our Regulated Businesses. We also seek large acquisitions that allow us to acquire multiple water and wastewater utility systems in our existing markets and markets where we currently do not operate our Regulated Businesses. During 2004, 2005, and 2006, we had cash outflows of $1.6 million, $5.0 million and $12.5 million, respectively, for acquisitions of water and wastewater systems which allowed us to expand our regulated customer base. Our most recent significant acquisition was the 2002 purchase of the water and wastewater assets of Citizens Communications Company, adding approximately 342,000 customers in six states in which we had existing operations. We intend to continue to expand our regulated footprint geographically by acquiring water and wastewater systems in our existing markets and some markets in the United States where we do not currently operate our Regulated Businesses. Our experienced development team evaluates potential acquisition targets across the country, particularly in higher-growth areas. Before entering new markets, we will evaluate the regulatory environment to ensure that we will have the opportunity to achieve an appropriate return on our investment while maintaining our high standards for quality, reliability and compliance with environmental, health and safety and water quality standards. These acquisitions may include large acquisitions of companies that have operations in multiple markets. For further information, see Our BusinessOur Regulated BusinessesAcquisitions.
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Declining Water Usage Per Customer
Increased water conservation, including through the use of more efficient household fixtures and appliances among residential consumers, combined with declining household sizes in the United States, has contributed to a trend of declining residential per customer water usage. Because the characteristics of residential water use are driven by many factors, these declining trends will vary by state and service area and change over time. For example, areas with higher per customer residential water use (primarily due to lawn irrigation) will generally have a greater projected decline in the long term since the conservation potential is greater. Our Regulated Businesses are heavily dependent upon operating revenue generated from rates we charge to our residential customers for the volume of water they use. If rate increases authorized by state PUCs or growth in our residential customer base are not sufficient to offset declining revenue caused by this declining usage, this will have a negative impact on our long-term operating revenues.
Weather and Seasonality
Our ability to meet the existing and future water demands of our customers depends on an adequate supply of water. Drought, overuse of sources of water, the protection of threatened species or habitats or other factors may limit the availability of ground and surface water. Also, customer usage of water is affected by weather conditions, in particular during the summer. Our water systems experience higher demand in the summer due to the warmer temperatures and increased usage by customers for lawn irrigation and other outdoor uses. Summer weather that is cooler and wetter than average generally serves to suppress customer water demand, and can have a downward effect on our operating revenue and operating income. Conversely, when weather conditions are extremely dry, our systems may be affected by drought-related warnings and/or water usage restrictions imposed by governmental agencies, also serving to reduce water allocation due to passing-flow requirements, customer demand and operating revenue. These restrictions may be imposed at a regional or state level and may affect our service areas regardless of our readiness to meet unrestricted customer demands.
The geographic diversity of our service areas tends to mitigate some of the effect of weather extremes. In any given summer, some areas are likely to experience drier than average weather while other areas will experience wetter than average weather.
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Results of Operations
The following table sets forth our consolidated statement of operations data for the years ended December 31, 2004, 2005, and 2006 and the six months ended June 30, 2006 and 2007:
For the years ended December 31, | For the six months ended June 30, | |||||||||||||||||||
2004 | 2005 | 2006 | 2006 | 2007 | ||||||||||||||||
(unaudited) | (unaudited) | |||||||||||||||||||
(dollars in thousands except for share and per share data) | ||||||||||||||||||||
Operating revenues |
$ | 2,017,871 | $ | 2,136,746 | $ | 2,093,067 | $ | 1,007,691 | $ | 1,027,277 | ||||||||||
Operating expenses |
||||||||||||||||||||
Operation and maintenance |
1,121,970 | 1,201,566 | 1,174,544 | 562,072 | 581,999 | |||||||||||||||
Depreciation and amortization |
225,260 | 261,364 | 259,181 | 128,728 | 132,764 | |||||||||||||||
General taxes |
170,165 | 183,324 | 185,065 | 94,756 | 93,819 | |||||||||||||||
Loss (gain) on sale of assets |
(8,611 | ) | (6,517 | ) | 79 | (1,795 | ) | (6,113 | ) | |||||||||||
Impairment charges |
78,688 | 385,434 | 221,685 | | | |||||||||||||||
Total operating expenses, net |
1,587,472 | 2,025,171 | 1,840,554 | 783,761 | 802,469 | |||||||||||||||
Operating income (loss) |
430,399 | 111,575 | 252,513 | 223,930 | 224,808 | |||||||||||||||
Other income (deductions) |
||||||||||||||||||||
Interest |
(315,944 | ) | (345,257 | ) | (365,970 | ) | (178,968 | ) | (142,970 | ) | ||||||||||
Allowance for other funds used during construction |
5,476 | 5,810 | 5,980 | 3,145 | 3,169 | |||||||||||||||
Allowance for borrowed funds used during construction |
2,923 | 2,420 | 2,652 | 1,366 | 1,512 | |||||||||||||||
Amortization of debt expense |
(3,377 | ) | (4,367 | ) | (5,062 | ) | (1,678 | ) | (2,397 | ) | ||||||||||
Preferred dividends of subsidiaries |
(410 | ) | (227 | ) | (215 | ) | (112 | ) | (113 | ) | ||||||||||
Other, net |
6,361 | 5,895 | 1,164 | 528 | 2,783 | |||||||||||||||
Total other income (deductions) |
(304,971 | ) | (335,726 | ) | (361,451 | ) | (175,719 | ) | (138,016 | ) | ||||||||||
Income (loss) from continuing operations before income taxes |
125,428 | (224,151 | ) | (108,938 | ) | 48,211 | 86,792 | |||||||||||||
Provision for income taxes |
66,328 | 50,979 | 46,912 | 20,056 | 34,378 | |||||||||||||||
Income (loss) from continuing operations |
59,100 | (275,130 | ) | (155,850 | ) | 28,155 | 52,414 | |||||||||||||
Income (loss) from discontinued operations, net of tax |
(124,018 | ) | (49,910 | ) | (6,393 | ) | 1,703 | (551 | ) | |||||||||||
Net income (loss) |
$ | (64,918 | ) | $ | (325,040 | ) | $ | (162,243 | ) | $ | 29,858 | $ | 51,863 | |||||||
Net income (loss) per common share: |
||||||||||||||||||||
Basic |
||||||||||||||||||||
Income (loss) from continuing operations |
$ | 59,100 | $ | (275,130 | ) | $ | (155,850 | ) | $ | 28,155 | $ | 52,414 | ||||||||
Income (loss) from discontinued operations, net of tax |
$ | (124,018 | ) | $ | (49,910 | ) | $ | (6,393 | ) | $ | 1,703 | $ | (551 | ) | ||||||
Net income (loss) |
$ | (64,918 | ) | $ | (325,040 | ) | $ | (162,243 | ) | $ | 29,858 | $ | 51,863 | |||||||
Diluted |
||||||||||||||||||||
Income (loss) from continuing operations |
$ | 59,100 | $ | (275,130 | ) | $ | (155,850 | ) | $ | 28,155 | $ | 52,414 | ||||||||
Income (loss) discontinued operations, net of tax |
$ | (124,018 | ) | $ | (49,910 | ) | $ | (6,393 | ) | $ | 1,703 | $ | (551 | ) | ||||||
Net income (loss) |
$ | (64,918 | ) | $ | (325,040 | ) | $ | (162,243 | ) | $ | 29,858 | $ | 51,863 | |||||||
Average common shares outstanding during the period: |
||||||||||||||||||||
Basic |
1,000 | 1,000 | 1,000 | 1,000 | 1,000 | |||||||||||||||
Diluted |
1,000 | 1,000 | 1,000 | 1,000 | 1,000 | |||||||||||||||
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The following table summarizes certain financial information for our Regulated and Non-Regulated Businesses for the periods indicated (without giving effect to inter-segment eliminations):
For the years ended December 31, | For the six months ended June 30, | |||||||||||||||||||||||||||||||
2004 | 2005 | 2006 | 2006 | 2007 | ||||||||||||||||||||||||||||
Regulated Businesses |
Non- Regulated |
Regulated Businesses |
Non- Regulated |
Regulated Businesses |
Non- Regulated |
Regulated Businesses |
Non- Regulated |
Regulated Businesses |
Non- Regulated | |||||||||||||||||||||||
(unaudited) | (unaudited) | (unaudited) | (unaudited) | |||||||||||||||||||||||||||||
(dollars in thousands) | ||||||||||||||||||||||||||||||||
Operating revenues |
$ | 1,748,004 | $ | 290,037 | $ | 1,836,061 | $ | 310,771 | $ | 1,854,618 | $ | 248,451 | $ | 883,017 | $ | 129,428 | $ | 927,910 | $ | 106,960 | ||||||||||||
Adjusted EBIT1 |
$ | 482,127 | $ | 17,117 | $ | 469,921 | $ | (106 | ) | $ | 468,701 | $ | (4,725 | ) | $ | 220,555 | $ | 342 | $ | 210,052 | $ | 14,031 |
(1) |
Refer to Note 21 of the audited consolidated financial statements for the Companys definition of Adjusted EBIT. |
Our primary business involves the ownership of water and wastewater utilities that provide water and wastewater services to residential, commercial and industrial customers. As such, our results of operations are significantly impacted by rates authorized by the state PUCs in the states in which we operate. The table below details the annualized revenues (assuming constant sales volumes) resulting from rate authorizations, including distribution infrastructure and other surcharges, granted in 2004, 2005, 2006 and through June 30, 2007.
Annualized Rate Increases Granted | |||||||||||||
During the years | |||||||||||||
2004 | 2005 | 2006 | 2007 | ||||||||||
(dollars in millions) | |||||||||||||
State |
|||||||||||||
New Jersey |
$ | 29.7 | $ | | $ | | $ | 56.2 | |||||
Pennsylvania |
28.6 | 5.8 | 8.0 | 6.6 | |||||||||
Missouri |
(0.4 | ) | | 6.8 | 2.6 | ||||||||
Illinois |
| | 0.9 | 1.7 | |||||||||
Indiana |
2.7 | 0.9 | 1.8 | | |||||||||
California |
7.2 | 8.4 | 15.1 | 0.5 | |||||||||
West Virginia |
1.8 | 10.0 | | | |||||||||
Other |
9.5 | 9.9 | 8.7 | 13.4 | |||||||||
Total |
$ | 79.1 | $ | 35.0 | $ | 41.3 | $ | 81.0 | |||||
Comparison of Results of Operations for the Six Months Ended June 30, 2007 to the Six Months Ended June 30, 2006
Operating revenues. Our consolidated operating revenues increased $19.6 million, or 1.9%, from $1,007.7 million for the six months ended June 30, 2006, to $1,027.3 million for the six months ended June 30, 2007. An increase in operating revenues for our Regulated Businesses was somewhat offset by a decrease in operating revenues for our Non-Regulated Businesses. The increase in the Regulated Businesses operating revenues was primarily due to rate increases obtained through general rate cases in New Jersey, California, Arizona and other states, totaling approximately $26.5 million. In addition, rate increases obtained through infrastructure surcharges, primarily in Pennsylvania, Missouri, Illinois and Indiana, totaled approximately $8.0 million. Water service operating revenues increased due to growth of 0.9% in our Regulated Businesses customer base. Water sales volume associated with existing customers increased by 0.4% for our Regulated Businesses.
