A Wall Street Perspective

1
Identifying Mitigating Risks for Water Utilities

• A Wall Street Perspective
• Heike M. Doerr
• Janney Montgomery Scott LLC

1801 Market Street Philadelphia, PA 19103 (215)
665-6000 Members New York Stock Exchange FINRA
SIPC Research Analyst Certification and
Important Disclosures are located on page 17.
2
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3
Wall Streets View on Water Utilities
Water utilities depend on Wall Street But
investors have many choices So how do investors
view water utilities?
What Investors LIKE
What Investors DONT LIKE

• Water is an irreplaceable commodity, with stable
  demand the last monopoly
• High cap ex requirements drive investment,
  technology development, and rate base growth
• Industry still fragmented consolidation drives
  growth

• Government controls limit investment returns
  customer view that water should be free
• Rate increases dont keep up with cap ex
  regulatory lag causes negative cash flow and risk
  to returns
• MA activity at risk of regulatory and political
  interference

4
Attracting Capital Requires Investor Certainty

• Regulatory lag creates uncertainty
• Delays on rate case approvals can have
  significant impact on earnings
• Delays or unfavorable treatment of acquisitions
  can also have large impact on returns
• Local political issues create uncertainty
• Threat of condemnation by local municipalities
• Local opposition to rate case increases and
  private sector ownership
• Regular changes in political and personnel
  structure of PUC commissions

5
Drinking Water Investment Needs Remain High
277 Billion needed for U.S. drinking water
utilities
Estimated Required Spending Over Next 20 Years
on Drinking Water Infrastructure ( Billions)

• Emphasis on transmission distribution
• Pipe replacement cycles are not keeping up with
  increasing deterioration
• Depreciation rates are low due to long life of
  pipe assets
• Water rates remain low relative to other
  utilities in most jurisdictions
• Normal operating cash flow is unable to keep up
  with capital spending requirements
• For investor-owned utilities, this means frequent
  access of debt equity markets

Transmission Distribution Projects 183.6
Treatment Projects 53.2
Storage Projects 24.8
Source Projects 12.8
Other 2.3
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California Water (CWT) Impact of Rising Cap Ex
Utility plant per customer has grown about 40
over the past 5 years but water production is
largely flat, driving rate increases for existing
customers
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Capital Spending vs. Operating Cash Flow
Example Aqua America Rising gap between OCF
Cap Ex
8
Capital Spending Metrics
Water utility capital spending is very high
relative to DA and operating cash flow is this
sustainable?
9
Its All About Money
Financial implications of capital intensity

• Some more water industry statistics
• It takes over 3 in capital spending to generate
  1 in revenue at current prices
• Water infrastructure has a long asset life, with
  long depreciation schedules, especially for
  transmission pipes
• Replacement costs continue to rise, dramatically
  outpacing the book value of assets in the ground
• But what does this mean? It means
• Consistently negative free cash flow
• Regular access to debt and equity markets to fund
  cap ex
• Keeping Wall Street comfortable with the
  regulatory compact that fair returns will
  follow the needed investment

10
MA Issues Add Complexity

• MA makes sense in water
• High capital intensity supports continued
  consolidation
• Economies of scale across larger systems
• Technology, purchasing, management advantages as
  system operations become more complex
• Ability to spread rate increases across a larger
  customer base
• but investor uncertainty remains
• Continued lack of clarity on regulatory treatment
• Returns on needed cap ex or premiums to book
  value
• Europeans muddy the waters
• Cross-border buying and selling of water utility
  assets has obscured focus on capital investment
  and U.S.-based growth

11
Arent Water Utilities Recession-Resistant
Investments?

• On the one hand
• Demand for drinking water is static and
  residential consumption is not typically tied to
  economy
• With large infrastructure investment needs,
  capital expenditures are not driven by economic
  indicators
• But, has the market changed since the last
  recession?
• Dividend yields have not kept up with Treasuries
• Retail investors (with buy hold mentality) no
  longer own 70-80 shares
• Addition of ETF UIT sector investment have
  increased volatility

12
Additional Risk Considerations
Water utilities are supposed to be low-risk
regulated monopolies but are they really low
risk?

• Pressure on critical water supplies
• Costly environmental regulations
• Infrastructure replacement needs
• Rising security concerns
• High cap ex requirements low depreciation
  rates
• Effects of regulatory lag
• Local political risk

13
Importance of Allowed ROEs

• Investors have many choices if Commissions want
  to maintain existing corporate structure (50
  equity ratio) they need to provide incentives for
  investors
• Allowed ROEs are typically not achievable/maintain
  able due to existence of regulatory lag
• The fundamental question is Is the allowed
  national ROE average of 10.0 - 10.5 adequate to
  stimulate investor interest in the sector?

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Methods to Minimizing Regulatory Lag
A step in the right direction, but not an
adequate substitute for reasonable allowed ROEs

• Temporary rate increases
• Retroactive effective dates
• Single Rate Tariff Structure
• Expansion of DSIC
• Treatment of non-regulated asset sales
• Long-Term Project Management

15
Case Study Californias Efforts to Minimize Risk
The 2005 Water Action Plan currently being
implemented is creating more consistent
regulatory treatment

• Standardize rate cycle streamline process to
  create more timely decisions
• Temporary rate relief and retroactive effective
  dates to minimize regulatory lag
• Decouple revenue from consumption to encourage
  conservation
• Adjust balancing accounts for supply mix changes
• Consolidated cost of capital proceedings
• Infrastructure Improvement Surcharge Mechanism
  (IISM) encourages replacement cap ex