Essential Utilities, Inc. - Annual Report: 2016 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



FORM 10-K

(Mark One)





For the fiscal year ended December 31, 2016



Or





Commission File number 1-6659



AQUA AMERICA, INC.

(a Pennsylvania corporation)

762 W. Lancaster Avenue

Bryn Mawr, Pennsylvania 19010-3489

(610) 527-8000

I.R.S. Employer Identification Number 23-1702594



Securities registered pursuant to Section 12(b) of the Act:





Securities registered pursuant to Section 12(g) of the Act:  None.



Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. 

☑ Yes  ☐ No



Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. 

☐ Yes  ☑ No



Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  ☑ Yes  ☐ No



Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). 

☑ Yes  ☐ No



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☐



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12(b)-2 of the Exchange Act.: 



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  ☐ Yes ☑No



The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2016:  $6,309,558,158



The number of shares outstanding of the registrant's common stock as of February 13, 2017:  177,445,993



DOCUMENTS INCORPORATED BY REFERENCE



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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS



Certain statements in this Annual Report on Form 10-K (the “Annual Report”) are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are made based upon, among other things, our current assumptions, expectations, plans, and beliefs concerning future events and their potential effect on us.  These forward-looking statements involve risks, uncertainties and other factors, many of which are outside our control that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements.  In some cases you can identify forward-looking statements where statements are preceded by, followed by or include the words “believes,” “expects,” “anticipates,” “plans,” “future,” “potential,” “probably,” “predictions,” “intends,” “will,” “continue” “in the event” or the negative of such terms or similar expressions.  Forward-looking statements in this Annual Report include, but are not limited to, statements regarding:





Because forward-looking statements involve risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements, including but not limited to:



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Given these risks and uncertainties, you should not place undue reliance on any forward-looking statements.  You should read this Annual Report completely and with the understanding that our actual future results, performance and achievements may be materially different from what we expect.  These forward-looking statements represent assumptions, expectations, plans, and beliefs only as of the date of this Annual Report.  Except for our ongoing obligations to disclose certain information under the federal securities laws, we are not obligated, and assume no obligation, to update these forward-looking statements, even though our situation may change in the future.  For further information or other factors which could affect our financial results and such forward-looking statements, see Risk Factors.  We qualify all of our forward-looking statements by these cautionary statements.  



PART I





The Company



Aqua America, Inc. (referred to as “Aqua America”, the “Company”, “we”, “us”, or “our”), a Pennsylvania corporation, is the holding company for regulated utilities providing water or wastewater services to what we estimate to be almost three million people in Pennsylvania, Ohio, Texas, Illinois, North Carolina, New Jersey, Indiana, and Virginia.  Our largest operating subsidiary is Aqua Pennsylvania, Inc., which accounted for approximately 52% of our operating revenues and approximately 74% of our net income for 2016.  As of December 31, 2016, Aqua Pennsylvania provided water or wastewater services to approximately one-half of the total number of people we serve.  Aqua Pennsylvania’s service territory is located in the suburban areas in counties north and west of the City of Philadelphia and in 27 other counties in Pennsylvania.  Our other regulated utility subsidiaries provide similar services in seven other states.  In addition, the Company’s market-based activities are conducted through Aqua Resources Inc. and Aqua Infrastructure, LLC.  Aqua

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Resources provides water and wastewater service through operating and maintenance contracts with municipal authorities and other parties in close proximity to our utility companies’ service territories; and offers, through a third party, water and wastewater line repair service and protection solutions to households.  During 2016 we completed the sale of business units within Aqua Resources which provided liquid waste hauling and disposal services, and inspection, cleaning and repair of storm and sanitary wastewater lines.  Additionally, in 2016, we decided to market for sale business units within Aqua Resources which install and test devices that prevent the contamination of potable water, for which the sale was completed in January 2017, and a business unit that repairs and performs maintenance on water and wastewater systems.  These business units are reported as assets held for sale in the Company’s consolidated balance sheets included in this Annual Report.  Aqua Infrastructure provides non-utility raw water supply services for firms in the natural gas drilling industry.



Aqua America, which prior to its name change in 2004 was known as Philadelphia Suburban Corporation, was formed in 1968 as a holding company for its primary subsidiary, Aqua Pennsylvania, formerly known as Philadelphia Suburban Water Company.  In the early 1990s, we embarked on a growth through acquisition strategy focused on water and wastewater operations.  Our most significant transactions to date have been the merger with Consumers Water Company in 1999, the acquisition of the regulated water and wastewater operations of AquaSource, Inc. in 2003, the acquisition of Heater Utilities, Inc. in 2004, and the acquisition of American Water Works Company, Inc.’s regulated water and wastewater operations in Ohio in 2012.  Since the early 1990s, our business strategy has been primarily directed toward the regulated water and wastewater utility industry, where we have more than quadrupled the number of regulated customers we serve, and have extended our regulated operations from southeastern Pennsylvania to include our current regulated utility operations throughout Pennsylvania and in seven other states.  During 2010 through 2013, we sold our utility operations in six states, pursuant to a portfolio rationalization strategy to focus our operations in areas where we have critical mass and economic growth potential.  Currently, the Company seeks to acquire businesses in the U.S. regulated sector, which includes water and wastewater utilities and other regulated utilities, and to pursue growth ventures in market-based activities, such as infrastructure opportunities that are supplementary and complementary to our regulated businesses.   



In December 2014, we completed the sale of our water utility system in southwest Allen County, Indiana to the City of Fort Wayne, Indiana.  The completion of this sale settled the dispute concerning the February 2008 acquisition, by eminent domain, by the City of Fort Wayne, of the northern portion of our water and wastewater utility systems. 



The following table reports our operating revenues, by principal state, for the Regulated segment and Other and eliminations for the year ended December 31, 2016:









Information concerning revenues, net income, identifiable assets and related financial information for the Regulated segment and Other and eliminations for 2016, 2015, and 2014 is set forth in Management’s Discussion and Analysis of

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Financial Condition and Results of Operations and in Note 17 – Segment Information in the Notes to Consolidated Financial Statements which is contained in Item 8 of this Annual Report.



The following table summarizes our operating revenues, by utility customer class, for the Regulated segment and Other and eliminations for the year ended December 31, 2016:







Our utility customer base is diversified among residential water, commercial water, fire protection, industrial water, other water, wastewater customers, and other utility customers (consisting of operating contracts that are closely associated with the utility operations).  Residential water and wastewater customers make up the largest component of our utility customer base, with these customers representing approximately 70% of our water and wastewater revenues.  Substantially all of our water customers are metered, which allows us to measure and bill for our customers’ water consumption.  Water consumption per customer is affected by local weather conditions during the year, especially during late spring, summer, and early fall.  In general, during these seasons, an extended period of dry weather increases consumption, while above average rainfall decreases consumption.  Also, an increase in the average temperature generally causes an increase in water consumption.  On occasion, abnormally dry weather in our service areas can result in governmental authorities declaring drought warnings and imposing water use restrictions in the affected areas, which could reduce water consumption.  See “Business – Water Utility Supplies, and Facilities and Wastewater Utility Facilities” for a discussion of water use restrictions that may impact water consumption during abnormally dry weather.  The geographic diversity of our utility customer base reduces the effect of our exposure to extreme or unusual weather conditions in any one area of our service territory.  Water usage is also affected by changing consumption patterns by our customers, resulting from such causes as increased water conservation and the installation of water saving devices and appliances that can result in decreased water usage.  It is estimated that in the event we experience a 0.50% decrease in residential water consumption it would result in a decrease in annual residential water revenue of approximately $2,400,000, and would likely be partially offset by a reduction in incremental water production expenses such as chemicals and power.