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The following table sets forth the percentage of our Regulated Businesses operating revenues and water sales volume by customer class:
For the six months ended June 30, | ||||||||||||
Operating Revenues | Water Sales Volume | |||||||||||
2006 | 2007 | 2006 | 2007 | |||||||||
Water service: |
||||||||||||
Residential |
57.3 | % | 57.7 | % | 51.6 | % | 52.3 | % | ||||
Commercial |
19.5 | % | 19.0 | % | 21.9 | % | 21.8 | % | ||||
Industrial |
5.1 | % | 5.0 | % | 11.1 | % | 10.8 | % | ||||
Public and other |
13.1 | % | 12.6 | % | 15.4 | % | 15.1 | % | ||||
Other water revenues |
1.1 | % | 1.7 | % | | | ||||||
Total water revenues |
96.1 | % | 96.0 | % | 100.0 | % | 100.0 | % | ||||
Wastewater service |
3.7 | % | 3.8 | % | ||||||||
Management fees |
0.2 | % | 0.2 | % | ||||||||
100.0 | % | 100.0 | % | |||||||||
Water ServicesWater service operating revenues from residential customers for the six months ended June 30, 2007 amounted to $535.3 million, a 5.9% increase over the same period in 2006 primarily due to rate increases and changes in sales volume. The volume of water sold to residential customers increased by 2.2% for the six months ended June 30, 2007 to 99.1 billion gallons, from 96.9 billion gallons for the same period in 2006.
Water service operating revenues from commercial customers for the six months ended June 30, 2007 amounted to $176.0 million, a 2.3% increase over the same period in 2006, primarily due to rate increases and changes in sales volume. The volume of water sold to commercial customers increased by 0.5% for the six months ended June 30, 2007 to 41.3 billion gallons, from 41.1 billion gallons for the same period in 2006.
Water service operating revenues from industrial customers for the six months ended June 30, 2007 amounted to $46.1 million, a 3.0% increase over the same period in 2006, primarily due to rate increases and changes in sales volume. The volume of water sold to industrial customers decreased by 2.0% for the six months ended June 30, 2007 to 20.5 billion gallons, from 20.9 billion gallons for the same period in 2006.
Water service operating revenues from public and other customers for the six months ended June 30, 2007 amounted to $116.7 million, a 0.6% increase over the same period in 2006. Water service operating revenues from municipal governments for fire protection services and customers requiring special private fire service facilities for the six months ended June 30, 2007 amounted to $49.2 million, a 2.0% decrease over the same period in 2006. Water service operating revenues from governmental entities and resale customers for the six months ended June 30, 2007 amounted to $67.5 million, a 2.6% increase over the same period in 2006.
Wastewater ServicesOur subsidiaries provide wastewater services in 11 states. Operating revenues from these services increased by 7.9% to $35.4 million for the six months ended June 30, 2007, from $32.8 million for the same period in 2006. The increases were attributable to rate increases and customer growth in our service areas.
Our Non-Regulated Businesses operating revenues decreased by $22.4 million, or 17.3%, from $129.4 million for the six months ended June 30, 2006 to $107.0 million for the six months ended June 30, 2007. The decline was primarily attributable to the inclusion in 2006 of approximately $28.5 million in operating revenues for work performed under a contract to design and build the Lake Pleasant Water Treatment Plant in Phoenix, Arizona. The decrease in our Non-Regulated Businesses operating revenues also reflects operating
47
contracts that ended during 2006. These decreases were partially offset by expansion into new geographic markets by the Homeowners Services Group (Virginia and Trenton, New Jersey) and a new contract awarded to American Water Enterprises in Fillmore, California for a design and build project.
Operation and maintenance. Our consolidated operation and maintenance expense increased $19.9 million, or 3.5%, from $562.1 million for the six months ended June 30, 2006, to $582.0 million for the six months ended June 30, 2007.
Operation and maintenance expense by major category was as follows:
For the six months ended June 30, | ||||||
2006 | 2007 | |||||
(dollars in thousands) | ||||||
Production costs |
$ | 121,431 | $ | 131,397 | ||
Employee-related costs |
205,853 | 223,262 | ||||
Operating supplies and services |
142,380 | 134,166 | ||||
Maintenance materials and services |
44,078 | 54,703 | ||||
Customer billing and accounting |
25,430 | 17,473 | ||||
Other |
22,900 | 20,998 | ||||
Total |
$ | 562,072 | $ | 581,999 | ||
Production costs, including fuel and power, purchased water, chemicals and waste disposal increased by 8.2% for the six months ended June 30, 2007 compared to the same period in 2006. The increase was primarily attributable to higher energy costs, which are mainly due to increased production, as well as higher electricity prices as rate freezes resulting from electricity deregulation expired in some states in which we operate.
Employee-related costs including wage and salary, group insurance, and pension expense increased by 8.5% for the six months ended June 30, 2007 compared to the same period in 2006. These costs represented 36.6%, and 38.4% of operation and maintenance expense for the six months ended June 30, 2006 and 2007, respectively. The increase in 2007 was due to higher wage, salary and group insurance expenses in our Regulated Businesses, primarily resulting from an increase in the number of employees and wage rate increases. This increase was offset by a reduction in pension expense. Pension expense in excess of the amount contributed to the pension plans is deferred by some of our regulated subsidiaries pending future recovery in rates as contributions are made to the plans. The decrease is primarily attributable to lower pension expense for those regulated subsidiaries as a result of reduced pension contributions. In addition, pension expense for the six months ended June 30, 2006 included additional pension expense due to curtailment charges.
Operating supplies and services include the day-to-day expenses of office operation, legal and other professional services, as well as information systems and other office equipment and facility rental charges. For the six months ended June 30, 2007, these costs decreased by 5.8% compared to the same period in 2006. A significant factor contributing to the decrease was approximately $27.6 million of expenses associated with the design and build of the Lake Pleasant Water Treatment Plant in Phoenix, Arizona which were included in operating supplies and services for the six months ended June 30, 2006. The decrease also reflects Non-Regulated Businesses operating contracts that ended during 2006, and a decline in design and build activity by the Applied Water Management Group due to a downturn in new home construction. In addition, offsetting the decrease was additional expense associated with several new operating contracts and expansion into new markets by the Homeowner Services Group.
Offsetting the decline in Non-Regulated Businesses operating supplies and services was an increase in accounting, legal and consulting costs. Our remediation efforts in connection with the Sarbanes-Oxley Act resulted in an increase of $14.6 million for the six months ended June 30, 2007, as compared to the same period in 2006. Transportation costs for the six months ended June 30, 2007 increased by $2.4 million due to increased
48
vehicle leasing costs and higher gasoline prices. Also included in the six months ended June 30, 2006 was a recovery of $2.4 million previously disallowed in the regulatory process by our Indiana subsidiary. Expenses related to the RWE Divestiture were $2.3 million lower for the six months ended June 30, 2007 than in the same period in 2006 as regulatory approval activity related to the divestiture declined.
Maintenance materials and services, which include emergency repairs as well as costs for preventive maintenance, increased by 24.1% for the six months ended June 30, 2007 compared to the same period in 2006. This increase was primarily the result of a larger number of main breaks in the first quarter of 2007 compared to the first quarter of 2006 experienced by several of our operating subsidiaries due to winter weather conditions.
Customer billing and accounting expenses decreased by 31.3% for the six months ended June 30, 2007 compared to the same period in 2006. Lower uncollectible accounts expense by our regulated subsidiaries as a result of an increased focus on collection of past due accounts contributed to the decrease.
Other operation and maintenance expenses include casualty and liability insurance premiums and regulatory costs. These costs decreased by 8.3% in 2007 primarily due to a reduction in insurance cost resulting from favorable claims experience.
Depreciation and amortization. Our consolidated depreciation and amortization expense increased $4.1 million, or 3.2%, from $128.7 million for the six months ended June 30, 2006, to $132.8 million for the six months ended June 30, 2007. The increase was primarily due to property placed in service, net of retirements, of approximately $319.9 million as a result of an increased focus on infrastructure spending mainly in our Regulated Businesses.
General taxes. Our consolidated general taxes expense, which includes taxes for property, payroll, gross receipts and other miscellaneous items, decreased $1.0 million, or 1.1%, from $94.8 million for the six months ended June 30, 2006, to $93.8 million for the six months ended June 30, 2007. The decrease was primarily due to lower taxes for expatriates because employees seconded by Thames Water to American Water were no longer employed by American Water in 2007.
Loss (gain) on sale of assets. Our consolidated gain on sale of assets increased $4.3 million, or 238.9%, from $(1.8) million for the six months ended June 30, 2006, to $(6.1) million for the six months ended June 30, 2007. This line of our Statement of Operations represents loss (gain) on non-recurring sales of assets not needed in our utility operations.
Other income (deductions). Interest expense, the primary component of our consolidated other income (deductions), decreased $36.0 million, or 20.1%, from $179.0 million for the six months ended June 30, 2006, to $143.0 million for the six months ended June 30, 2007. The decline was primarily due to the repayment of outstanding debt with new equity contributions from RWE in order to establish a capital structure that is consistent with other regulated utilities and also to meet the capital structure expectations of various state regulatory commissions. This decrease was offset slightly by an increase in interest expense of our Regulated Businesses of $7.4 million mainly due to increased borrowings to fund capital programs.
Provision for income taxes. Our consolidated provision for income taxes increased $14.3 million, or 71.1%, from $20.1 million for the six months ended June 30, 2006, to $34.4 million for the six months ended June 30, 2007. The increase reflects a 80.0% increase in pre-tax income for the six months ended June 30, 2007, as compared with the same period in 2006. The effective tax rates for the six months ended June 30, 2006 and 2007 were 41.6% and 39.6%, respectively.
Net income (loss). Our consolidated net income including results from discontinued operations increased $22.0 million, or 73.6%, from $29.9 million for the six months ended June 30, 2006, to $51.9 million for the six months ended June 30, 2007. The increase is the result of the changes discussed above.
49
Comparison of Results of Operations for the Years Ended December 31, 2006 and 2005
Operating revenues. Our consolidated operating revenues decreased $43.6 million, or 2.0%, from $2,136.7 million for 2005 to $2,093.1 million for 2006. A decline in operating revenues associated with our Non-Regulated Businesses was partially offset by an overall increase in operating revenues from our Regulated Businesses.
