“It’s such a capital-intensive industry that it’s always negative free cash flow,” notes Coy. Indeed, “we have to invest $3.45 for every $1 [in revenue] we get back,” says Peter Cook, director of the National Association of Water Companies (NAWC), an industry group for private water companies. That compares with $1.61 of revenue per dollar of investment for electric utilities, $1.11 for telephone, and 94 cents for natural gas, according to a 2006 report by AUS Consultants.
This model of spending money before you have it is hard for outsiders to grasp, says Coy, but ironically, it’s what keeps shareholders interested. “Positive cash isn’t a point we look forward to, because then it’s harder to get growth in net income,” explains Smeltzer.
That’s because water companies recoup their investments and earn profits through various types of rate increases that come only after the money is spent. And rate increases must be approved by state utilities commissioners, a process that varies from state to state and can take up to a year. However, unlike most municipalities, private companies rely on appointed, rather than elected, officials for rate increases, which generally makes it easier to get the requested boosts. “If you couldn’t rely on regulators to let them keep raising rates, the business model wouldn’t work,” says Coy. (Not surprisingly, this is also why most towns balk at privatizing their pipes.)
Currently, experts say that regulators in many states are favorably disposed toward rate hikes in exchange for infrastructure improvements. “We’ve never had a regulatory commission disallow a [reimbursement for] capital expenditures we’ve made, meaning we’ve never had to argue over whether the money we put in the ground [for pipes and other equipment] was prudent,” says Wolf of American Water, which operates in 29 states. While nothing is guaranteed, says Pennsylvania Utilities Commission chairman Wendell Holland, “we generally grant all prudently incurred costs.” In about 12 states, including Pennsylvania, companies can even take a portion of their costs through surcharges, giving them some cash up front.
Expenses for interest on debt used to finance the projects are also covered, usually without much debate, since they are easily quantified. Still, regulators like to see that “we are getting the best possible borrowing rates,” says Smeltzer, making it important to maintain strong credit ratings and to mine opportunities for tax-free or low-interest-rate borrowing through towns and counties. Aqua America’s weighted average cost for the $917 million it carries in long-term debt is below 6 percent, thanks to about $300 million borrowed tax-free at 5.2 percent and another $80 million at a 2.1 percent interest rate funded through the Pennsylvania Infrastructure Investment Authority. That’s down from 7.4 percent in 1999.
At Connecticut Water, CFO David Benoit says that “virtually all our debt has been issued through the Connecticut Development Authority as tax-free debt,” making for a weighted average cost of 4.9 percent on its $77 million in long-term debt.
Floating New Shares
But rate hikes that just cover operational expenditures and interest costs are not enough, since that would bring a water utility only to the break-even point. A crucial element in making a profit is to have equity in the mix, since most state laws allow for a “fair” or “reasonable” rate of return on equity, or the cash that companies use for projects.