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Our growth in revenues over the past five years is primarily a result of increases in water and wastewater rates and customer growth.  See Economic Regulation for a discussion of water and wastewater rates.  The increase in our utility customer base has been due to customers added through acquisitions, partnerships with developers, and organic growth (excluding dispositions) as shown below: 







In 2016, our customer count increased by 14,399 customers, primarily due to organic growth and utility systems that we acquired, offset by the loss of customers due to dispositions.  Overall, for the five-year period of 2012 through 2016, our utility customer base, adjusted to exclude customers associated with utility system dispositions, increased at an annual compound rate of 2.5%.  During the five-year period ended December 31, 2016, our utility customer base including customers associated with utility system acquisitions and dispositions increased from 966,136 at January 1, 2012 to 972,265 at December 31, 2016.    This five-year period includes the impact of the condemnation of our Fort Wayne, IN system in 2014, which resulted in the loss of approximately 13,000 connections.    



Acquisitions and Other Growth Ventures



According to the U.S. Environmental Protection Agency (“EPA”), approximately 85% of the U.S. population obtains its water from community water systems, and 15% of the U.S. population obtains its water from private wells.  With approximately 53,000 community water systems in the U.S. (82% of which serve less than 3,300 customers), the water industry is the most fragmented of the major utility industries (telephone, natural gas, electric, water and wastewater).  The majority of these community water systems are government-owned, and the balance of the systems are privately-owned (or investor-owned).  The nation’s water systems range in size from large government-owned systems, such as the New York City water system which serves approximately 8.5 million people, to small systems, where a few customers share a common well.  In the states where we operate regulated utilities, we believe there are approximately 14,500 community water systems of widely-varying size, with the majority of the population being served by government-owned water systems. 



Although not as fragmented as the water industry, the wastewater industry in the U.S. also presents opportunities for consolidation.  According to the EPA’s most recent survey of wastewater treatment facilities (which includes both government-owned and privately-owned facilities) in 2012, there are approximately 15,000 such facilities in the nation serving approximately 76% of the U.S. population.  The remaining population represents individual homeowners with their own treatment facilities; for example, community on-lot disposal systems and septic tank systems.  A majority of wastewater facilities are government-owned rather than privately-owned.  The EPA’s survey also indicated that there are approximately 4,000 wastewater facilities in operation in the states where we operate regulated utilities.



Because of the fragmented nature of the water and wastewater utility industries, we believe there are many potential water and wastewater system acquisition candidates throughout the U.S.  We believe the factors driving consolidation of these systems are:



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We are actively exploring opportunities to expand our utility operations through acquisitions or other growth ventures.  During the five-year period ended December 31, 2016, we expanded our utility operations by completing 84 acquisitions or other growth ventures.  



We believe that acquisitions will continue to be an important source of customer growth for us.  We intend to continue to pursue acquisitions of government-owned and privately-owned water and wastewater systems that provide services in areas near our existing service territories or in new service areas.  We engage in continuing activities with respect to potential acquisitions, including calling on prospective sellers, performing analyses and investigations of acquisition candidates, making preliminary acquisition proposals, and negotiating the terms of potential acquisitions.  Further, we are also seeking other potential business opportunities, including but not limited to partnering with public and private utilities to invest in infrastructure improvements, and growing our market-based activities by acquiring businesses that provide water and wastewater management services, other utility services and investing in infrastructure projects.



Water Utility Supplies and Facilities and Wastewater Utility Facilities



Our water utility operations obtain their water supplies from surface water sources, underground aquifers, and water purchased from other water suppliers.  Our water supplies are primarily self-supplied and processed at twenty surface water treatment plants located in four states, and numerous well stations located in all of the states in which we conduct business.  Approximately 8% of our water supplies are provided through water purchased from other water suppliers.  It is our policy to obtain and maintain the permits necessary to obtain the water we distribute. 



We believe that the capacities of our sources of supply, and our water treatment, pumping and distribution facilities, are generally sufficient to meet the present requirements of our customers under normal conditions.  We plan system improvements and additions to capacity in response to normal replacement and renewal needs, changing regulatory standards, changing patterns of consumption, and increased demand from customer growth.  The various state utility commissions have generally recognized the operating and capital costs associated with these improvements in setting water and wastewater rates.



On occasion, drought warnings and water use restrictions are issued by governmental authorities for portions of our service territories in response to extended periods of dry weather conditions.  The timing and duration of the warnings and restrictions can have an impact on our water revenues and net income.  In general, water consumption in the summer months is more affected by drought warnings and restrictions because discretionary and recreational use of water is at its highest during the summer months.  At other times of the year, warnings and restrictions generally have less of an effect on water consumption.  Currently, portions of our Pennsylvania (four counties), New Jersey, and Texas service areas are under drought warnings.  The entire Pennsylvania and New Jersey service areas are under drought watch.  Portions of our northern and central Texas service areas have conservation water restrictions.  Drought warnings and watches result in the public being asked to voluntarily reduce water consumption. 



We believe that our wastewater treatment facilities are generally adequate to meet the present requirements of our customers under normal conditions.  Additionally, we own several wastewater collection systems that convey the wastewater to a municipally-owned facility for treatment.  Changes in regulatory requirements can be reflected in revised permit limits and conditions when permits are renewed, typically on a five-year cycle, or when treatment capacity is expanded.  Capital improvements are planned and budgeted to meet normal replacement and renewal needs, anticipated changes in regulations, needs for increased capacity related to projected growth, and to reduce inflow and infiltration to collection systems.  The various state utility commissions have generally recognized the operating and capital costs associated with these improvements in setting wastewater rates for current and new customers.  It is our policy to obtain and maintain the permits necessary for the treatment of the wastewater that we return to the environment.  



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Economic Regulation



Most of our water and wastewater utility operations are subject to regulation by their respective state utility commissions, which have broad administrative power and authority to regulate billing rates, determine franchise areas and conditions of service, approve acquisitions and authorize the issuance of securities.  The utility commissions also establish uniform systems of accounts and approve the terms of contracts with affiliates and customers, business combinations with other utility systems, and loans and other financings.  The policies of the utility commissions often differ from state to state, and may change over time.  A small number of our operations are subject to rate regulation by county or city governments.  The profitability of our utility operations is influenced to a great extent by the timeliness and adequacy of rate allowances we are granted by the respective utility commissions or authorities in the various states in which we operate. 



