General Information
The primary business of the Company is to impound, purify to meet or exceed safe drinking water standards and distribute water. The Company also owns and operates three wastewater collection systems and two treatment systems. The Company operates within its franchised water territory, which covers 39 municipalities within York County, Pennsylvania and nine municipalities within Adams County, Pennsylvania. The Company's wastewater operations include portions of four municipalities in York County, Pennsylvania. The Company is regulated by the Pennsylvania Public Utility Commission, or PPUC, for both water and wastewater in the areas of billing, payment procedures, dispute processing, terminations, service territory, debt and equity financing and rate setting. The Company must obtain PPUC approval before changing any practices associated with the aforementioned areas.
Water service is supplied through the Company's own distribution system. The Company obtains the bulk of its water supply from both the South Branch and East Branch of the Codorus Creek, which together have an average daily flow of 73.0 million gallons. This combined watershed area is approximately 117 square miles. The Company has two reservoirs, Lake Williams and Lake Redman, which together hold up to approximately 2.2 billion gallons of water. The Company supplements its reservoirs with a 15-mile pipeline from the Susquehanna River to Lake Redman which provides access to an additional supply of 12.0 million gallons of untreated water per day. The Company also owns seven wells which are capable of providing a safe yield of approximately 366,000 gallons per day to supply water to its customers in Carroll Valley Borough and Cumberland Township, Adams County. As of June 30, 2017, the Company's average daily availability was 35.4 million gallons, and average daily consumption was approximately 18.2 million gallons. The Company's service territory had an estimated population of 196,000 as of December 31, 2016. Industry within the Company's service territory is diversified, manufacturing such items as fixtures and furniture, electrical machinery, food products, paper, ordnance units, textile products, air conditioning systems, laundry detergent, barbells and motorcycles.
The Company's water business is somewhat dependent on weather conditions, particularly the amount and timing of rainfall. Revenues are particularly vulnerable to weather conditions in the summer months. Prolonged periods of hot and dry weather generally cause increased water usage for watering lawns, washing cars, and keeping golf courses and sports fields irrigated. Conversely, prolonged periods of dry weather could lead to drought restrictions from governmental authorities. Despite the Company's adequate water supply, customers may be required to cut back water usage under such drought restrictions which would negatively impact revenues. The Company has addressed some of this vulnerability by instituting minimum customer charges which are intended to cover fixed costs of operations under all likely weather conditions.
The Company's business does not require large amounts of working capital and is not dependent on any single customer or a very few customers for a material portion of its business. Increases in revenues are generally dependent on the Company's ability to obtain rate increases from the PPUC in a timely manner and in adequate amounts and to increase volumes of water sold through increased consumption and increases in the number of customers served. The Company continuously looks for water and wastewater acquisition and expansion opportunities both within and outside its current service territory as well as additional opportunities to enter into bulk water contracts with municipalities and other entities to supply water.
The Company has agreements with several municipalities to provide sewer billing and collection services. The Company also has a service line protection program on a targeted basis in order to further diversify its business. Under this optional program, customers pay a fixed monthly fee, and the Company will repair or replace damaged customer service lines, as needed, subject to an annual maximum dollar amount. Opportunities to expand both initiatives are being pursued.
Results of Operations
Three Months Ended June 30, 2017 Compared
With Three Months Ended June 30, 2016
Net income for the second quarter of 2017 was $2,935, an increase of $88, or 3.1%, from net income of $2,847 for the same period of 2016. The primary contributing factors to the increase were higher revenues, an increased allowance for funds used during construction, and lower income taxes, which were partially offset by higher operating expenses.