Operating revenues from our Regulated Businesses increased by $18.6 million in 2006 compared to 2005, even with a 2.0% decline in water sales volume primarily due to weather fluctuations in 2006, as compared to 2005. The increase was primarily due to rate increases obtained through general rate cases in Arizona, California and New York as well as other states totaling $12.4 million. In addition, infrastructure surcharges in Pennsylvania, Missouri, Indiana, Illinois, and Ohio provided $13.7 million in additional operating revenues. Operating revenue also increased due to the addition of approximately 1.5%, or 51,000 customers, in our Regulated Businesses customer base through small acquisitions to our service areas and through growth in existing service areas.
The following table sets forth the percentage of our Regulated Businesses operating revenues and water sales volume by customer class:
For the years ended December 31, | ||||||||||||
Operating Revenues | Water Sales Volume | |||||||||||
2005 | 2006 | 2005 | 2006 | |||||||||
Water service: |
||||||||||||
Residential |
58.2 | % | 57.6 | % | 52.4 | % | 52.1 | % | ||||
Commercial |
19.3 | % | 19.6 | % | 21.9 | % | 22.0 | % | ||||
Industrial |
5.3 | % | 5.0 | % | 10.6 | % | 10.6 | % | ||||
Public and other |
12.2 | % | 12.5 | % | 15.1 | % | 15.3 | % | ||||
Other water revenues |
1.4 | % | 1.4 | % | | | ||||||
Total water revenues |
96.4 | % | 96.1 | % | 100.0 | % | 100.0 | % | ||||
Wastewater service |
3.4 | % | 3.7 | % | ||||||||
Management fees |
0.2 | % | 0.2 | % | ||||||||
100.0 | % | 100.0 | % | |||||||||
Water ServicesWater service operating revenues from residential customers in 2006 amounted to $1,068.2 million, relatively unchanged from 2005, as rate increases offset changes in sales volume. The volume of water sold to residential customers decreased by 2.5% in 2006 to 217.2 billion gallons, from 222.8 billion gallons for 2005.
Water service operating revenues from commercial customers in 2006 amounted to $362.7 million, a 2.5% increase over 2005, primarily due to rate increases and changes in sales volume. The volume of water sold to commercial customers decreased by 1.7% in 2006 to 91.6 billion gallons, from 93.2 billion gallons for 2005.
Water service operating revenues from industrial customers in 2006 amounted to $92.0 million, a 5.4% decrease over 2005, primarily due to rate increases and changes in sales volume. The volume of water sold to industrial customers decreased by 1.8% in 2006 to 44.4 billion gallons, from 45.2 billion gallons for 2005.
Water service operating revenues from public and other customers for 2006 amounted to $231.5 million, a 3.6% increase over 2005 primarily due to rate increases and changes in sales volume. Water service operating revenues from municipal governments for fire protection services and customers requiring special private fire service facilities for 2006 amounted to $98.5 million, a 9.6% increase from 2005. Water service operating revenues from governmental entities and resale customers 2006 amounted to $133.0 million, a 0.4% decrease from 2005.
50
Wastewater ServicesOur subsidiaries provide wastewater services in 11 states. Operating revenues from these services increased by 8.1% to $68.1 million for 2006, from $63.0 million for 2005. The increases were attributable to rate increases and customer growth in our service areas.
Non-Regulated Businesses operating revenues decreased by $62.3 million, or 20.0% from $310.8 million for 2005 to $248.5 million for 2006. The decrease was primarily due to a decline of approximately $63.4 million in operating revenue for work performed under a contract to design and build the Lake Pleasant Water Treatment Plant in Phoenix, Arizona. The decrease in operating revenues also reflects the cessation of some operating contracts that ended during fiscal 2006. Partially offsetting the decrease was expansion into new markets by the Applied Water Management Group and the Homeowner Services Group, as well as increased revenues from some O&M contracts and a new contract in Fillmore, California for a design and build project.
Operation and maintenance. Our consolidated operation and maintenance expense decreased $27.1 million, or 2.3%, from $1,201.6 million for 2005, to $1,174.5 million for 2006.
Operation and maintenance expense by major category was as follows:
For the years ended December 31, | ||||||
2005 | 2006 | |||||
(dollars in thousands) | ||||||
Production costs |
$ | 262,629 | $ | 264,385 | ||
Employee-related costs |
408,834 | 446,231 | ||||
Operating supplies and services |
338,052 | 268,199 | ||||
Maintenance materials and services |
97,866 | 96,502 | ||||
Customer billing and accounting |
44,413 | 55,601 | ||||
Other |
49,772 | 43,626 | ||||
Total |
$ | 1,201,566 | $ | 1,174,544 | ||
Production costs, including fuel and power, purchased water, chemicals and waste disposal, increased by 0.7% in 2006 compared to 2005. Increases in chemical prices and energy costs in our Regulated Businesses were the principal drivers of the increase, mitigated by the overall decline in water sales and decreases in costs resulting from reduced Non-Regulated Businesses activities. Energy costs increased due to higher electricity prices as rate freezes resulting from electricity deregulation expired in some states in which we operate. The unit cost of water produced was up 7.3% in 2006 compared to 2005.
Employee-related costs include wage and salary, group insurance, pension expense and expenses related to our long-term incentive plan, referred to as the LTIP, for certain key employees. These costs represented 38.0% of operation and maintenance expense in 2006 and increased 9.1% in 2006 as compared to 2005. Wage and salary expenses were up $22.2 million, or 6.9%, in 2006 due to salary increases and workforce additions. The LTIP accounted for $3.1 million of the increase. Group insurance expense, which includes the cost of providing current health care and life insurance benefits as well as the expected cost of providing postretirement benefits, increased 15.1% in 2006 as a result of workforce additions and higher group insurance premiums associated with our active employees. In addition, the cost accrued for postretirement benefits in 2006 also increased due to lower than expected returns on plan assets and a decrease in the discount rate actuarial assumption. Pension expense increased by 32.5% in 2006 compared to 2005, due to lower than expected returns on plan assets and a decrease in the discount rate actuarial assumption. Additionally, our contributions to a defined contribution plan for employees increased over 2005 as the number of program participants increased.
Operating supplies and services include the day-to-day expenses of office operation, legal and other professional services, as well as information systems and other office equipment and facility rental charges. These costs decreased by 20.7% in 2006 compared to 2005. The expenses in this category include rents, general office expense, and other miscellaneous expenses. A significant factor contributing to the decrease was
51
approximately $63.0 million of expenses associated with the timing of project activity for the design and build of the Lake Pleasant Water Treatment Plant in Phoenix, Arizona. The majority of the project activity occurred during 2005. These Non-Regulated Businesses operating expenses also decreased as a result of the aforementioned operating and maintenance contracts that ended during 2006. These cost reductions were offset by additional expenses related to expansion into new markets by the Applied Water Management Group and Homeowner Services Group, as well as costs associated with several new O&M contracts. These changes resulted in a decrease of $54.0 million in operating supplies and services by our Non-Regulated Businesses in 2006 as compared to 2005.
In addition to the decline in our Non-Regulated Businesses operating supplies and services, there was a decrease in accounting, legal and consulting costs in 2006. A significant portion of the decrease was due to lower management charges allocated from Thames Water of $9.1 million in 2006 as compared to 2005 and a recovery of $2.4 million previously disallowed in the regulatory process for our Indiana subsidiary. During 2005, the Company also recorded $3.5 million in expense relating to a special program established to protect the environment along the central coastal area of California. In addition, there was a decrease of $3.9 million relating to costs incurred in 2005 that were subsequently not allowed to be recovered in rates at our Kentucky subsidiary. These decreases were offset by higher expenses related to the RWE Divestiture of $7.4 million and increased costs related to the Companys compliance with the Sarbanes-Oxley Act of $3.8 million from 2005 to 2006.
Maintenance materials and services, which include emergency repairs as well as costs for preventive maintenance, decreased by 1.4% in 2006 compared to 2005. The cessation of some O&M contracts managed by our Non-Regulated Businesses was the primary reason for this decrease.
Customer billing and accounting expenses increased by 25.2% in 2006 compared to 2005, due to higher uncollectible expense due to a decline in the quality of our customer accounts receivable, increases in postage costs to mail customer bills and an increased number of bills being sent as a result of customer growth.
Other operation and maintenance expenses include casualty and liability insurance premiums and regulatory costs. Total other costs decreased in 2006 by 12.3% from 2005, due to improved claims experience following an increase in 2005. Regulatory costs increased during 2006 due to increased regulatory filings by our subsidiaries.
Depreciation and amortization. Our consolidated depreciation and amortization expense decreased $2.2 million, or 0.8%, from $261.4 million for 2005, to $259.2 million for 2006. The decrease was primarily due to a write-off in 2005 of $21.6 million associated with an abandoned information technology project. This decrease was offset by an increase in depreciation expense due to property placed in service, net of retirements, of $697.1 million as a result of infrastructure replacement in our Regulated Businesses.
General taxes. Our consolidated general taxes expense, which includes taxes for property, payroll, gross receipts and other miscellaneous items, was relatively unchanged from $183.3 million for 2005 to $185.1 million for 2006. The increase was primarily due to higher gross receipts taxes as a result of increased Regulated Businesses operating revenues. Gross receipts and franchise taxes that vary based on operating revenues were higher by 7.5% in 2006 compared to 2005. Property and capital stock taxes that are assessed on the basis of tax values assigned to assets and capitalization were down 3% in 2006 compared to 2005 due to property tax appeals and dispositions.
Loss (gain) on sale of assets. Our consolidated gain on sale of assets was $(6.5) million for 2005, compared to a loss on sale of assets of $0.1 million for 2006. The decrease in 2006 was primarily due to the fact that 2005 included sales of various properties and investments not needed in our utility operations.
Impairment charges. Our consolidated impairment charges were $385.4 million for 2005 and $221.7 million for 2006. The 2005 impairment charge was primarily the result of a change in our strategic business plan
52
for our Non-Regulated Businesses and lower margins than previously forecasted in our Regulated Businesses. The 2006 impairment charge was primarily attributable to higher interest rates in our Regulated Businesses and a change in the potential net realizable value of our Non-Regulated Businesses.
Other income (deductions). Interest expense, the primary component of our consolidated other income (deductions), increased $20.7 million, or 6.0%, from $345.3 million for 2005 to $366.0 million for 2006. This increase was primarily due to higher interest rates for new debt issuances, mitigated by overall reduced borrowings as a result of repaying outstanding debt with new equity contributions.
Provision for income taxes. Our consolidated provision for income taxes decreased $4.1 million, or 8.0%, from $51.0 million for 2005, to $46.9 million for 2006. This decrease was primarily due to the mix of taxable income by jurisdiction.