Rate Case Management Capability – We maintain a rate case management capability, the objective of which is to provide that the tariffs of our utility operations reflect, to the extent practicable, the timely recovery of increases in costs of operations, capital expenditures, interest expense, taxes, energy, materials, and compliance with environmental regulations.  We file rate increase requests to recover and earn a fair return on the infrastructure investments that we make in improving or replacing our facilities and to recover expenses.  In the states in which we operate, we are primarily subject to economic regulation by the following state utility commissions:







Our water and wastewater operations are comprised of 53 rate divisions, each of which requires a separate rate filing for the evaluation of the cost of service, including the recovery of investments, in connection with the establishment of rates for that rate division.  When feasible and beneficial to our utility customers, we will seek approval from the applicable state regulatory commission to consolidate rate divisions to achieve a more even distribution of costs over a larger customer base.  All of the states in which we operate permit us to file a revenue requirement for some form of consolidated rates for all, or some of the rate divisions in that state.



In Virginia, we may seek authorization to bill our utility customers in accordance with a rate filing that is pending before the respective regulatory commission.  As of December 31, 2016, we have no billings under interim rate arrangements for rate case filings in progress.  Furthermore, some utility commissions authorize the use of expense deferrals and amortization in order to provide for an impact on our operating income by an amount that approximates the requested amount in a rate request.  In these states the additional revenue billed and collected prior to the final regulatory commission ruling is subject to refund to customers based on the outcome of the ruling.  The revenue recognized and the expenses deferred by us reflect an estimate as to the final outcome of the ruling.  If the request is denied completely or in part, we could be required to refund to customers some or all of the revenue billed to date, and write-off some or all of the deferred expenses.



Revenue Surcharges – Six states in which we operate water utilities, and five states in which we operate wastewater utilities, permit us to add a surcharge to water or wastewater bills to offset the additional depreciation and capital costs associated with capital expenditures related to replacing and rehabilitating infrastructure systems.  Without this surcharge, a water and wastewater utility absorbs all of the depreciation and capital costs of these projects between base rate increases.  The gap between the time that a capital project is completed and the recovery of its costs in rates is known as regulatory lag.  This surcharge is intended to substantially reduce regulatory lag, which often acted as a disincentive to water and wastewater utilities to rehabilitate their infrastructure.  In addition, our subsidiaries in some states use a surcharge or credit on their bills to reflect

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changes in costs, such as changes in state tax rates, other taxes and purchased water costs, until such time as the new cost levels are incorporated into base rates.



Currently, with the exception of New Jersey, which allows for an infrastructure rehabilitation surcharge for water utilities, Pennsylvania, Illinois, Ohio, Indiana, and North Carolina allow for the use of an infrastructure rehabilitation surcharge for both water and wastewater utility systems.  The infrastructure rehabilitation surcharge typically adjusts periodically based on additional qualified capital expenditures completed or anticipated in a future period, and is capped at a percentage of base rates, generally at 5% to 12.75%, and is reset to zero when new base rates that reflect the costs of those additions become effective or when a utility’s earnings exceed a regulatory benchmark.  This surcharge provided revenues of $7,379,000 in 2016, $3,261,000 in 2015, and $4,598,000 in 2014. 



Income Tax Accounting Change – In December 2012, Aqua Pennsylvania adopted an income tax accounting change, implemented on Aqua America’s 2012 federal income tax return, which was filed in September 2013.  This accounting change allows a tax deduction for qualifying utility asset improvements that were formerly capitalized for tax purposes, and was implemented in response to a June 2012 rate order issued by the Pennsylvania Public Utility Commission.  The Pennsylvania rate order provides for the flow-through of income tax benefits which results in a reduction in current income tax expense as a result of the recognition of income tax benefits resulting from the accounting change.  This tax accounting change and its treatment under the Pennsylvania rate order financially offset the impact of the water infrastructure rehabilitation surcharge suspension.  During 2013, our Ohio and North Carolina operating divisions implemented this change.  These divisions currently do not employ a method of accounting that provides for a reduction in current income tax expense, and as such this change had no impact on our effective income tax rate.



Competition



In general, we believe that Aqua America and its subsidiaries have valid authority, free from unduly burdensome restrictions, to enable us to carry on our business as presently conducted in the franchised or contracted areas we now serve.  The rights to provide water or wastewater service to a particular franchised service territory are generally non-exclusive, although the applicable utility commissions usually allow only one regulated utility to provide service to a given area.  In some instances, another water utility provides service to a separate area within the same political subdivision served by one of our subsidiaries.  Therefore, as a regulated utility, there is little or no competition for the daily water and wastewater service we provide to our customers.  Water and wastewater utilities may compete for the acquisition of other water and wastewater utilities or for acquiring new customers in new service territories.  Competition for these acquisitions generally comes from nearby utilities, either investor-owned or municipal-owned, and sometimes from strategic or financial purchasers seeking to enter or expand in the water and wastewater industry.  We compete for new service territories and the acquisition of other utilities on the following bases: 





The addition of new service territories and the acquisition of other utilities by regulated utilities such as us are generally subject to review and approval by the applicable state utility commissions.



In a very few number of instances, in one of our southern states, where there are municipally-owned water or wastewater systems near our operating divisions, the municipally-owned system may either have water distribution or wastewater collection mains that are located adjacent to our division's mains or may construct new mains that parallel our mains.  In

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these circumstances, on occasion, the municipally-owned system may attempt to voluntarily offer service to customers who are connected to our mains, resulting in our mains becoming surplus or underutilized without compensation.



In the states where our subsidiaries operate, it is possible that portions of our subsidiaries’ operations could be acquired by municipal governments by one or more of the following methods:





The price to be paid upon such an acquisition by the municipal government is usually determined in accordance with applicable law under eminent domain. In other instances, the price may be negotiated, fixed by appraisers selected by the parties or computed in accordance with a formula prescribed in the law of the state or in the particular franchise or charter.  We believe that our operating subsidiaries will be entitled to fair market value for any assets that are condemned, and we believe the fair market value will be in excess of the book value for such assets.



Despite maintaining a program to monitor condemnation interests and activities that may affect us over time, one of our primary strategies continues to be to acquire additional water and wastewater systems, to maintain our existing systems where there is a business or a strategic benefit, and to actively oppose unilateral efforts by municipal governments to acquire any of our operations, particularly for less than the fair market value of our operations or where the municipal government seeks to acquire more than it is entitled to under the applicable law or agreement.  On occasion, we may voluntarily agree to sell systems or portions of systems in order to help focus our efforts in areas where we have more critical mass and economies of scale or for other strategic reasons. 



Environmental, Health and Safety Regulation



Provision of water and wastewater services is subject to regulation under the federal Safe Drinking Water Act, the Clean Water Act, and related state laws, and under federal and state regulations issued under these laws.  These laws and regulations establish criteria and standards for drinking water and for wastewater discharges.  In addition, we are subject to federal and state laws and other regulations relating to solid waste disposal, dam safety and other aspects of our operations.  Capital expenditures and operating costs required as a result of water quality standards and environmental requirements have been traditionally recognized by state utility commissions as appropriate for inclusion in establishing rates.



