With over 130 years of experience, Aqua America (NYSE:WTR), knows a thing or two about providing water to customers. Of course, that doesn't mean that it's unsinkable. Let's wade through the company's recent 10-K to examine some of the challenges management recognizes as threats to the company's success.
Piping up about the pipeline
From the 10-K "Our business requires significant capital expenditures that are partially dependent on our ability to secure appropriate funding."
Unlike some companies whose Byzantine corporate structures can confuse even the most savvy of investors, Aqua America's business is extraordinarily simple: providing water services to customers. With a transmission and distribution network of more than 12,500 miles of pipe, the company must maintain a massive infrastructure to provide water service to its more than three million customers. And it's not just pipes; the company also maintains 183 wastewater treatment plants, more than 3,000 wells, and more than 860 water storage tanks.
In order to keep the water flowing through the pipes and plants -- among other things -- the company's capex spending totaled $365 million in FY 2015 -- a hefty 44.8% of the company's operating revenue. According to management, the capex spending was primarily due to both the maintenance of existing and expansion of new water distribution systems, plus the modernization and replacement of existing water treatment plants and water meters. Management expects capex spending to total more than $350 million in FY 2016; however, the company hasn't reported its fourth quarter earnings yet, so it's unclear what this means as a percentage of operating revenue. In the coming year, management expects capex spending to rise to more than $450 million.
If the company's ability to secure funding for capex is compromised it would significant impact the company's profitability. In order to obtain every drop of value out of its enterprise, the company -- like any other -- must keep expenses low. In order to assess this, management relies on the management expense ratio -- the ratio of operations and maintenance expense compared to operating revenues. The company has averaged a ratio of 37.4% over the past three years. If the company is unable to fund its capex projects, this figure would surely increase while profits would surely decrease.
Be sure to ask nicely
Again from the 10-K: "If we are unable to obtain government approval of our requests for rate increases or if approved rate increases are untimely or inadequate to recover and earn a return on our capital investments, to recover expenses or taxes, or to take into account changes in water usage, our profitability may suffer."
Unlike some water companies that have more exposure to the unregulated water market, Aqua America's regulated utilities are the ones that primarily account for the company's consolidated revenue -- 96% in FY 2015. Through its eight subsidiaries, the company provides water and wastewater services whose rates are subject to approval from utility commissions. In other words, the company can't just unilaterally raise rates because it wants to replace some old pipes.
In order to raise its rates -- "to recover investments in utility plants and expenses" -- the company must file a request with the utility commission. And there's no guarantee that the requests will be granted in a timely manner -- if at all. In fact, the company specifies that "the amount or frequency of rate increases increases may be decreased or lengthened as a result of many factors." Characterized as "regulatory lag," the delay between when the operating expenses are incurred and when the rate adjustments are realized can factor in significantly to the company's operating expense ratio; moreover, it can adversely affect the company's cash flow and liquidity.
Once more from the 10-K: "One of the important elements of our growth strategy is the acquisition of water and wastewater utility systems. Any future acquisitions we decide to undertake may involve risks."
Although Aqua America attributes some of the increase in its operating revenue to organic growth in its customer base, the company's predominant means of growth is through acquisitions. Illustrating this strategy, the company completed 19 acquisitions, totaling $22 million, in FY 2016, growing its customer base by 1.6%. Management expects customer growth to total between 1.5% and 2% in FY 2017; it anticipates closing on four acquisitions for $113.7 million.
Recognizing both government-owned and privately owned water and wastewater utilities as potential acquisitions, Aqua America is amenable to acquisitions of utilities both near its current service areas and in new service areas. But management also recognizes that it's not the only game in town: "We compete with governmental entities, other regulated utilities, and strategic and financial buyers, for acquisition opportunities."
Although the company seems to have been successful in acquiring water and wastewater utilities, there is no guarantee that it will be successful in the future; however, Aqua America doesn't have much choice. Sure, it can file requests for rate increases, but that's not something upon which the company can consistently rely -- utility commissions will not grant repeated requests over short periods of time. As a result, successfully executing its acquisition strategy is paramount for the company's growth.
Although utilities are often considered some of the safer investments available to investors, there's always risk. And Aqua America is no exception. Should the company fail to effectively deploy capex dollars, receive approvals for rate increases, and successfully execute its growth through acquisition strategy, it could sink investors' hopes of financial gains.
Scott Levine enjoys a cool glass of water from time to time, but he has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.