Operating revenues for the three months ended June 30, 2017, increased $434, or 3.7%, from $11,820 for the three months ended June 30, 2016 to $12,254 for the corresponding 2017 period. The primary reasons for the increase were revenues from the recent West York Borough wastewater acquisition of $188 and the distribution system improvement charge, or DSIC, allowed by the PPUC of $62. The DSIC allows the Company to add a charge to customers' water bills for qualified replacement costs of certain infrastructure without submitting a rate filing. Growth in the water customer base also added to revenues. The average number of water customers served in the 2017 period increased as compared to the 2016 period by 1,038 customers, from 65,938 to 66,976 customers. The average number of wastewater customers served in the 2017 period increased as compared to the 2016 period by 1,644 customers, from 641 to 2,285 customers, due to the acquisition. The increase in revenue was partially offset by lower per capita consumption. Total per capita consumption for the second quarter of 2017 was 3.1% lower than the same period last year.
Operating expenses for the second quarter of 2017 increased $600, or 9.8%, from $6,125 for the second quarter of 2016 to $6,725 for the corresponding 2017 period. The increase was primarily due to higher expenses of approximately $164 for West York wastewater operating expenses, $131 for depreciation and $118 for health insurance. Also adding to the increase were $34 for wages, $40 for directors fees, $25 for water treatment materials and supplies, $25 for other taxes and $23 for decreased wages and benefits that were able to be capitalized. Other expenses increased by a net of $89. The increase was partially offset by approximately $26 for lower costs for the annual shareholder reports and $23 for the absence of rate case expenses.
Interest on debt for the second quarter of 2017 increased $10, or 0.8%, from $1,316 for the second quarter of 2016 to $1,326 for the corresponding 2017 period. The increase was primarily due to interest on line of credit borrowings. The average debt outstanding under the lines of credit was $1,374 for the second quarter of 2017 and $0 for the second quarter of 2016. The average interest rate on the lines of credit was 2.06% for the quarter ended June 30, 2017.
Allowance for funds used during construction increased $149, from $47 in the second quarter of 2016 to $196 in the corresponding 2017 period, due to a higher volume of eligible construction mainly related to the pumping station and force main project.
Other income (expenses), net for the second quarter of 2017 reflects decreased expenses of $5 as compared to the same period of 2016. Lower charitable contributions of $12 were the primary reason for the decrease. Other expenses increased by a net of $7.
Income taxes for the second quarter of 2017 decreased $110, or 7.4%, compared to the same period of 2016 due to a higher volume of asset improvements eligible for the tax benefit under the Internal Revenue Service, or IRS, tangible property regulations, or TPR. The Company's effective tax rate was 31.8% for the second quarter of 2017 and 34.2% for the second quarter of 2016.
Six Months Ended June 30, 2017 Compared
With Six Months Ended June 30, 2016
Net income for the first six months of 2017 was $5,516, an increase of $183, or 3.4%, from net income of $5,333 for the same period of 2016. The primary contributing factors to the increase were lower income taxes, higher revenues and an increased allowance for funds used during construction, which were partially offset by higher operating expenses.
Operating revenues for the six months ended June 30, 2017 increased $446, or 1.9%, from $23,098 for the six months ended June 30, 2016 to $23,544 for the corresponding 2017 period. The primary reasons for the increase were $250 of revenues from the recent West York Borough wastewater acquisition and $62 from the DSIC. Growth in the water customer base also added to revenues. The average number of water customers served in the 2017 period increased as compared to the 2016 period by 1,046 customers, from 65,776 to 66,822 customers. The average number of wastewater customers served in the 2017 period increased as compared to the 2016 period by 1,096 customers, from 639 to 1,735 customers, due to the acquisition. The increase in revenue was partially offset by lower per capita consumption. Total per capita consumption for the first six months of 2017 was 2.1% lower than the same period last year. For the remainder of the year, the Company expects revenues to increase due to the DSIC, higher summer demand, and an expected increase in the number of water and wastewater customers from acquisitions and growth within the Company's service territory. Other regulatory actions and weather patterns could impact results.