From time to time, Aqua America has acquired, and may acquire, systems that have environmental compliance issues.  Environmental compliance issues also arise in the course of normal operations or as a result of regulatory changes.  Aqua America attempts to align capital budgeting and expenditures to address these issues in due course.  We believe that the capital expenditures required to address outstanding environmental compliance issues have been budgeted in our capital program and represent approximately $47,100,000, or approximately 2% of our expected total capital expenditures over the next five years.  We are parties to agreements with regulatory agencies in Pennsylvania, Texas, and Indiana under which we have committed to make improvements for environmental compliance.  These agreements are intended to provide the regulators with assurance that problems covered by these agreements will be addressed, and the agreements generally provide protection from fines, penalties and other actions while corrective measures are being implemented.  We are actively working directly with state environmental officials in Pennsylvania, Texas, and Indiana to implement or amend these agreements as necessary.



Safe Drinking Water Act - The Safe Drinking Water Act establishes criteria and procedures for the EPA to develop national quality standards for drinking water.  Regulations issued pursuant to the Safe Drinking Water Act set standards regarding the amount of microbial and chemical contaminants and radionuclides in drinking water.  Current requirements under the Safe Drinking Water Act are not expected to have a material impact on our business, financial condition, or

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results of operations as we have made and are making investments to meet existing water quality standards.  We may, in the future, be required to change our method of treating drinking water at some sources of supply and make additional capital investments if additional regulations become effective.



Clean Water Act - The Clean Water Act regulates discharges from drinking water and wastewater treatment facilities into lakes, rivers, streams, and groundwater.  It is our policy to obtain and maintain all required permits and approvals for the discharges from our water and wastewater facilities, and to comply with all conditions of those permits and other regulatory requirements.  A program is in place to monitor facilities for compliance with permitting, monitoring and reporting for wastewater discharges.  From time to time, discharge violations may occur which may result in fines.  These fines and penalties, if any, are not expected to have a material impact on our business, financial condition, or results of operations.  We are also parties to agreements with regulatory agencies in several states where we operate while improvements are being made to address wastewater discharge issues. 



Solid Waste Disposal - The handling and disposal of waste generated from water and wastewater treatment facilities is governed by federal and state laws and regulations.  A program is in place to monitor our facilities for compliance with regulatory requirements, and we are not aware of any significant environmental remediation costs necessary from our handling and disposal of waste material from our water and wastewater operations.   



Dam Safety - Our subsidiaries own thirty dams, of which fifteen are classified as high hazard dams that are subject to the requirements of the federal and state regulations related to dam safety, which undergo regular inspections and an annual engineering inspection. After a thorough review and inspection of our dams by professional outside engineering firms, we  believe that all fifteen dams are structurally sound and well-maintained.  These inspections provide recommendations for ongoing rehabilitation which we include in our capital improvement program.   



We performed studies of our dams that identified three dams in Pennsylvania and two dams in Ohio requiring capital improvements resulting from the adoption by state regulatory agencies of revised formulas for calculating the magnitude of a possible maximum flood event.  The most significant capital improvement remaining to be performed is on one dam in Pennsylvania at a total estimated cost of $13,700,000.  Design for this dam commenced in 2013 and construction is expected to be completed in 2021. 



Safety Standards - Our facilities and operations may be subject to inspections by representatives of the Occupational Safety and Health Administration from time to time.  We maintain safety policies and procedures to comply with the Occupational Safety and Health Administration’s rules and regulations, but violations may occur from time to time, which may result in fines and penalties, which are not expected to have a material impact on our business, financial condition, or results of operations.  We endeavor to correct such violations promptly when they come to our attention.



Security



We maintain security measures at our facilities, and collaborate with federal, state and local authorities and industry trade associations regarding information on possible threats and security measures for water and wastewater utility operations.  The costs incurred are expected to be recoverable in water and wastewater rates and are not expected to have a material impact on our business, financial condition, or results of operations.



We also maintain cyber security protection measures with respect to our information technology, including our customer data, and, in some cases, the monitoring and operation of our treatment, storage and pumping facilities. 



Employee Relations



As of December 31, 2016, we employed a total of 1,551 full-time employees.  Our subsidiaries are parties to 15 labor agreements with labor unions covering 580 employees.  The labor agreements expire at various times between April 2017 and May 2021.           



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Available Information



We file annual, quarterly, current reports, proxy statements, and other information with the Securities and Exchange Commission (“SEC”).  You may read and copy any document we file with the SEC at the SEC’s public reference room at 100 F Street, NE, Washington, DC 20549.  Please call the SEC at 1-800-SEC-0330 for further information on the public reference room.  You may also obtain our SEC filings from the SEC’s web site at www.sec.gov.



Our internet web site address is www.aquaamerica.com.  We make available free of charge through our web site’s Investor Relations page all of our filings with the SEC, including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and other information.  These reports and information are available as soon as reasonably practicable after such material is electronically filed with the SEC.



In addition, you may request a copy of the foregoing filings, at no cost by writing or telephoning us at the following address or telephone number: 



Investor Relations Department

Aqua America, Inc.

762 W. Lancaster Avenue

Bryn Mawr, PA 19010-3489

Telephone:  610-527-8000



Our Board of Directors has various committees including an audit committee, an executive compensation committee, a corporate governance committee, and a risk mitigation and investment policy committee.  Each of these committees has a formal charter.  We also have Corporate Governance Guidelines and a Code of Ethical Business Conduct.  Copies of these charters, guidelines, and codes can be obtained free of charge from our Investor Relations page on our web site, www.aquaamerica.com.  In the event we change or waive any portion of the Code of Ethical Business Conduct that applies to any of our directors, executive officers, or senior financial officers, we will post that information on our web site.  



The references to our web site and the SEC’s web site are intended to be inactive textual references only, and the contents of those web sites are not incorporated by reference herein and should not be considered part of this or any other report that we file with or furnish to the SEC.







In addition to the other information included in this Annual Report, the following factors should be considered in evaluating our business and future prospects.  Any of the following risks, either alone or taken together, could materially harm our business, financial condition, and results of operations.  If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, our business, financial condition, and results of operations could be materially harmed.



Contamination of our water supply, including water provided to our customers, may result in disruption in our services, additional costs and litigation which could harm our business, financial condition, and results of operations.



Our water supplies, including water provided to our customers, are subject to possible contamination, including from:



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Depending on the nature of the water contamination, we may have to interrupt the use of that water supply until we are able to substitute, where feasible, the flow of water from an uncontaminated water source, including if practicable, the purchase of water from other suppliers, or continue the water supply under restrictions on use for drinking or broader restrictions against all use except for basic sanitation and essential fire protection.  We may incur significant costs, including, but not limited to, costs for water quality testing and monitoring, treatment of the contaminated source through modification of our current treatment facilities or development of new treatment methods, or the purchase of alternative water supplies.  In addition, the costs we could incur to decontaminate a water source or our water distribution system and dispose of waste could also be significant.  The costs resulting from the contamination may not be recoverable in rates we charge our customer, or may not be recoverable in a timely manner.  If we are unable to adequately treat the contaminated water supply or substitute a water supply from an uncontaminated water source in a timely or cost‑effective manner, there may be an adverse effect on our business, financial condition, and results of operations.  We could also be subject to: 





We may incur costs to defend our position and/or incur reputational damage even if we are not liable for consequences arising out of human exposure to contamination and/or hazardous substances in our water supplies or other environmental damage.  Our insurance policies may not be sufficient to cover the costs of these claims, and losses incurred may make it difficult for us to secure insurance in the future at acceptable rates.  Such claims or actions could harm our business, financial condition, and results of operations.