Net income (loss). Our consolidated net (loss), including results from discontinued operations, decreased $162.8 million, or 50.1%, from $(325.0) million for 2005, to $(162.2) million for 2006. The decrease was primarily due to the changes discussed above.
Comparison of Results of Operations for December 31, 2005 and 2004
Operating revenues. Our consolidated operating revenues increased $118.8 million, or 5.9%, from $2,017.9 million for 2004 to $2,136.7 million for 2005. The increase was primarily due to increased water sales volume of 3.1% from existing customers, increased customer growth, and the effects of rate increases granted to our regulated subsidiaries. In addition, revenues from our Non-Regulated Businesses increased primarily due to the timing of work performed on a design and build contract and expansion into new markets by Applied Water Management Group and Homeowner Services Group, offset in part by the cessation of some operations contracts.
Operating revenues from our Regulated Businesses increased $88.1 million, or 5.0%, from $1,748.0 million for 2004 to $1,836.1 million for 2005. The increase was primarily due to rate increases from general rate cases in California, Kentucky, New Jersey, New York, Pennsylvania and West Virginia as well as other states totaling $34.6 million. In addition, infrastructure related provisions in Indiana, Ohio and Pennsylvania provided $6.5 million in additional operating revenues. Operating revenues also increased due to the addition of nearly 38,000 new customers and a 2.6% increase in water sales volume from existing customers over 2004 due to favorable weather conditions in the summer of 2005.
The following table sets forth the percentage of our Regulated Businesses operating revenues and water volume by customer class:
For the years ended December 31, | ||||||||||||
Operating Revenues | Water Sales Volume | |||||||||||
2004 | 2005 | 2004 | 2005 | |||||||||
Water service: |
||||||||||||
Residential |
57.6 | % | 58.2 | % | 50.6 | % | 52.4 | % | ||||
Commercial |
19.5 | % | 19.3 | % | 23.2 | % | 21.9 | % | ||||
Industrial |
5.7 | % | 5.3 | % | 10.9 | % | 10.6 | % | ||||
Public and other |
12.5 | % | 12.2 | % | 15.3 | % | 15.1 | % | ||||
Other water revenues |
1.2 | % | 1.4 | % | | | ||||||
Total water revenues |
96.5 | % | 96.4 | % | 100.0 | % | 100.0 | % | ||||
Wastewater service |
3.3 | % | 3.4 | % | ||||||||
Management fees |
0.2 | % | 0.2 | % | ||||||||
100.0 | % | 100.0 | % | |||||||||
53
Water ServicesWater service operating revenues from residential customers in 2005 amounted to $1,068.1 million, a 6.1% increase over those for 2004 primarily due to rate increases and changes in sales volume. The volume of water sold to residential customers increased by 7.2% in 2005 to 222.8 billion gallons, from 207.8 billion gallons for 2004.
Water service operating revenues from commercial customers in 2005 amounted to $353.7 million, a 3.9% increase over 2004 primarily due to rate increases and changes in sales volume. The volume of water sold to commercial customers decreased by 2.0% in 2005 to 93.2 billion gallons, from 95.1 billion gallons for 2004.
Water service operating revenues from industrial customers in 2005 amounted to $97.2 million, a 2.6% decrease over 2004 primarily due to rate increases and changes in sales volume. The volume of water sold to industrial customers increased by 0.9% in 2005 to 45.2 billion gallons from 44.8 billion gallons for 2004.
Water service operating revenues from public and other customers for 2005 amounted to $223.4 million, a 2.4% increase over 2004 primarily due to rate increases and changes in sales volume. Water service operating revenues from municipal governments for fire protection services and customers requiring special private fire service facilities for 2005 amounted to $89.9 million, a 4.1% decrease over 2004. Water service operating revenues from governmental entities and resale customers in 2005 amounted to $133.5 million, an 7.4% increase over 2004.
Wastewater ServicesOur subsidiaries provide wastewater services in 11 states. Operating revenues from these services increased by 9.8% to $63.0 million for 2005, from $57.4 million for 2004. The increases were attributable to rate increases and customer growth in our service areas.
Operating Revenues for our Non-Regulated Businesses increased $20.8 million, or 7.2%, from $290.0 million for 2004, to $310.8 million for 2005. The increase was primarily for work performed on the design and build of the Lake Pleasant Water Treatment Plant in Phoenix, Arizona. This resulted in approximately $50.3 million in additional operating revenues. The increase was somewhat offset by work performed on the design and build of a wastewater plant adjoining existing facilities at Camp Creek in Fulton County, Georgia of approximately $28.6 million. The increase in operating revenues also includes expansion into new markets by the Applied Water Management Group and Homeowner Services Group and general price increases in operating contracts for 2005, partly offset by operation and maintenance contracts that ended in 2005. Offsetting these increases were lower production costs from the Non-Regulated Businesses primarily due to operating contracts that ended in 2005.
Operation and maintenance. Our consolidated operation and maintenance expense increased $79.6 million or 7.1%, from $1,122.0 million for 2004 to $1,201.6 million for 2005.
Operation and maintenance expense by major category was as follows:
Year ended December 31, | ||||||
2004 | 2005 | |||||
(dollars in thousands) | ||||||
Production costs |
$ | 248,487 | $ | 262,629 | ||
Employee-related costs |
407,661 | 408,834 | ||||
Operating supplies and services |
289,329 | 338,052 | ||||
Maintenance materials and services |
90,620 | 97,866 | ||||
Customer billing and accounting |
42,460 | 44,413 | ||||
Other |
43,413 | 49,772 | ||||
Total |
$ | 1,121,970 | $ | 1,201,566 | ||
Production costs, including fuel and power, purchased water, chemicals and waste disposal, increased by 5.7% in 2005 compared to 2004. Higher chemical prices and energy costs were the principal drivers of the
54
increase, along with the incremental costs associated with increased sales volume. Offsetting these increases were lower production costs from the Non-Regulated Businesses primarily due to operating contracts that ended in 2005.
Employee-related costs include wage and salary, group insurance, and pension expense. These costs increased 0.3% in 2005 compared to 2004. Wage and salary expense decreased by 1.2% in 2005 compared to 2004. Group insurance expense increased by 6.5% in 2005 compared to 2004. The total expense in 2004 was higher than normal as a result of severance and other compensation related costs associated with organizational restructuring during that year. Pension expense increased by 1.9% in 2005 compared to 2004. The increase was due primarily to a decrease in the discount rate actuarial assumption. Pension expense in excess of the amount contributed to the pension plans is deferred by some regulated subsidiaries pending future recovery in rates charged for water services as contributions are made to the plans.
Operating supplies and services include the day-to-day expenses of office operation, legal and other professional services, as well as information systems and other office equipment and facility rental charges. These costs increased by 16.8% in 2005 compared to 2004. The increase in operating expense in 2005 compared to 2004 for our Non-Regulated Businesses was mainly attributable to approximately $49.8 million of costs associated with the Lake Pleasant Water Treatment Plant in Phoenix, Arizona. The additional increase can be attributed to a number of items, including increased costs due to the expansion into new markets by the Applied Water Management Group and Homeowner Services Group, increased business development costs due to enhanced emphasis on exploring potential business growth opportunities and higher administrative costs associated with a management restructuring of our contract operations. Offsetting these expenses were lower costs related to the Camp Creek project in Fulton County, Georgia of approximately $27.6 million. Operating supplies and services expenses also decreased as a result of the contracts that ended during 2005, partially offset by the new contracts awarded and Consumer Price Index increases in existing contracts.
In addition to the increase in Non-Regulated Businesses operating supplies and services, a portion of the increase was due to higher management charges allocated from Thames Water of $2.4 million in 2005 as compared to 2004. During 2005, we also recorded $3.5 million in expense relating to a special program established to protect the environment along the central coastal area of California.
Maintenance materials and services, which include emergency repairs as well as costs for preventive maintenance, increased by 8.0% in 2005 compared to 2004. The increase was primarily due to costs associated with main breaks, as well as tank painting.
Customer billing and accounting expenses increased by 4.6% in 2005 compared to 2004, due to higher uncollectible expense resulting from a decline in the quality of our customer accounts receivable, increases in postage costs to mail customer bills and an increase in the number of bills mailed as a result of customer growth.
Other operation and maintenance expenses increased by 14.6% in 2005 compared to 2004. These expenses include casualty and liability insurance premiums and regulatory costs. Casualty and liability insurance increased based on claims experience. Regulatory costs increased during 2005 compared to 2004 due to increased regulatory filings by our subsidiaries.
Depreciation and amortization. Our consolidated depreciation and amortization expense increased $36.1 million, or 16.0%, from $225.3 million for 2004, to $261.4 million for 2005. The increase was primarily due to a write-off in 2005 of $21.6 million associated with an abandoned information technology project. In addition, the increase was due to increased property placed in service, net of retirements, of $515.1 million as a result of infrastructure replacement in our Regulated Businesses.
General taxes. Our consolidated general taxes expense, which includes taxes for property, payroll, gross receipts and other miscellaneous items, increased $13.1 million, or 7.7%, from $170.2 million for 2004, to
55
$183.3 million for 2005. The increase was primarily due to a 9.7% increase in our Regulated Businesses gross receipts and franchise taxes driven by increased operating revenues, as well as a 3% increase in regulated property and capital stock taxes.
Loss (gain) on sale of assets. Our consolidated gain on sale of assets was ($8.6) million for 2004, compared to ($6.5) million for 2005. This line of our Statement of Operations represents loss (gain) on non-recurring sales of assets not needed in our utility operations.
Impairment charges. Our consolidated impairment charges were $78.7 million for 2004 and $385.4 million for 2005. The 2004 impairment charge was for our Non-Regulated Businesses and was primarily attributable to lower than expected growth and slower development compared with original expectations. The 2005 impairment charge was primarily the result of a change in our strategic business plan for our Non-Regulated Businesses and lower margins than previously forecasted in our Regulated Businesses.
Other income (deductions). Interest expense, the primary component of our consolidated other income (deductions), increased $29.4 million, or 9.3%, from $315.9 million for 2004, to $345.3 million for 2005. A portion of this increase is due to the fact that 2004 interest expense included an offsetting gain of $11.4 million resulting from an early extinguishment of debt. The remaining increase in interest expense was the result of additional borrowings from the regulated subsidiaries and additional interest expense of $7.1 million associated with the Companys long-term borrowings from RWE.
Provision for income taxes. Our consolidated provision for income taxes expense decreased $15.3 million, or 23.1%, from $66.3 million for 2004, to $51.0 million for 2005.
Net income (loss). Our consolidated net (loss), including results from discontinued operations, increased $260.1 million, or 400.8%, from $(64.9) million for 2004, to $(325.0) million for 2005. The increase was due to the changes discussed above, as well as a $74.1 million reduction in our loss from discontinued operations.