Operating expenses for the first six months of 2017 increased $969, or 7.9%, from $12,189 for the first six months of 2016 to $13,158 for the corresponding 2017 period. The increase was primarily due to higher expenses of approximately $232 for West York wastewater operating expenses, $223 for health insurance and $185 for depreciation. Also adding to the increase were $77 for legal expenses for a tariff modification and lead disclosure, $56 for wages, $52 for water treatment expenses, $41 for decreased wages and benefits that were able to be capitalized and $33 for power costs. Other expenses increased by a net of $127. The increase was partially offset by approximately $57 for the absence of rate case expenses. For the remainder of the year, the Company expects depreciation expense to continue to rise due to additional investment in utility plant, and other expenses to increase at a moderate rate as costs to treat water and to maintain and extend the distribution system continue to rise and the full cost to operate the West York Borough wastewater collection system are incurred.
Interest on debt for the first six months of 2017 increased $21, or 0.8%, from $2,621 for the first six months of 2016 to $2,642 for the corresponding 2017 period. The increase was due to higher short-term interest rates on the variable rate debt and interest on line of credit borrowings. The average debt outstanding under the lines of credit was $691 for the first six months of 2017 and $0 for first six months of 2016. The average interest rate on the lines of credit was 1.03% for the six months ended June 30, 2017. Interest expense for the remainder of the year is expected to remain higher due to continued borrowings under lines of credit.
Allowance for funds used during construction increased $219, from $100 in the first six months of 2016 to $319 in the corresponding 2017 period, due to a higher volume of eligible construction mainly related to the pumping station and force main project. Allowance for funds used during construction for the remainder of the year is expected to increase until the completion of the project, at which time the amount will decrease, likely in the fourth quarter of 2017.
Other income (expenses), net for the first six months of 2017 reflects decreased expenses of $42 as compared to the same period of 2016. Higher earnings on life insurance policies of approximately $36, outside services in 2016 not repeated in 2017 of $23, and lower retirement expense of $7 were the primary reasons for the decrease. Other expenses increased by a net of $24.
For the remainder of the year, other income (expenses) will be largely determined by the change in market returns and discount rates for retirement programs and related assets.
Income taxes for the first six months of 2017 decreased $466, or 16.7%, compared to the same period of 2016 due to a higher volume of asset improvements eligible for the tax benefit under the IRS TPR. The Company's effective tax rate was 29.7% for the first six months of 2017 and 34.4% for the first six months of 2016.
The Company expects the effective tax rate to be approximately 28% to 32% for 2017 due to the continued expensing of asset improvements that would have been capitalized for tax purposes prior to the implementation of the TPR. The Company's effective tax rate will vary depending on the level of eligible assets improvements that are placed in service each period.
Rate Matters
See Note 11 to the financial statements included herein for a discussion of rate matters.
Effective July 1, 2017, the Company's tariff included a distribution system improvement charge on revenues of 2.96%. A partial month of this surcharge is included in results of operations for the three and six months ended June 30, 2017 for bills rendered after July 1, 2017 that included June consumption.
The benefit from the implementation of the IRS TPR impacts the rate matters of the Company. Reduced taxes have contributed to increased e
arnings, lengthening the amount of time between rate increase requests.
When the Company does file for its next rate increase, the PPUC will take into account the lower income taxes which resulted from the implementation of the IRS TPR, effectively reducing the amount of revenue required in future years and lowering the Company's rate increase request. The Company does not expect to file a rate increase request in 2017.
Acquisitions and Growth
See Note 9 to the financial statements included herein for a discussion of completed acquisitions included in financial results.
On October 8, 2013, the Company signed an agreement to purchase the wastewater assets of SYC WWTP, L.P. in Shrewsbury and Springfield Townships,
York County, Pennsylvania. Completion of the acquisition is contingent upon receiving approval from all required regulatory authorities. Closing is expected in 2018, at which time the Company will add approximately 30 commercial and industrial wastewater customers.
This acquisition is expected to be immaterial to Company results. The Company is also pursuing other bulk water contracts and acquisitions in and around its service territory to help offset any further declines in per capita water consumption and to grow its business.