The rates we charge our customers are subject to regulation.  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.



The rates we charge our customers are subject to approval by utility commissions in the states in which we operate.  We file rate increase requests, from time to time, to recover our investments in utility plant and expenses.  Our ability to maintain and meet our financial objectives is dependent upon the recovery of, and return on, our capital investments and expenses through the rates we charge our customers.  Once a rate increase petition is filed with a utility commission, the ensuing administrative and hearing process may be lengthy and costly, and our costs may not always be fully recoverable.  The timing of our rate increase requests are therefore partially dependent upon the estimated cost of the administrative process in relation to the investments and expenses that we hope to recover through the rate increase.  In addition, the amount or frequency of rate increases may be decreased or lengthened as a result of many factors including changes in regulatory oversight in the states in which we operate water and wastewater utilities and income tax laws, including regulations regarding tax-basis depreciation as it applies to our capital expenditures or qualifying utility asset improvements.  We can provide no assurances that any future rate increase request will be approved by the appropriate utility commission; and, if approved, we cannot guarantee that these rate increases will be granted in a timely or sufficient manner.



In Virginia, we may seek authorization to bill our utility customers in accordance with a rate filing that is pending before the respective regulatory commission.  Furthermore, some utility commissions authorize the use of expense deferrals and amortization in order to provide for an impact on our operating income by an amount that approximates the requested amount in a rate request.  The additional revenue billed and collected prior to the final ruling is subject to refund to customers based on the outcome of the ruling.  The revenue recognized and the expenses deferred by us reflect an estimate as to the final outcome of the ruling.  If the request is denied completely or in part, we could be required to refund to customers some or all of the revenue billed to date, and write-off some or all of the deferred expenses.    

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Our business requires significant capital expenditures that are partially dependent on our ability to secure appropriate funding.  Disruptions in the capital markets may limit our access to capital.  If we are unable to obtain sufficient capital, or if the cost of borrowing increases, it may harm our business, financial condition, results of operations, and our ability to pay dividends.



Our business is capital intensive.  In addition to the capital required to fund customer growth through our acquisition strategy, on an annual basis, we spend significant sums for additions to or replacement of property, plant and equipment.  We obtain funds for our capital expenditures from operations, contributions and advances by developers and others, debt issuances, and equity issuances.  We have paid dividends consecutively for 72 years and our Board of Directors recognizes the value that our common shareholders place on both our historical payment record and on our future dividend payments.  Our ability to maintain and meet our financial objectives is dependent upon the availability of adequate capital, and we may not be able to access the capital markets on favorable terms or at all.  If in the future, our credit facilities are not renewed or our short-term borrowings are called for repayment, we would need to seek alternative financing sources; however, there can be no assurance that these alternative financing sources would be available on terms acceptable to us.  In the event we are unable to obtain sufficient capital, we may need to take steps to conserve cash by reducing our capital expenditures or dividend payments and our ability to pursue acquisitions may be limited.  The reduction in capital expenditures may result in reduced potential earnings growth, affect our ability to meet environmental laws and regulations, and limit our ability to improve or expand our utility systems to the level we believe appropriate.  There is no guarantee that we will be able to obtain sufficient capital in the future on reasonable terms and conditions for expansion, construction and maintenance.  In addition, delays in completing major capital projects could delay the recovery of the capital expenditures associated with such projects through rates.  If the cost of borrowing increases, we might not be able to recover increases in our cost of capital through rates.  The inability to recover higher borrowing costs through rates, or the regulatory lag associated with the time that it takes to begin recovery, may harm our business, financial condition, and results of operations. 



Our inability to comply with debt covenants under our credit facilities could result in prepayment obligations.



We are obligated to comply with debt covenants under some of our loan and debt agreements.  Failure to comply with 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 finance these borrowings before their due date, limit future borrowings, cause us to default on other obligations, and increase borrowing costs.  If we are forced to repay or refinance (on less favorable terms) these borrowings, our business, financial condition, and results of operations could be harmed by reduced access to capital and increased costs and rates.



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.  Further, competition for acquisition opportunities from other regulated utilities, governmental entities, and strategic and financial buyers may hinder our ability to grow our business.



One important element of our growth strategy is the acquisition and integration of water and wastewater utility systems in order to broaden our service areas.  We will not be able to acquire other businesses if we cannot identify suitable acquisition opportunities or reach mutually agreeable terms with acquisition candidates.  It is our intent, when practical, to integrate any businesses we acquire with our existing operations.  The negotiation of potential acquisitions as well as the integration of acquired businesses could require us to incur significant costs and cause diversion of our management's time and resources.  Future acquisitions by us could result in:



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Some or all of these items could harm our business and our ability to finance our business and to comply with regulatory requirements.  The businesses we acquire in the future may not achieve sales and profitability that would justify our investment, and any difficulties we encounter in the integration process, including in the integration of processes necessary for internal control and financial reporting, could interfere with our operations, reduce our operating margins and harm our internal controls.  



We compete with governmental entities, other regulated utilities, and strategic and financial buyers, for acquisition opportunities.  As consolidation becomes more prevalent in the utility industry and competition for acquisitions increases, the prices for suitable acquisition candidates may increase to unacceptable levels and limit our ability to grow through acquisitions.  In addition, our competitors may impede our growth by purchasing utilities near our existing operations, thereby preventing us from acquiring them.  Governmental entities or environmental / social activist groups have challenged, and may in the future challenge our efforts to acquire new service territories, particularly from municipalities or municipal authorities.  Higher purchase prices and resulting rates may limit our ability to invest additional capital for system maintenance and upgrades in an optimal manner.  Our growth could be hindered if we are not able to compete effectively for new companies and/or service territories with other companies or strategic and financial buyers that have lower costs of operations or capital, or that submit more attractive bids. Any of these risks may harm our business, financial condition, and results of operations.



Our facilities could be the target of a possible terrorist or other deliberate attack which could harm our business, financial condition and results of operations.



In addition to the potential contamination of our water supply as described in a separate risk factor herein, we maintain security measures at our facilities and have heightened employee and public safety official awareness of potential threats to our water systems.  We have and will continue to bear increases in costs for security precautions to protect our facilities, operations, and supplies, most of which have been recoverable under state regulatory policies.  While the costs of increases in security, including capital expenditures, may be significant, we expect these costs to continue to be recoverable in water and wastewater rates.  Despite our security measures, we may not be in a position to control the outcome of terrorist events, or other attacks on our water systems, should they occur.  Such an event could harm our business, financial condition, and results of operations.



The failure of, or the requirement to repair, upgrade or dismantle any of our dams or reservoirs may harm our business, financial condition, and results of operations. 