Liquidity and Capital Resources
Our business is capital intensive and requires considerable capital resources. A portion of these capital resources are provided by internally generated cash flows from operations. When necessary, we obtain funds from external sources in the capital markets and through bank borrowings. Our access to external financing on reasonable terms depends on our credit ratings and current business conditions, including that of the water utility industry in general. If these conditions deteriorate to the extent that we no longer have access to the capital markets at reasonable terms, we have access to revolving credit facilities with aggregate bank commitments of $810.0 million that we currently utilize to support our commercial paper programs and to issue letters of credit. See Credit Facilities and Short-Term Debt.
In addition, our regulated utility subsidiaries receive advances and contributions from customers, home builders and real estate developers to fund construction necessary to extend service to new areas. Advances for construction are refundable for limited periods, which vary according to state regulations, as new customers begin to receive service or other contractual obligations are fulfilled. Amounts which are no longer refundable are reclassified to contributions in aid of construction. Utility plant funded by advances and contributions is excluded from rate base. Generally, we depreciate contributed property and amortize contributions in aid of construction at the composite rate of the related property. Some of our subsidiaries do not depreciate contributed property, based on regulatory guidelines.
We use our capital resources, including cash, to (i) fund capital requirements, including construction expenditures, (ii) pay off maturing debt, (iii) pay dividends, (iv) fund pension obligations and (v) invest in new and existing ventures. We spend a significant amount of cash on construction projects that have a long-term return on investment. Additionally, we operate in rate-regulated environments in which the amount of new investment recovery may be limited, and where such recovery takes place over an extended period of time, as our
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recovery is subject to regulatory lag. See BusinessRegulationEconomic Regulation. As a result of these factors, our working capital, defined as current assets less current liabilities, as of June 30, 2007, is in a net deficit position.
To maintain our capital structure, we intend to refinance maturing long-term debt during 2007 with proceeds of future external debt offerings. Prior to the consummation of this offering, we intend to use the proceeds from the issuance of approximately $1,500.0 million aggregate principle amount of senior notes together with commercial paper and excess cash to fund the early redemption of $1,750.0 million of preferred stock and the repayment of $222.0 million aggregate principal amount of the RWE notes. In addition, concurrently with this offering, we intend to use the proceeds from the issuance of approximately $500.0 million equity units to fund the repayment of commercial paper borrowed to repay the preferred stock owed to RWE and the RWE notes, with the balance of excess cash used to fund general working capital requirements. Future acquisitions that we may undertake may involve external debt financing or the issuance of additional common stock.
We expect to fund future maturities of long-term debt through a combination of external debt and cash flow from operations. We have no plans to reduce debt significantly.
Cash Flows from Operating Activities
Our future cash flows from operating activities will be affected by economic utility regulation; infrastructure investment; inflation; compliance with environmental, health and safety standards; production costs; customer growth; and declining per customer usage of water; and weather and seasonality. See Managements Discussion and Analysis of Financial Condition and Results of OperationsFactors Affecting our Results of Operations.
Cash flows from operating activities have been a reliable, steady source of cash flow, sufficient to meet operating requirements and a portion of our capital expenditures requirements. We expect to have access to debt and equity capital markets to meet the balance of our capital expenditure requirements. There can be no assurance that we will be able to successfully access such markets on favorable terms or at all. Operating cash flows can be negatively affected by changes in our rate regulatory environments. Taking into account the factors noted above, we also obtain cash from non-operating sources such as the proceeds from debt issuances, customer advances and contributions in aid of construction and equity offerings.
The following table provides a summary of the major items affecting our cash flows from operating activities for the periods indicated:
Year ended December 31, | Six months ended June 30, | |||||||||||||||||||
2004 | 2005 | 2006 | 2006 | 2007 | ||||||||||||||||
(dollars in thousands) | ||||||||||||||||||||
Net income (loss) |
$ | (64,918 | ) | $ | (325,040 | ) | $ | (162,243 | ) | $ | 29,858 | $ | 51,863 | |||||||
Add (subtract): |
||||||||||||||||||||
Non-cash operating activities(1) |
560,135 | 799,127 | 582,569 | 141,285 | 143,622 | |||||||||||||||
Income taxes, paid net of refunds |
(18,109 | ) | (43,694 | ) | (11,633 | ) | (6,389 | ) | 8,967 | |||||||||||
Changes in working capital and other noncurrent assets and liabilities(2) |
28,365 | 148,288 | (3,454 | ) | (57,472 | ) | (36,564 | ) | ||||||||||||
Pension and postretirement healthcare contributions |
(47,065 | ) | (53,246 | ) | (81,491 | ) | (40,559 | ) | (31,707 | ) | ||||||||||
Net cash flows provided by operations |
$ | 458,408 | $ | 525,435 | $ | 323,748 | $ | 66,723 | $ | 136,181 | ||||||||||
(1) | Includes (gain) loss on sale of businesses, depreciation and amortization, impairment charges, removal costs net of salvage, provision for deferred income taxes, amortization of deferred investment tax credits, provision for losses on utility accounts receivable, allowance for other funds used during construction, employee benefit expenses greater (less) than funding, (gain) loss on sale of assets, deferred regulatory costs, amortization of deferred charges and other non-cash items, net, less income taxes and pension and postretirement healthcare contributions. |
(2) | Changes in working capital and other noncurrent assets and liabilities include the changes to accounts receivable and unbilled utility revenue, other current assets, accounts payable, interest accrued and other current liabilities. |
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The decrease in cash flows from operations during 2006 versus 2005 was primarily the result of higher contributions to pension and postretirement healthcare trusts and higher taxes paid. Excluding these items, changes in our cash flows from operating activities were generally consistent with changes in the results of operations as adjusted by changes in working capital in the normal course of business.
The increase in cash flow from operations during 2005 versus 2004 was primarily due to improvements in working capital driven mainly by the changes in accounts receivable and unbilled utility revenues. This improvement was offset in part by higher contributions to pension and postretirement healthcare trusts and higher taxes paid.
The increase in cash flow from operations during the six months ended June 30, 2007 versus the same period for 2006 was primarily due to greater net income and improvements in working capital. Also adding to the improved cash flow for this period were the lower contributions to pension and postretirement healthcare trusts than made in the same period for the prior year.
Cash Flows from Investing Activities
Cash flows used in investing activities were as follows for the periods indicated:
Year ended December 31, |
Six months ended June 30, |
|||||||||||||||||||
2004 | 2005 | 2006 | 2006 | 2007 | ||||||||||||||||
(dollars in thousands) |
||||||||||||||||||||
Construction expenditures |
$ | (546,241 | ) | $ | (558,446 | ) | $ | (688,843 | ) | $ | (235,818 | ) | $ | (307,726 | ) | |||||
Other Investing activities, net(1) |
338 | 28,281 | (2,595 | ) | (5,906 | ) | 28,285 | |||||||||||||
Net cash flows used in investing activities |
$ | (545,903 | ) | $ | (530,165 | ) | $ | (691,438 | ) | $ | (241,724 | ) | $ | (279,441 | ) | |||||
(1) | Includes allowances for other funds used during construction, acquisitions, proceeds from the sale of assets and securities, proceeds from the sale of discontinued operations, removal costs from property, plant and equipment retirements, receivables from affiliates and restricted funds. |
Cash flows used in investing activities increased significantly in 2006 versus 2005 as we increased investment in regulated infrastructure projects. Cash flows used in investing activities will continue to rise during 2007 as construction expenditures are expected to be approximately $740 to $780 million during 2007. We intend to invest capital prudently to provide essential services to our regulated customer base, while working with regulators in the various states in which we operate to have the opportunity to earn appropriate rates of return of and on these investments.
Our infrastructure investment plan consists of both infrastructure renewal programs, where we replace infrastructure as needed, and major capital investment projects, where we will construct new water and wastewater treatment and delivery facilities. Our projected capital expenditures and other investments are subject to periodic review and revision to reflect changes in economic conditions and other factors.
The following table provides a summary of our historical construction expenditures:
Year ended December 31, | Six months ended June 30, | ||||||||||||||
2004 | 2005 | 2006 | 2006 | 2007 | |||||||||||
(dollars in thousands) | |||||||||||||||
Transmission and distribution |
$ | 264,673 | $ | 238,972 | $ | 314,282 | $ | 107,591 | $ | 135,115 | |||||
Treatment and pumping |
104,655 | 137,299 | 133,074 | 45,556 | 69,881 | ||||||||||
Services, meter and fire hydrants |
86,161 | 84,148 | 132,610 | 45,397 | 50,323 | ||||||||||
General structures and equipment |
73,796 | 81,516 | 72,892 | 24,954 | 29,533 | ||||||||||
Sources of supply |
16,956 | 16,511 | 35,985 | 12,320 | 22,874 | ||||||||||
Total construction expenditures |
$ | 546,241 | $ | 558,446 | $ | 688,843 | $ | 235,818 | $ | 307,726 | |||||
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Construction expenditures for the periods noted above were partially offset by customer advances and contributions for construction (net of refunds) of $15.7 million, $47.4 million, $52.0 million and $45.1 million in the six months ended June 30, 2007 and years ended December 31, 2006, 2005 and 2004, respectively. Customer advances and contributions are reflected in our net cash flows from investing activities. Capital expenditures during the periods noted above are related to the renewal of supply and treatment assets, new water mains and customer service lines, as well as rehabilitation of existing water mains and hydrants.
Construction expenditures for 2006 increased by $130.4 million or 23.4% over 2005. Expenditures related to transmission and distribution increased by $75.3 million in 2006 over 2005 and meter and fire hydrant replacements increased by $48.5 million in 2006 compared to 2005. These increases occurred due to an increase in the rate of infrastructure replacement. In addition, treatment plant improvements caused an increase from 2005 to 2006 in the amount of $15.2 million. These improvements are taking place primarily at our Joplin, Missouri, Verrado, Arizona and Somerset, New Jersey facilities.
Construction expenditures in 2005 increased $12.2 million from 2004. This increase can be attributed to an increase in treatment and pumping related construction expenditures of $32.6 million or 31.2%. Our Arizona subsidiary treatment facility incurred capital expenditures for a treatment facility in 2005 that were $30.3 million greater than in 2004. Upgrades to the Mechanicsburg, Pennsylvania treatment plant also contributed $3.4 million of the 2005 increase. Expenditures for year ended December 31, 2005 increased $7.7 million over 2004 for computer equipment and systems as well as facilities. A temporary curtailment in our infrastructure replacement program offset some of the increase as expenditures for these categories declined by $27.7 million.
The increase of $71.9 million in construction expenditures for the six months ended June 30, 2007 compared to the same period in 2006 consists mainly of infrastructure replacements amounting to $27.7 million and upgrades to treatment facilities amounting to $33.2 million at several plants including Joplin, Missouri, Verrado, Arizona, Somerset, New Jersey and Champaign, Illinois.