On May 10, 2017, the Company signed an emergency interconnect agreement with Dallastown-Yoe Water Authority. The effectiveness of this agreement is contingent upon receiving approval from all required regulatory authorities. Approval is expected to be granted in the fourth quarter of 2017 at which time the Company will construct a water main extension to a single point of interconnection and supply an agreed upon amount of water to the authority at current tariff rates.
Capital Expenditures
For the six months ended June 30, 2017, the Company invested $13,867 in construction expenditures for routine items and an additional raw water pumping station and force main, as well as various replacements and improvements to infrastructure. In addition, the Company invested $472 in the acquisition of water and wastewater systems. The Company was able to fund construction expenditures using internally-generated funds, line of credit borrowings, proceeds from its stock purchase plans and customer advances and contributions.
The Company anticipates construction expenditures for the remainder of 2017 of approximately $9,000 exclusive of any potential acquisitions not yet approved. In addition to routine transmission and distribution projects, a portion of the anticipated expenditures will be for additional main extensions, completion of the additional raw water pumping station and force main, and various replacements and improvements to infrastructure. The Company intends to use primarily internally-generated funds for its anticipated construction and fund the remainder through line of credit borrowings, proceeds from its stock purchase plans and customer advances and contributions. Customer advances and contributions are expected to account for between 5% and 10% of funding requirements during the remainder of 2017. The Company believes it will have adequate credit facilities and access to the capital markets, if necessary, to meet its anticipated capital needs in 2017 and 2018.
Liquidity and Capital Resources
Cash
The Company manages its cash through a cash management account that is directly connected to one of its lines of credit. Excess cash generated automatically pays down outstanding borrowings under the line of credit arrangement. If there are no outstanding borrowings, the cash is used as an earnings credit to reduce banking fees. Likewise, if additional funds are needed beyond what is generated internally for payroll, to pay suppliers, to fund capital expenditures, or to pay debt service, funds are automatically borrowed under the line of credit. The Company fully utilized its cash on hand during the first six months of 2017 primarily as a result of higher capital expenditures and repurchase of common stock, incurring a cash overdraft on its cash management account of $1,083 as of June 30, 2017. In addition, the Company borrowed $3,507 under its lines of credit in the second quarter of 2017. The cash management facility and other lines of credit are expected to provide the necessary liquidity and funding for the Company's operations, capital expenditures, acquisitions and potential buybacks of stock for the foreseeable future.
Accounts Receivable
The accounts receivable balance tends to follow the change in revenues but is also affected by the timeliness of payments by customers and the level of the reserve for doubtful accounts. In the three months ended June 30, 2017, higher revenue levels as compared to the end of 2016 resulted in an increase in accounts receivable as reflected on the statement of cash flows. Timeliness of payments and the level of the reserve were not significant factors to the change. A reserve is maintained at a level considered adequate to provide for losses that can be reasonably anticipated based on inactive accounts with outstanding balances. Management periodically evaluates the adequacy of the reserve based on past experience, agings of the receivables, adverse situations that may affect a customer's ability to pay, current economic conditions, and other relevant factors. If the status of these factors deteriorates, the Company may incur additional expenses for uncollectible accounts and experience a reduction in its internally-generated funds.
Internally-generated Funds
The amount of internally-generated funds available for operations and construction depends on the Company's ability to obtain timely and adequate rate relief, changes in regulations including taxes, customers' water usage, weather conditions, customer growth and controlled expenses. During the first six months of 2017, the Company generated $9,366 internally from operations as compared to the $8,256 it generated during the first six months of 2016 due primarily to lower income taxes paid and an increase in depreciation and amortization, a non-cash expense.
Credit Lines
Historically, the Company has borrowed $15,000 to $20,000 under its lines of credit before refinancing with long-term debt or equity capital. As of June 30, 2017, the Company maintained unsecured lines of credit aggregating $41,500 with four banks at interest rates of LIBOR plus 1.20% and LIBOR plus 1.25%. The Company had $3,507 in outstanding borrowings under its lines of credit as of June 30, 2017.