Several of our water systems include impounding dams and reservoirs of various sizes.  Although we believe our dams are structurally sound and well-maintained, the failure of a dam could result in significant downstream damage and could result in claims for property damage or for injuries or fatalities.  We periodically inspect our dams and purchase liability insurance to cover such risks, but depending on the nature of the downstream damage and cause of the failure, the policy limits of insurance coverage may not be sufficient, and losses incurred may make it difficult for us to secure insurance in the future at acceptable rates.  A dam failure could also result in damage to, or disruption of, our water treatment and pumping facilities that are often located downstream from our dams and reservoirs.  Significant damage to these facilities, or a significant decline in the storage of the raw water impoundment, could affect our ability to provide water to our customers until the facilities and a sufficient raw water impoundment can be restored.  The estimated costs to maintain our dams are included in our capital budget projections and, although such costs to date have been recoverable in rates, there can be no assurance that rate increases will be granted in a timely or sufficient manner to recover such costs in the future, if at all. 



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Any failure of our water and wastewater treatment plants, network of water and wastewater pipes, or water reservoirs could result in damages that may harm our business, financial condition, and results of operations.



Our operating subsidiaries treat water and wastewater, distribute water and collect wastewater through an extensive network of pipes, and store water in reservoirs.  A failure of a major treatment plant, pipe, or reservoir could result in claims for injuries or property damage.  The failure of a major treatment plant, pipe, or reservoir 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 quality and quantities to our customers or collect and treat wastewater in accordance with standards prescribed by governmental regulators, including state utility commissions, and may harm our business, financial condition, and results of operations.  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.



We are increasingly dependent on the continuous and reliable operation of our information technology systems, and a disruption of these systems, resulting from cyber security attacks or other cyber-related events, could harm our business.



We rely on our information technology systems in connection with the operation of our business, especially with respect to customer service and billing, accounting and, in some cases, the monitoring and operation of our treatment, storage and pumping facilities.  In addition, we rely on our systems to track our utility assets and to manage maintenance and construction projects, materials and supplies, and our human resource functions.  A loss of these systems, or major problems with the operation of these systems, could harm our business, financial condition, and results of operations.  Our information technology systems may be vulnerable to damage or interruption from the following types of cyber security attacks or other cyber-related events:





Although we do not believe that our systems are at a materially greater risk of cyber security attacks than other similar organizations, our information technology systems may be vulnerable to damage or interruption from the types of cyber security attacks or other events listed above or other similar actions, and such incidents may go undetected for a period of time.  Such cyber security attacks or other events may result in: 





Possible impacts associated with a cyber security attack or other events may include:  remediation costs related to lost, stolen, or compromised data; repairs to data processing systems; increased cyber security protection costs; adverse effects on our compliance with regulatory and environmental laws and regulation, including standards for drinking water; litigation; and reputational damage.  We maintain insurance to help defray costs associated with cyber security attacks or other events, but we cannot provide assurance that such insurance will provide coverage for any particular type of incident or event or that such insurance will be adequate, and losses incurred may make it difficult for us to secure insurance in the future at acceptable rates.



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Our business is impacted by weather conditions and is subject to seasonal fluctuations, which could harm demand for our water service and our revenues and earnings.



Demand for our water during the warmer months is generally greater than during cooler months due primarily to additional requirements for water in connection with irrigation systems, swimming pools, cooling systems, and other outside water use.  Throughout the year, and particularly during typically warmer months, demand will vary with temperature, rainfall levels and rainfall frequency.  In the event that temperatures during the typically warmer months are cooler than normal, if there is more rainfall than normal, or rainfall is more frequent than normal, the demand for our water may decrease and harm our business, financial condition, and results of operations.



Decreased residential customer water consumption as a result of water conservation efforts may harm demand for our water service and may reduce our revenues and earnings. 



There has been a general decline in water usage per residential customer as a result of an increase in conservation awareness, and the impact of an increased use of more efficient plumbing fixtures and appliances.  These gradual, long-term changes are normally taken into account by the utility commissions in setting rates, whereas short-term changes in water usage, if significant, may not be fully reflected in the rates we charge.  We are dependent upon the revenue generated from rates charged to our residential customers for the volume of water used.  If we are unable to obtain future rate increases to offset decreased residential customer water consumption to cover our investments, expenses, and return for which we initially sought the rate increase, our business, financial condition, and results of operations may be harmed.



Drought conditions and government imposed water use restrictions may impact our ability to serve our current and future customers, and may impact our customers' use of our water, which may harm our business, financial condition, and results of operations.



We depend on an adequate water supply to meet the present and future demands of our customers.  Drought conditions could interfere with our sources of water supply and could harm our ability to supply water in sufficient quantities to our existing and future customers.  An interruption in our water supply could harm our business, financial condition, and results of operations.  Moreover, governmental restrictions on water usage during drought conditions may result in a decreased demand for our water, even if our water supplies are sufficient to serve our customers during these drought conditions, which may harm our business, financial condition, and results of operations.



We employ a portfolio rationalization strategy to focus our operations in areas where we have critical mass and economic growth potential and to divest operations where limited customer growth opportunities exist or where we are unable to achieve favorable operating results or a return on equity that we consider acceptable.   Dispositions we decide to undertake may involve risks which could harm our business, operating results, and financial condition. 



In the event we determine a division, utility system or business should be sold, we may be unable to reach terms that are agreeable to us or find a suitable buyer.  If the business is part of our regulated operations, we may face additional challenges in obtaining regulatory approval for the disposition, and the regulatory approval obtained may include restrictive conditions.  We may be required to continue to hold or assume residual liabilities with respect to the business sold.  The negotiation of potential dispositions as well as the efforts to divest the acquired business could require us to incur significant costs and cause diversion of our management’s time and resources.  Any of these risks may harm our business, financial condition, and results of operations.



Our operations are geographically concentrated in Pennsylvania

Although we operate water and wastewater facilities in a number of states, our operations are concentrated in Pennsylvania.  As a result, our financial results are largely subject to political, water supply, labor, utility cost and regulatory risks, economic conditions, natural disasters and other risks affecting Pennsylvania.



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General economic conditions may affect our financial condition and results of operations. 



A general economic downturn may lead to a number of impacts on our business and may affect our financial condition and results of operations.  Such impacts may include:





General economic turmoil may also lead to an investment market downturn, which may result in our pension and other post-retirement plans’ asset market values suffering a decline and significant volatility.  A decline in our plans’ asset market values could increase our required cash contributions to the plans and expense in subsequent years.  



Our water and wastewater systems may be subject to condemnations or other methods of taking by governmental entities.



In the states where our subsidiaries operate, it is possible that portions of our subsidiaries’ operations could be acquired by municipal governments by one or more of the following methods:





The price to be paid upon such an acquisition by the municipal government is usually determined in accordance with applicable law under eminent domain.  In other instances, the price may be negotiated, fixed by appraisers selected by the parties or computed in accordance with a formula prescribed in the law of the state or in the particular franchise or charter.  We believe that our operating subsidiaries will be entitled to receive fair market value for any assets that are condemned.  However, there is no assurance that the fair market value received for assets condemned will be in excess of book value.