An integral aspect of our strategy is to seek growth through tuck-ins and other acquisitions which are complementary to our existing business and support the continued geographical diversification and growth of American Waters operations. Generally, acquisitions are funded initially with short-term debt and later refinanced with the proceeds from long-term debt or equity offerings.
We also conduct ongoing reviews of our existing investments. As a result of these reviews, we sold the operations of various non-regulated water-related businesses over the last two years.
The following provides a summary of the major acquisitions and dispositions affecting our cash flows from investing activities in the periods indicated:
Six months ended June 30, 2007:
| We received approximately $9.7 million in cash proceeds from the sale of a group of assets of the Residuals business. |
| We paid approximately $0.2 million for the acquisition of water and wastewater systems. |
2006:
| We paid approximately $12.5 million for the acquisition of water and wastewater systems. |
| We received approximately $30.2 million in cash proceeds from the sale of discontinued operations including a group of assets of the Residuals business and the Underground business. |
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2005:
| We received approximately $15.3 million in cash proceeds from the sale of Engineerings Canadian operations and the assets of Ashbrook Corporation. |
Cash Flows from Financing Activities
Our financing activities include the issuance of long-term and short-term debt, primarily through our wholly owned financing subsidiary, AWCC. From time to time, we will pursue tax-exempt financing at the state utility level provided that the overall cost of the debt, including issuance costs, are below the overall cost of debt issued through AWCC. In addition, we have received capital contributions from RWE and intend to issue equity in the future to maintain an appropriate capital structure, subject to any restrictions in the registration rights agreement to be entered into with RWE. In order to finance new infrastructure, we received customer advances and contributions for construction (net of refunds) of $15.7 million, $47.4 million, $52.0 million and $45.1 million in the six months ended June 30, 2007 and years ended December 31, 2006, 2005 and 2004 respectively. In connection with the RWE Divestiture, we have made and will continue to make significant changes to our capital structure through debt refinancing and equity offerings.
RWE made equity contributions of $650.0 million and $1,194.5 million to us in March 2007 and December 2006, respectively. We used the contributions to pay down loans payable to RWE, to pay off commercial paper and for other corporate purposes.
AWCC issued senior notes in principal amounts of $617.0 million during the first six months of 2007. Interest rates on the senior notes ranged from 5.39% to 5.77% and maturities ranged from 7 years to 15 years. The net proceeds from these debt issues were used to pay off RWE debt prior to maturity in contemplation of the RWE Divestiture.
The following long-term debt was issued in the first six months of 2007:
Company |
Type |
Interest Rate | Maturity | Amount | |||||
(dollars in thousands) | |||||||||
American Water Capital Corp. |
Senior notes | 5.39%-5.77% | 2018-2022 | $ | 617,000 | ||||
Other Subsidiaries |
Miscellaneous | 1.39%-1.62% | 2022-2023 | 450 | |||||
Total issuances |
$ | 617,450 | |||||||
The following debt was retired through extinguishments, optional redemption or payment at maturity in the first six months of 2007:
Company |
Type |
Interest Rate | Maturity | Amount | |||||
(dollars in thousands) | |||||||||
American Water Capital Corp. |
Senior notes Fixed Rate | 6.87% | 2011 | $ | 28,000 | ||||
American Water Capital Corp. |
RWE notes Fixed Rate | 4.00%-5.90% | 2007-2034 | 384,300 | |||||
Elizabethtown Water Co |
Called Senior Debt | 7.25%-8.75% | 2021-2028 | 92,500 | |||||
Various Subsidiaries |
Miscellaneous | 0%-9.87% | 2007-2032 | 33,083 | |||||
Total extinguishments |
$ | 537,883 | |||||||
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The following long-term debt was issued in 2006:
Company |
Type |
Interest Rate | Maturity | Amount | |||||
(dollars in thousands) | |||||||||
American Water Capital Corp. |
Senior notes | 5.39%-5.77% | 2013-2018 | $ | 483,000 | ||||
Missouri-American Water Company |
Tax exempt first mortgage bonds | 4.60% | 2036 | 57,480 | |||||
Indiana-American Water Company |
Tax exempt first mortgage Bonds | 4.88% | 2036 | 25,770 | |||||
Other Subsidiaries |
State financing authority loans & other | 0%-5.00% | 2019-2026 | 16,248 | |||||
Total issuances |
$ | 582,498 | |||||||
The following debt was retired through extinguishments, optional redemption or payment at maturity during 2006:
Company |
Type |
Interest Rate | Maturity | Amount | |||||
(dollars in thousands) | |||||||||
Long-term debt |
|||||||||
American Water Works Company, Inc. |
RWE notes | 4.92% | 2006 | $ | 150,000 | ||||
American Water Capital Corp. |
RWE notes-fixed rate | 4.00%-6.05% | 2006-2034 | 1,086,500 | |||||
American Water Capital Corp. |
RWE notes-floating rate | 4.02%-4.66% | 2006-2015 | 482,300 | |||||
Missouri-American Water Company |
Mortgage bonds-fixed rate | 5.50%-5.85% | 2006-2026 | 57,565 | |||||
Indiana-American Water Company |
Mortgage bonds-fixed rate | 5.35%-5.90% | 2022-2026 | 27,004 | |||||
West Virginia-American Water Company |
Mortgage bonds-fixed rate | 6.81% | 2006 | 11,000 | |||||
Other Subsidiaries |
0%-9.87% | 2006-2034 | 17,564 | ||||||
Preferred stock with mandatory redemption requirements |
|||||||||
Miscellaneous |
4.60%-8.80% | 2007-2019 | 538 | ||||||
Total extinguishments |
$ | 1,832,471 | |||||||
From time to time and as market conditions warrant, we may engage in long-term debt retirements via tender offers, open market repurchases or other viable alternatives to strengthen our balance sheets.
We intend to pay quarterly cash dividends on our common stock at an initial rate of $ per share per annum. The first such dividend will be declared and paid in the first quarter following the completion of this offering. The declaration, payment and amount of future dividends to holders of our common stock will be at the discretion of our board of directors and will depend on many factors, including our financial condition and results of operations, liquidity requirements, capital requirements of our subsidiaries, legal requirements, regulatory constraints and other factors deemed relevant by our board of directors.
Credit Facilities and Short-Term Debt
The components of short-term debt at December 31, 2006 were as follows:
2006 | |||
RWE revolver |
$ | 130,000 | |
RWE short-term notes |
268,230 | ||
Commercial paper, net of discount |
321,339 | ||
Other short-term debt |
176 | ||
Total short-term debt |
$ | 719,745 | |
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On January 26, 2007, AWCC entered into a $10.0 million committed revolving line of credit with a financial institution. This line of credit will terminate on December 31, 2007 unless extended and is used primarily for short-term working capital needs. Interest rates on advances under this line of credit are based on either the prime rate of the financial institution or the applicable London Interbank Offering Rate, referred to as LIBOR, for the term selected plus 25 basis points. As of June 30, 2007, $0.4 million was outstanding under this revolving line of credit.
On December 21, 2004, AWCC entered into a $550.0 million 364-day unsecured revolving credit facility with RWE. The facility was renewed on October 28, 2006 and was terminated on December 28, 2006. On September 15, 2006, AWCC entered into a new $800.0 million unsecured revolving credit facility syndicated among a group of ten banks. This revolving credit facility, which terminates on September 15, 2011, is principally used to support the commercial paper program at AWCC and to provide up to $150.0 million in letters of credit. AWCC had no loans outstanding under the net $800.0 million unsecured revolving credit facility as of June 30, 2007.
On December 31, 2006 and June 30, 2007, respectively, AWCC had the following sub-limits and available capacity under the revolving credit facility and indicated amounts of outstanding commercial paper.
Letter of Credit Sublimit |
Available Capacity | Outstanding Commercial Paper | ||||||
(dollars in thousands) | (dollars in thousands) | (dollars in thousands) | ||||||
December 31, 2006 |
$150,000 |
$ | 85,986 | $ | 322,734 | |||
June 30, 2007 |
$150,000 |
$ | 88,172 | $ | 0 |
Interest rates on advances under the revolving credit facility are based on either prime or LIBOR plus an applicable margin based upon our credit ratings, as well as total outstanding amounts under the agreement at the time of the borrowing. The maximum LIBOR margin is 55 basis points.
The credit facility requires us to maintain a ratio of consolidated debt to consolidated capitalization of not more than 0.70 to 1.00. On June 30, 2007, we were in compliance with the ratio.
Capital Structure
Our capital structure was as follows:
At June 30, 2007 |
At December 31, 2006 |
At December 31, 2005 |
|||||||
Common stockholder equity and preferred stock without mandatory redemption rights |
46 | % | 40 | % | 29 | % | |||
Long-term debt |
52 | % | 50 | % | 50 | % | |||
Short-term debt and current portion of long-term debt |
2 | % | 10 | % | 21 | % | |||
100 | % | 100 | % | 100 | % | ||||
As a condition to some PUC approvals of the RWE Divestiture, we have agreed to maintain a capital structure which includes a minimum of 45% common equity at the time of the consummation of this offering. The changes to capital resource mix during 2006 and 2007 were accomplished through the various financing activities noted above. The capital structure at June 30, 2007 more closely reflects our expected future capital structure following the consummation of this offering, at which point our credit rating will no longer reflect RWEs controlling ownership.
Debt covenants
Our debt agreements contain financial and non-financial covenants. To the extent that we are not in compliance, we or our subsidiaries may be restricted in our ability to pay dividends, issue debt or access our revolving credit lines. We were not in compliance with our reporting covenants as of June 30, 2007. See Risk FactorsOur
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failure to comply with restrictive covenants under our credit facilities could trigger repayment obligations. However, AWCCs creditors waived the reporting requirements for all debt issued by AWCC and the revolving credit facilities.
Security Ratings
On October 13, 2006, S&P assigned its A-/A-2 corporate credit rating to the Company. At the same time, S&P affirmed its A- rating on AWCC and assigned its A-2 rating to AWCCs $700.0 million commercial paper program. The ratings on the Company and AWCC were on CreditWatch with negative implications at June 30, 2007.
On October 17, 2006, Moodys assigned a Prime-2 short term rating to AWCC in connection with its $700 million commercial paper program. At the same time, Moodys affirmed AWCCs Baa1 long-term senior unsecured rating and VMIG-2 short term rating. The outlook was negative on June 30, 2007.
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.
We primarily access the capital markets, including the commercial paper market, through AWCC. However, we do issue debt at our regulated subsidiaries, primarily in the form of tax exempt securities, to lower overall cost of debt. The following table shows the Companys securities ratings at June 30, 2007:
Securities |
Moodys Investors Service |
Standard & Poors Ratings Service | ||
Senior unsecured debt |
Baa1 | BBB+ | ||
Commercial paper |
P2 | A2 |
None of our borrowings are subject to default or prepayment as a result of a downgrading of securities although such a downgrading could increase fees and interest charges under our credit facilities.