The interest rate on line of credit borrowings as of June 30, 2017 was 2.31%.
In the second quarter of 2017, the Company renewed two of its committed lines of credit aggregating $24,000 and extended the maturity date to May 2019. In addition, the Company renewed its $7,500 committed line of credit and extended the maturity to June 2018.
The Company plans to renew its $10,000 line of credit that expires in September 2017 for an additional year under similar terms and conditions
.
The Company has taken steps to manage the risk of reduced credit availability. It has maintained committed lines of credit that cannot be called on demand and obtained a 2-year revolving maturity on its larger facilities. There is no guarantee that the Company will be able to obtain sufficient lines of credit with favorable terms in the future. If the Company is unable to obtain sufficient lines of credit or to refinance its line of credit borrowings with long-term debt or equity when necessary, it may have to eliminate or postpone capital expenditures. Management believes the Company will have adequate capacity under its current lines of credit and access to capital markets, if necessary, to meet anticipated financing needs throughout 2017 and 2018.
Long-term Debt
The Company's loan agreements contain various covenants and restrictions. Management believes it is currently in compliance with all of these restrictions. See Note 4 to the Company's Annual Report on Form 10-K for the year ended December 31, 2016 for additional information regarding these restrictions.
The Company's total long-term debt as a percentage of the total capitalization, defined as total common stockholders' equity plus total long-term debt, was 44.1% as of June 30, 2017 and 43.4% as of December 31, 2016. The Company began using its line of credit in the second quarter of 2017 which increased the debt to total capitalization ratio. The Company expects to allow the debt percentage to trend upward until it approaches fifty percent before considering additional equity. A debt to total capitalization ratio between forty-six and fifty percent has historically been acceptable to the PPUC in rate filings. Due to its ability to generate and retain cash internally, the Company has been able to keep its ratio below fifty percent.
Income Taxes, Deferred Income Taxes and Uncertain Tax Positions
The Company has a substantial deferred income tax asset primarily due to the differences between the book and tax balances of the pension and deferred compensation plans. The Company does not believe a valuation allowance is required due to the expected generation of future taxable income during the periods in which those temporary differences become deductible.
The Company has seen an increase in its deferred income tax liability amounts primarily as a result of the accelerated and bonus depreciation deduction available for federal tax purposes which creates differences between book and tax depreciation expense. The Company expects this trend to continue as it makes significant investments in capital expenditures subject to accelerated and bonus depreciation or TPR.
The Company filed for a change in accounting method under the IRS TPR effective in 2014. Under the change in accounting method, the Company is permitted to deduct the costs of certain asset improvements that were previously being capitalized and depreciated for tax purposes as an expense on its income tax return. This ongoing deduction results in a reduction in the effective income tax rate, a net reduction in income tax expense, and a reduction in the amount of income taxes currently payable. It also results in increases to deferred tax liabilities and regulatory assets representing the appropriate book and tax basis difference on capital additions. The Company expects an effective tax rate of 28% to 32% each year based on current asset improvement estimates. The effective tax rate will vary depending on the level of eligible assets improvements that are placed in service each period.
The Company has determined there are no uncertain tax positions that require recognition as of June 30, 2017.
Common Stock
Common stockholders' equity as a percent of the total capitalization was 55.9% as of June 30, 2017 and 56.6% as of December 31, 2016. The ratio decreased during the six months ended June 30, 2017 due to share repurchases and higher debt from increased capital expenditures. Similar transactions, among other things, could further reduce this percentage in the future. It is the Company's general intent to target a ratio between fifty and fifty-four percent.
Credit Rating
On April 21, 2017, Standard & Poor's affirmed the Company's credit rating at A-, with a stable outlook and adequate liquidity. The Company's ability to maintain its credit rating depends, among other things, on adequate and timely rate relief, which it has been successful in obtaining, its ability to fund capital expenditures in a balanced manner using both debt and equity and its ability to generate cash flow. The Company's objectives are to continue to maximize its funds provided by operations and maintain a strong capital structure in order to be able to attract capital.