In a very few number of instances, in one of our southern states where there are municipally-owned water or wastewater systems near our operating divisions, the municipally-owned system may either have water distribution or wastewater collection mains that are located adjacent to our division's mains or may construct new mains that parallel our mains.  In these circumstances, on occasion, the municipally-owned system may attempt to offer service to customers who are connected to our mains, resulting in our mains becoming surplus or underutilized without compensation.



The final determination of our income tax liability may be materially different from our income tax provision.



Significant judgment is required in determining our provision for income taxes.  Our calculation of the provision for income taxes is subject to our interpretation of applicable business tax laws in the jurisdictions in which we file.  In addition, our income tax returns are subject to periodic examination by the Internal Revenue Service and other taxing authorities.  In December 2012, Aqua Pennsylvania changed its tax method of accounting to permit the expensing of qualifying utility asset improvement costs that were previously being capitalized and depreciated for tax purposes.  Subsequently, the Company’s other regulated subsidiaries similarly changed their tax method of accounting.  Our determination of what qualifies as a capital cost versus a tax deduction for utility asset improvements is subject to subsequent adjustment and may impact the income tax benefits that have been recognized.  Although we believe our income tax estimates, including any tax reserves for uncertain tax positions or valuation allowances on deferred tax assets are appropriate, there is no assurance that the final determination of our income tax liability will not be materially different; either higher or lower, from what is reflected in our

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income tax provision.  In the event we are assessed additional income taxes, our business, financial condition, and results of operations could be harmed.  



Federal and state environmental laws and regulations impose substantial compliance requirements on our operations.  Our operating costs could be significantly increased in order to comply with new or stricter regulatory standards imposed by federal and state environmental agencies.



Our water and wastewater services are governed by various federal and state environmental protection and health and safety laws and regulations, including the federal Safe Drinking Water Act, the Clean Water Act, Clean Air Act, Resource Conservation and Recovery Act and similar state laws, and federal and state regulations issued under these laws by the EPA and state environmental regulatory agencies.  These laws and regulations establish, among other things, criteria and standards for drinking water and for discharges into the waters of the U.S. as well as dam safety, air emissions, and residuals management.  Pursuant to these laws, we are required to obtain various environmental permits from environmental regulatory agencies for our operations.  We cannot assure you that we will be at all times in total compliance with these laws, regulations and permits.  If we fail to comply with these laws, regulations or permits, we could be fined or otherwise sanctioned by regulators and such noncompliance could result in civil suits.  Environmental laws and regulations are complex and change frequently.  These laws, and the enforcement thereof, have tended to become more stringent over time.  While we have budgeted for future capital and operating expenditures to comply with these laws and our permits, it is possible that new or stricter standards could be imposed that will require additional capital expenditures or raise our operating costs.  Although these expenditures and costs may be recovered in the form of higher rates, there can be no assurance that the various state utility commissions that govern our business would approve rate increases to enable us to recover such expenditures and costs.  In summary, we cannot assure you that our costs of complying with, current and future environmental and health and safety laws will not harm our business, financial condition, and results of operations.



Federal and state environmental laws, regulatory initiatives relating to hydraulic fracturing, changes in technology or hydraulic fracturing processes, and volatility in natural gas prices, could result in reduced demand for raw water utilized in hydraulic fracturing and harm our joint venture business, financial condition, or results of operations.



We have invested in a joint venture for the construction and operation of a private pipeline system to supply raw water to natural gas drilling operations for hydraulic fracturing.  Hydraulic fracturing involves the injection under pressure of water, along with other materials such as sand, into rock formations to stimulate natural gas production.  In general, the environmental community has taken an interest in monitoring and understanding the potential environmental impact of hydraulic fracturing.  Although hydraulic fracturing is currently regulated, in the event the use of hydraulic fracturing is further limited through regulation, our investment in the raw water pipeline may be harmed in the event that demand for raw water is reduced. 



Changes in technology or hydraulic fracturing processes may occur which allows drillers to reuse injected water on a limited basis, or apply treatment processes to allow further reuse of water for drilling.  These changes may reduce demand for raw water. 



Furthermore, natural gas prices have historically been volatile, and are likely to continue to be volatile.  A decrease in demand for natural gas, due to price volatility, could result in reduced demand for raw water utilized in hydraulic fracturing.  In the fourth quarter of 2015, the joint venture recognized an impairment charge on its long-lived assets, which reduced the carrying value of our investment in the joint venture.  The impairment resulted from a marked decline in natural gas prices in 2015, a further reduction in the volume of water sales by the joint venture, which led to a lowered forecast on future sales volumes, as well as changes in the natural gas industry activities in the Marcellus Shale region and general market conditions.  In the event hydraulic fracturing is limited, due to a further reduction in demand for natural gas or other factors affecting the industry, our investment in the raw water pipeline may be harmed should the demand for raw water be reduced. 



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Wastewater operations entail significant risks and may impose significant costs.



Wastewater collection and treatment and septage pumping and sludge hauling involve various unique risks.  If collection or treatment systems fail or do not operate properly, or if there is a spill, untreated or partially treated wastewater could discharge onto property or into nearby streams and rivers, causing various damages and injuries, including environmental damage.  These risks are most acute during periods of substantial rainfall or flooding, which are the main causes of wastewater overflow and system failure.  Liabilities resulting from such damages and injuries could harm our business, financial condition, and results of operations.  



Work stoppages and other labor relations matters could harm our operating results.



Approximately 37% of our workforce is unionized under 15 labor contracts with labor unions, which expire over several years.  In light of rising costs for healthcare and retirement benefits, contract negotiations in the future may be difficult.  We are subject to a risk of work stoppages and other labor actions as we negotiate with the unions to address these issues, which could harm our business, financial condition, and results of operations.  We cannot assure you that issues with our labor forces will be resolved favorably to us in the future or that we will not experience work stoppages.



Significant or prolonged disruptions in the supply of important goods or services from third parties could harm our business, financial condition, and results of operations.



We are dependent on a continuing flow of important goods and services from suppliers for our water and wastewater businesses.  A disruption or prolonged delays in obtaining important supplies or services, such as maintenance services, purchased water, chemicals, water pipe, valves, hydrants, electricity, or other materials, could harm our water or wastewater services and our ability to operate in compliance with all regulatory requirements, which could harm our business, financial condition, and results of operations.  In some circumstances, we rely on third parties to provide important services (such as customer bill print and mail activities or utility service operations in some of our divisions) and a disruption in these services could harm our business, financial condition, and results of operations.  Some possible reasons for a delay or disruption in the supply of important goods and services include:





As a result of any of these factors, we may be required to find alternative suppliers for the materials and services on which we rely.  Accordingly, we may experience delays in obtaining appropriate 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 harm our business, financial condition, and results of operations.



We depend significantly on the services of the members of our management team, and the departure of any of those persons could cause our operating results to suffer.



Our success depends significantly on the continued individual and collective contributions of our management team.  The loss of the services of any member of our management team or the inability to hire and retain experienced management personnel could harm our business, financial condition, and results of operations.