As part of the normal course of business, we routinely enter into physical contracts for the purchase and sale of water, energy, fuels and other services. These contracts either contain express provisions or otherwise permit us and our counterparties to demand adequate assurance of future performance when there are reasonable grounds for doing so. In accordance with the contracts and applicable contract law, if we are downgraded by a credit rating agency, especially if such downgrade is to a level below investment grade, it is possible that a counterparty would attempt to rely on such a downgrade as a basis for making a demand for adequate assurance of future performance. Depending on its net position with a counterparty, the demand could be for the posting of collateral. In the absence of expressly agreed provisions that specify the collateral that must be provided, the obligation to supply the collateral requested will be a function of the facts and circumstances of the Companys situation at the time of the demand. If we can reasonably claim that we are willing and financially able to perform our obligations, it may be possible to successfully argue that no collateral should be posted or that only an amount equal to two or three months of future payments should be sufficient.
Regulatory Restrictions
The issuance by the Company or AWCC of long-term debt or equity securities does not require authorization of any state PUC if no guarantee or pledge of the regulated subsidiaries is utilized. However, state PUC authorization is required to issue long-term debt or equity securities at most regulated subsidiaries. Our regulated subsidiaries normally obtain the required approvals on a periodic basis to cover their anticipated financing needs for a period of time or in connection with a specific financing.
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Under applicable law, our subsidiaries can pay dividends only from retained, undistributed or current earnings. A significant loss recorded at a subsidiary may limit the dividends that these companies can distribute to us.
Insurance Coverage
We carry various property, casualty and financial insurance policies with limits, deductibles and exclusions consistent with industry standards. However, insurance coverage may not be adequate or available to cover unanticipated losses or claims. We are self-insured to the extent that losses are within the policy deductible or exceed the amount of insurance maintained. Such losses could have a material adverse effect on our short-term and long term financial condition and the results of operations and cash flows.
Contractual Obligations and Commitments
We enter into obligations with third parties in the ordinary course of business. These obligations, as of December 31, 2006, are set forth in the table below:
Contractual obligation |
Total | Less Than 1 Year |
1-3 Years | 3-5 Years | More than 5 Years | ||||||||||
(dollars in thousands) | |||||||||||||||
Long term debt obligations(a) |
$ | 3,284,933 | $ | 286,786 | $ | 250,535 | $ | 87,949 | $ | 2,659,663 | |||||
Interest on long-term debt(b) |
3,686,578 | 294,625 | 542,220 | 520,935 | 2,328,798 | ||||||||||
Capital lease obligations(c) |
2,191 | 209 | 323 | 408 | 1,251 | ||||||||||
Operating lease obligations(d) |
213,469 | 26,180 | 46,311 | 28,840 | 112,138 | ||||||||||
Purchase water obligations(e) |
789,633 | 38,645 | 77,979 | 81,185 | 591,824 | ||||||||||
Other purchase obligations(f) |
7,589 | 7,589 | | | | ||||||||||
Post-retirement benefit plans obligations(g) |
25,000 | 25,000 | | | | ||||||||||
Pension ERISA minimum funding requirement |
49,600 | 49,600 | | | | ||||||||||
Preferred stocks with mandatory redemption requirements(h) |
1,775,032 | 388 | 436 | 616 | 1,773,592 | ||||||||||
Other obligations(i)(j) |
87,337 | 77,176 | 7,993 | 678 | 1,490 | ||||||||||
Total |
$ | 9,921,362 | $ | 806,198 | $ | 925,797 | $ | 720,611 | $ | 7,468,756 | |||||
(a) | Represents sinking fund obligations and debt maturities. |
(b) | Represents expected interest payments on outstanding long-term debt. Amounts reported may differ from actual due to future refinancing of debt. |
(c) | Represents future minimum payments under noncancelable capital leases. |
(d) | Represents future minimum payments under noncancelable operating leases, primarily for the lease of motor vehicles, buildings, land and other equipment. |
(e) | Represents future payments under water purchase agreements for minimum quantities of water. |
(f) | Represents the open purchase orders as of December 31, 2006, for goods and services purchased in the ordinary course of business. |
(g) | Represents contributions expected to be made to postretirement benefit plans. |
(h) | Includes $1,750.0 million of preferred stock held by RWE which will be redeemed early. |
(i) | Represents capital expenditures estimated to be required under legal and binding contractual obligations. |
(j) | Includes unrecognized tax benefits of $1.8 million at December 31, 2006. |
Off-Balance Sheet Arrangements
From 1997 through 2002, West Virginia-American Water Company, our subsidiary, referred to as the Subsidiary, entered into a series of agreements with various public entities to establish certain joint ventures, commonly referred to as public-private partnerships. The Subsidiary agreed to transfer and convey
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some of its real and personal property, referred to as the Subsidiary Facilities, to various public entities, subject to the lien of its General Mortgage Indenture, in exchange for an equal principal amount of Industrial Development Bonds, referred to as IDBs, to be issued by the various public entities under a state Industrial Development Bond and Commercial Development Act.
The Subsidiary leased back the Subsidiary Facilities under capital leases for a period of 40 years. The leases have payments that approximate the payments required by the terms of the IDBs. In accordance with Financial Accounting Standards Board Interpretation Number 39, Offsetting of Amounts Related to Certain Contracts, we have presented the transaction on a net basis in the consolidated financial statements. The carrying value of the Subsidiary Facilities was $162.6 million at December 31, 2006.
Market Risk
We are exposed to market risk associated with changes in commodity prices, equity prices and interest rates. We use a combination of fixed-rate and variable-rate debt to reduce interest rate exposure. As of June 30, 2007 a hypothetical 10% increase in interest rates associated with variable rate debt would result in a $1.0 million decrease in our pre-tax earnings. Our risks associated with price increases for chemicals, electricity and other commodities are reduced through long-term contracts and the ability to recover price increases through rates.
Critical Accounting Policies and Estimates
The application of critical accounting policies is particularly important to our financial condition and results of operations and provides a framework for management to make significant estimates, assumptions and other judgments. Although our management believes that these estimates, assumptions and other judgments are appropriate, they relate to matters that are inherently uncertain. Accordingly, changes in the estimates, assumptions and other judgments applied to these accounting policies could have a significant impact on our financial condition and results of operations as reflected in our consolidated financial statements.
Our financial condition, results of operations and cash flow are impacted by the methods, assumptions and estimates used in the application of critical accounting policies. Management believes that the areas described below require significant judgment in the application of accounting policy or in making estimates and assumptions in matters that are inherently uncertain and that may change in subsequent periods. Our management has reviewed these critical accounting policies, and the estimates and assumptions regarding them, with our Audit Committee. In addition, our management has also reviewed the following disclosures regarding the application of these critical accounting policies with the Audit Committee.
Regulatory Accounting
Our regulated utility subsidiaries are subject to regulation by state PUCs and the local governments of the states in which they operate. As such, we account for these regulated operations in accordance with SFAS No. 71, Accounting for the Effects of Certain Types of Regulation, referred to as SFAS No. 71, which requires us to reflect the effects of rate regulation in our financial statements. Use of SFAS No. 71 is applicable to utility operations that meet the following criteria: (1) third-party regulation of rates; (2) cost-based rates; and (3) a reasonable assumption that all costs will be recoverable from customers through rates. As of December 31, 2006, we had concluded that the operations of our regulated subsidiaries meet the criteria. If it is concluded in a future period that a separable portion of the businesses no longer meets the criteria, we are required to eliminate the financial statement effects of regulation for that part of the business, which would include the elimination of any or all regulatory assets and liabilities that had been recorded in the consolidated financial statements. Failure to meet the criteria of SFAS No. 71 could materially impact our consolidated financial statements as a one-time extraordinary item and through impacts on continuing operations.
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Regulatory assets represent costs that have been deferred to future periods when it is probable that the regulator will allow for recovery through rates charged to customers. Regulatory liabilities represent revenues received from customers to fund expected costs that have not yet been incurred. As of December 31, 2006, we have recorded $587.2 million of net regulatory assets within our consolidated financial statements. Also, at December 31, 2006, we had recorded $166.9 million of regulatory liabilities within our consolidated financial statements. See Note 6 of the Notes to Consolidated Financial Statements for further information regarding the significant regulatory assets.
For each regulatory jurisdiction where we conduct business, we continually assess whether the regulatory assets and liabilities continue to meet the criteria for probable future recovery or settlement. This assessment includes consideration of factors such as changes in applicable regulatory environments, recent rate orders to other regulated entities in the same jurisdiction, the status of any pending or potential deregulation legislation and the ability to recover costs through regulated rates.
Goodwill
As of December 31, 2006, we had $2,962.5 million of goodwill. The goodwill is associated primarily with the acquisition by an affiliate of RWE of American Water in 2003 and ETown Corporation in 2001, representing the excess of the purchase price over the fair value of the net tangible and intangible assets acquired, and was assigned to reporting units based on the fair values at the date of the acquisition. The Regulated Businesses have been aggregated and deemed a single reporting unit because they have similar economic characteristics. In the Non-Regulated Businesses segment, the business is organized into eight reporting units.
In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, referred to as SFAS 142, goodwill is reviewed annually, or more frequently if changes in circumstances indicate the carrying value may not be recoverable. To test for impairment, we utilize discounted estimated future cash flows and comparable public company market data analyses for the regulated segment to measure fair value for each reporting unit. This calculation is highly sensitive to both the estimated future cash flows of each reporting unit, the discount rate assumed and the change in market data in these calculations. Annual impairment reviews are performed in the fourth quarter. Application of the goodwill impairment test requires managements judgments, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. In addition, we will need to consider the market price of our common stock at the offering date or a decline over a period of time of our stock price following the consummation of this offering.
For the years ended December 31, 2006, 2005 and 2004, we determined that our goodwill was impaired and recorded impairments of $227.8 million, $396.3 million and $192.9 million, respectively, including impairment charges from discontinued operations (See Note 18Goodwill and Intangible Assets of the Notes to our Consolidated Financial Statements.) It is reasonably possible that further goodwill impairment charges will be required depending upon changes in market conditions or circumstances.