Environmental Matters
During its triennial testing completed in 2016, the Company determined it exceeded the action level for lead at the customer's tap as established by the Lead and Copper Rule, or LCR, issued by the U.S. Environmental Protection Agency. The rule allows the Company to have five samples of the 50 high-risk homes tested exceed the action level of 15 parts per billion, or PPB. The testing found that six properties with lead service lines, all built before 1935, exceeded the action level, and the reported exceedance amount was 1 PPB. The Company has determined that only 3% of the company-owned service lines in the system are lead. The Company will be required, per the LCR, to engage in more frequent testing for lead, public education, and annually replace 7% of the remaining company-owned lead service lines in its distribution system. The Company has announced plans to perform in excess of the required actions. Specifically, the Company will provide the affected customers with a free water test and a 200 gallon per month credit to flush their line in order to reduce any lead content until their lead service line has been replaced. The cost of the water tests and flushing credits was $4 for the three months ended June 30, 2017 and $11 for the six months ended June 30, 2017. Additional amounts for water tests and flushing credits are not expected to have a material impact on the financial position of the Company over the remaining three and a half years.
In addition, the Company has entered into a consent order agreement with the Pennsylvania Department of Environmental Protection. Under the agreement, the Company has committed to exceed the LCR replacement schedule by replacing all of the remaining company-owned lead service lines within the next three and a half years. The cost for these service line replacements was approximately $1,030 through June 30, 2017 and is included in utility plant. Additional replacements are expected to be approximately $1,600 over the next three and a half years, and will be integrated into the Company's annual capital budgets.
Finally, the Company has been granted approval by the PPUC to modify its tariff to include the cost of the replacement of lead customer-owned service lines that are discovered when the Company replaces its lead service lines over three and a half years, and to include the cost of the annual replacement of up to 400 lead customer-owned service lines whenever they are discovered, regardless of the material used for the Company-owned service line over nine years. The tariff modification allows the Company to replace customer-owned service lines at its own initial cost. The Company will record the costs as a regulatory asset to be recovered in future base rates to customers, over a reasonable period of at least four but not more than six years. The cost for the customer-owned lead service line replacements under the four-year tariff modification was approximately $93 through June 30, 2017 and is included as a regulatory asset. Additional replacements are expected to be approximately $130 under the four-year tariff modification, assuming the average percentage of customer-owned lead service lines that were replaced when company-owned lead service lines have been replaced through June 30, 2017 remains consistent over the entire replacement period. The Company is unable to predict how many lead customer-owned service lines are in use, and, therefore, its current estimate of $1,040 for replacements under the nine-year tariff modification is subject to adjustment as more facts become available.
Labor Relations
The current union contract expired on April 30, 2017. Management and the union leadership have agreed to honor the expired contract and continue to work under its terms. Both sides are negotiating in good faith and the Company expects to reach an operationally and fiscally responsible agreement with no interruption of service.
Critical Accounting Estimates
The methods, estimates and judgments the Company used in applying its accounting policies have a significant impact on the results reported in its financial statements. The Company's accounting policies require management to make subjective judgments because of the need to make estimates of matters that are inherently uncertain. The Company's most critical accounting estimates include regulatory assets and liabilities, revenue recognition and accounting for its pension plans. There has been no significant change in accounting estimates or the method of estimation during the quarter ended June 30, 2017.
Off-Balance Sheet Arrangements
The Company does not use off-balance sheet transactions, arrangements or obligations that may have a material current or future effect on financial condition, results of operations, liquidity, capital expenditures, capital resources or significant components of revenues or expenses. The Company does not use securitization of receivables or unconsolidated entities. For risk management purposes, the Company uses a derivative financial instrument, an interest rate swap agreement discussed in Note 6 to the financial statements included herein. The Company does not engage in trading or other risk management activities, does not use other derivative financial instruments for any purpose, has no material lease obligations, no guarantees and does not have material transactions involving related parties.