Impairment of Long-Lived Assets
Long-lived assets, other than goodwill which is discussed above, include land, buildings, equipment and long-term investments. Long-lived assets, other than investments, land and goodwill, are depreciated over their estimated useful lives, and are reviewed for impairment whenever changes in circumstances indicate the carrying value of the asset may not be recoverable. Such circumstances would include items such as a significant decrease in the market price of a long-lived asset, a significant adverse change in the manner in which the asset is being used or planned to be used or in its physical condition, or a history of operating or cash flow losses associated with the use of the asset. In addition, changes in the expected useful life of these long-lived assets may also be an impairment indicator. When such events or changes occur, we estimate the fair value of the asset from future cash flows expected to result from the use and, if applicable, the eventual disposition of the assets and compares that to the carrying value of the asset. If the carrying value is greater than the fair value, an impairment loss is
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recognized equal to the amount by which the assets carrying value exceeds its fair value. The key variables that must be estimated include assumptions regarding sales volume, rates, operating costs, labor and other benefit costs, capital additions, assumed discount rates and other economic factors. These variables require significant management judgment and include inherent uncertainties since they are forecasting future events. A variation in the assumptions used could lead to a different conclusion regarding the realizability of an asset and, thus, could have a significant effect on the consolidated financial statements.
The long-lived assets of the regulated utility subsidiaries are grouped on a separate entity basis for impairment testing as they are integrated state-wide operations that do not have the option to curtail service and generally have uniform tariffs. A regulatory asset is charged to earnings if and when future recovery in rates of that asset is no longer probable.
We performed a valuation of long-lived assets, other than investments and goodwill, as of December 31, 2006, 2005 and 2004. As a result of the impairment analyses, we recorded pretax charges of $24.0 million and $23.0 million including impairments recorded associated with discontinued operations for the years ended December 2005 and 2004, respectively. No impairment charges were recorded in 2006. The impairments primarily resulted from lower than expected growth, slower development compared with original expectations and changes in the value of a building with a carrying value that exceeded its fair value. These charges are included in impairment charges in the statements of operations. The remaining values as of December 31, 2006, 2005 and 2004 were determined to be appropriate.
The fair values of long-term investments are dependent on the financial performance and solvency of the entities in which we invest, as well as volatility inherent in the external markets. In assessing potential impairment for these investments, we consider these factors and in one case also receive annual appraisals. If such assets are considered impaired, an impairment loss is recognized equal to the amount by which the assets carrying value exceeds its fair value. We determined the values of long-term investments were appropriate for the years ended December 31, 2006, 2005 and 2004.
Revenue Recognition
Revenues of the regulated utility subsidiaries are recognized as water and wastewater services are delivered to customers and include amounts billed to customers on a cycle basis and unbilled amounts based on estimated usage from the date of the latest meter reading to the end of the accounting period. Unbilled revenues as of December 31, 2006, 2005 and 2004 were $123.2 million, $106.0 million and $185.2 million, respectively. Increases in volumes delivered to the utilities customers and favorable rate mix due to changes in usage patterns in customer classes in the period could be significant to the calculation of unbilled revenue. Changes in the timing of meter reading schedules and the number and type of customers scheduled for each meter reading date would also have an effect on the estimated unbilled revenue; however, since the majority of our customers are billed on a monthly basis, total operating revenues would remain materially unchanged.
Revenue from non-regulated operations is recognized as services are rendered. Revenues from certain construction projects are recognized over the contract term based on the estimated percentage of completion during the period compared to the total estimated services to be provided over the entire contract. Losses on contracts are recognized during the period in which the loss first becomes known. Revenues recognized during the period in excess of billings on construction contracts are recorded as unbilled revenue. Billings in excess of revenues recognized on construction contracts are recorded as other current liabilities on the balance sheet until the recognition criteria are met. Changes in contract performance and related estimated contract profitability may result in revisions to costs and revenues and are recognized in the period in which revisions are determined.
Accounting for Income Taxes
We participate in a consolidated federal income tax return for United States tax purposes. Members of the consolidated group are charged with the amount of federal income tax expense determined as if they filed separate returns.
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We estimate the amount of income tax payable or refundable for the current year and the deferred income tax liabilities and assets that results from estimating temporary differences resulting from the treatment of certain items, such as depreciation, for tax and financial statement reporting. These differences result from the recognition of a deferred tax asset or liability on our consolidated balance sheet and require us to make judgments regarding the probability of the ultimate tax impact of the various transactions we enter into. Based on these judgments we may record tax reserves or adjustments to valuation allowances on deferred tax assets to reflect the expected realization of future tax benefits. Actual income taxes could vary from these estimates and changes in these estimates can increase income tax expense in the period that these changes in estimate occur.
Accounting for Pension and Postretirement Benefits
We maintain noncontributory defined benefit pension plans covering substantially all non-union employees of our regulated utility and shared service operations. The pension plans have been closed for any employees hired on or after January 1, 2006. Union employees hired on or after January 1, 2001 and non-union employees hired on or after January 1, 2006 will be provided with a 5.25% of base pay defined contribution plan. We also maintain postretirement benefit plans for eligible retirees. The retiree welfare plans are closed for union employees hired on or after January 1, 2006. The plans had previously closed for non-union employees hired on or after January 1, 2002. We follow the guidance of SFAS 87, Employers Accounting for Pensions, and SFAS 106, Employers Accounting for Postretirement Benefits Other Than Pensions, when accounting for these benefits. In addition, we adopted the recognition and disclosure requirements of SFAS 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, effective December 31, 2006. See Note 6Pension and Other Postretirement Benefits of the Notes to Consolidated Financial Statements for further information regarding the accounting for the defined benefit pension plans and postretirement benefit plans.
Under these accounting standards, assumptions are made regarding the valuation of benefit obligations and the performance of plan assets. Delayed recognition in earnings of differences between actual results and expected or estimated results is a guiding principle of these standards. This delayed recognition of actual results allows for a smoothed recognition of costs over the working lives of the employees who benefit under the plans. The primary assumptions are:
| Discount RateThe discount rate is used in calculating the present value of benefits, which are based on projections of benefit payments to be made in the future. The objective in selecting the discount rate is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the accumulated benefits when due; |
| Expected Return on Plan AssetsManagement projects the future return on plan assets considering prior performance, but primarily based upon the plans mix of assets and expectations for the long-term returns on those asset classes. These projected returns reduce the net benefit costs we record currently; |
| Rate of Compensation IncreaseManagement projects employees annual pay increases, which are used to project employees pension benefits at retirement; and |
| Health Care Cost Trend RateManagement projects the expected increases in the cost of health care. |
In selecting a discount rate for our pension and postretirement benefit plans, a yield curve was developed for a portfolio containing the majority of United States-issued Aa-graded non-callable (or callable with make-whole provisions) corporate bonds. For each plan, the discount rate was developed as the level equivalent rate that would yield the same present value as using spot rates aligned with the projected benefit payments. The discount rate for determining both pension benefit obligations and other postretirement benefit obligations was 5.65%, 6.00% and 6.25% at December 31, 2006, 2005 and 2004, respectively.
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In selecting an expected return on plan assets, we considered tax implications, past performance and economic forecasts for the types of investments held by the plans. The long-term expected rate of return on plan assets (EROA) assumption used in calculating pension cost was 8.25% for 2006 and 8.75% for 2005 and 2004. The weighted average EROA assumption used in calculating other postretirement benefit costs was 7.95% for 2006, and 8.40% in 2005 and 2004.
In selecting a rate of compensation increase, we consider past experience in light of movements in inflation rates. At December 31, 2006, the Companys rate of compensation increase was 4.25% for 2006 and 2005 and 4.75% for 2004.
In selecting health care cost trend rates, we consider past performance and forecasts of increases in health care costs. Our health care cost trend rate used to calculate the periodic cost was an increase of 10.0% for 2006 compared to the rate used for 2005, gradually declining to increases of 5.0% in years 2011 and thereafter.
Assumed health care cost trend rates have a significant effect on the amounts reported for the other postretirement benefit plans. The health care cost trend rate is based on historical rates and expected market conditions. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
Change in Actuarial Assumption |
Impact on Other Postretirement Benefit Obligation at December 31, 2006 |
Impact on 2006 Total Service and Interest Cost Components |
||||||
Increase assumed health care cost trend by 1% |
$ | 56,263 | $ | 6,124 | ||||
Decrease assumed health care cost trend by 1% |
$ | (46,710 | ) | $ | (4,985 | ) |
We will use a discount rate and EROA of 8% and 5.9%, respectively, for estimating our 2007 pension costs. Additionally, we will use a discount rate and expected return on plan assets of 8% and 5.9%, respectively, for estimating our 2007 other postretirement benefit costs.
The assumptions are reviewed annually and at any interim remeasurement of the plan obligations. The impact of assumption changes is reflected in the recorded pension and postretirement benefit amounts as they occur, or over a period of time if allowed under applicable accounting standards. The assumptions are selected to represent the average expected experience over time and may differ in any one year from actual experience due to changes in capital markets and the overall economy. As these assumptions change from period to period, recorded pension and postretirement benefit amounts and funding requirements could also change.
Recent Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board, referred to as FASB, issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an amendment of FASB Statement No. 115, referred to as SFAS 159. This standard permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This standard will be effective for us on January 1, 2008. We are currently evaluating the effect, if any, that the adoption of SFAS 159 will have on our results of operations, financial position and cash flows.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB Statements No. 87, 88, 106 and 132(R), referred to as SFAS 158. This statement requires the recognition of the overfunded or underfunded status of pension and other postretirement benefit plans on the balance sheet. Under SFAS 158,
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actuarial gains and losses, prior service costs or credits, and transition obligations and assets that have not been recognized in net periodic benefit cost under previous accounting standards will be recognized as a regulatory asset for the portion of the underfunded liability that meets the recovery criteria prescribed in SFAS 71 and as accumulated other comprehensive income, net of tax effects, for that portion of the underfunded liability that does not meet SFAS 71 regulatory accounting criteria. We adopted the recognition and disclosure requirements of the statement on December 31, 2006.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements, referred to as SFAS 157. This statement defines fair value, establishes a framework for using fair value to measure assets and liabilities, and expands disclosures about fair value measurements. The statement applies when other statements require or permit the fair value measurement of assets and liabilities. This statement does not expand the use of fair value measurement. SFAS 157 is effective for us beginning January 1, 2008. We are currently evaluating the provisions of this statement and have not yet determined the effect of adoption on our results of operations or financial position.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, referred to as SAB 108. SAB 108 provides guidance on how prior year misstatements should be considered when quantifying misstatements in current year financial statements for purposes of determining whether the current years financial statements are materially misstated. SAB 108 is effective for the fiscal year ended December 31, 2006.
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, referred to as FIN 48, an Interpretation of SFAS No. 109, Accounting for Income Taxes. FIN 48 is intended to address inconsistencies among entities with the measurement and recognition in accounting for income tax deductions for financial statement purposes. Specifically, FIN 48 addresses the timing of the recognition of income tax benefits. FIN 48 requires the financial statement recognition of an income tax benefit when we determine that it is more-likely-than-not that the tax position will be sustained. FIN 48 is effective for fiscal years beginning after December 15, 2006. We adopted it as required on January 1, 2007 and it did not have a significant effect on our results of operations or financial position.
During 2006, the Emerging Issues Task Force of the Financial A