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Climate change laws and regulations have been passed and are being proposed that require compliance with greenhouse gas emissions standards, as well as other climate change initiatives. 



Climate change is receiving ever increasing attention worldwide.  Many scientists, legislators, and others attribute global warming to increased levels of greenhouse gases (“GHG”), including carbon dioxide.  Climate change laws and regulations enacted and proposed limit GHG emissions from covered entities, and require additional monitoring/reporting.  At this time, the existing GHG laws and regulations are not expected to materially harm the Company’s operations or capital expenditures.  However, because of the uncertainty of future climate change regulatory requirements, particularly given the change in the federal administration, we cannot predict the potential impact of future laws and regulations on our business, financial condition, or results of operations.  Although these future expenditures and costs for regulatory compliance may be recovered in the form of higher rates, there can be no assurance that the various state utility commissions that govern our business would approve rate increases to enable us to recover such expenditures and costs. 



Some scientific experts are predicting a worsening of weather volatility in the future, possibly created by the climate change greenhouse gases.  Changing severe weather patterns could require additional expenditures to reduce the risk associated with any increasing storm, flood and drought occurrences.



The issue of climate change is receiving ever increasing attention worldwide.  Many climate change predictions, if true, present several potential challenges to water and wastewater utilities, such as:  increased frequency and duration of droughts, increased precipitation and flooding, potential degradation of water quality, and changes in demand for services.  We maintain an ongoing facility planning process, and this planning or the enactment of new standards may result in the need for additional capital expenditures or raise our operating costs.  Because of the uncertainty of weather volatility related to climate change, we cannot predict its potential impact on our business, financial condition, or results of operations.  Although any potential expenditures and costs may be recovered in the form of higher rates, there can be no assurance that the various state utility commissions that govern our business would approve rate increases to enable us to recover such expenditures and costs.  We cannot assure you that our costs of complying with any climate change weather related measures will not harm our business, financial condition, or results of operations.











None







Our properties consist of water transmission and distribution mains and wastewater collection pipelines, water and wastewater treatment plants, pumping facilities, wells, tanks, meters, pipes, dams, reservoirs, buildings, vehicles, land, easements, rights-of-way, and other facilities and equipment used for the operation of our systems, including the collection, treatment, storage, and distribution of water and the collection and treatment of wastewater.  Substantially all of our treatment, storage, and distribution properties are owned by our subsidiaries, and a substantial portion of our property is subject to liens of mortgage or indentures.  These liens secure bonds, notes and other evidences of long-term indebtedness of our subsidiaries.  For some properties that we acquired through the exercise of the power of eminent domain and other properties we purchased, we hold title for water supply purposes only.  We own, operate and maintain over twelve thousand miles of transmission and distribution mains, 21 surface water treatment plants, many well treatment stations, and 187 wastewater treatment plants.  A small portion of the properties are leased under long-term leases.



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The following table indicates our net property, plant and equipment, in thousands of dollars, as of December 31, 2016 in the principal states where we operate:









We believe that our properties are generally maintained in good condition and in accordance with current standards of good water and wastewater industry practice.  We believe that our facilities are adequate and suitable for the conduct of our business and to meet customer requirements under normal circumstances.



Our corporate offices are leased from our subsidiary, Aqua Pennsylvania, and are located in Bryn Mawr, Pennsylvania.









There are various legal proceedings in which we are involved.  Although the results of legal proceedings cannot be predicted with certainty, there are no pending legal proceedings, other than as set forth below, to which we or any of our subsidiaries is a party or to which any of our properties is the subject that we believe are material or are expected to materially harm our business, operating results or financial condition. 













Not applicable.

PART II





Our common stock is traded on the New York Stock Exchange under the ticker symbol WTR.  As of February 13, 2017, there were approximately 24,649 holders of record of our common stock.



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The following table shows the high and low intraday sales prices for our common stock as reported on the New York Stock Exchange composite transactions reporting system and the cash dividends paid per share for the periods indicated: 







We have paid dividends consecutively for 72 years.  On August 2, 2016, our Board of Directors authorized an increase of 7.5% in the September 1, 2016 quarterly dividend over the dividend Aqua America paid in the previous quarter.  As a result of this authorization, beginning with the dividend payment in September 2016, the annualized dividend rate increased to $0.7652 per share.  This is the 26th dividend increase in the past 25 years and the 18th consecutive year that we have increased our dividend in excess of five percent.  We presently intend to pay quarterly cash dividends in the future, on March 1, June 1, September 1, and December 1, subject to our earnings and financial condition, restrictions set forth in our debt instruments, regulatory requirements and such other factors as our Board of Directors may deem relevant.  In 2016, our dividends paid represented 55.9% of net income.

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The following table summarizes the Company’s purchases of its common stock for the quarter ending December 31, 2016:



















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Summary of Selected Financial Data (Unaudited)

Aqua America, Inc. and Subsidiaries

(In thousands of dollars, except per share amounts)







 

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OVERVIEW



The following discussion and analysis of our financial condition and results of operations should be read together with our Consolidated Financial Statements and related Notes included in this Annual Report.  This discussion contains forward-looking statements that are based on management’s current expectations, estimates and projections about our business, operations and financial performance.  All dollar amounts are in thousands of dollars, except per share amounts. 



The Company

Aqua America, Inc., (referred to as “Aqua America”, the “Company”, “we”, “us”, or “our”), a Pennsylvania corporation, is the holding company for regulated utilities providing water or wastewater services to what we estimate to be almost three million people in Pennsylvania, Ohio, Texas, Illinois, North Carolina, New Jersey, Indiana, and Virginia.  Our largest operating subsidiary is Aqua Pennsylvania, Inc., which accounted for approximately 52% of our operating revenues and approximately 74% of our net income for 2016.  As of December 31, 2016, Aqua Pennsylvania provided water or wastewater services to approximately one-half of the total number of people we serve. Aqua Pennsylvania’s service territory is located in the suburban areas in counties north and west of the City of Philadelphia and in 27 other counties in Pennsylvania.  Our other regulated utility subsidiaries provide similar services in seven other states.  In addition, the Company’s market-based activities are conducted through Aqua Resources, Inc. and Aqua Infrastructure, LLC.  Aqua Resources provides water and wastewater service through operating and maintenance contracts with municipal authorities and other parties close to our utility companies’ service territories; and offers, through a third party, water and sewer line repair service and protection solutions to households. 



In 2016, the Company sold the following business units of Aqua Resources, which were reported as assets held for sale in the Company’s consolidated balance sheets:



 

Additionally, in 2016, the Company decided to market for sale a business unit within Aqua Resources, which installs and tests devices that prevent the contamination of potable water, for which the sale was completed in January 2017, and a business unit that repairs and performs maintenance on water and wastewater systems.  These business units are reported as assets held for sale in the Company’s consolidated balance sheets. Aqua Infrastructure provides non-utility raw water supply services for firms in the natural gas drilling industry. 



Industry Mission

The mission of the investor-owned water utility industry is to provide quality and reliable water service at reasonable rates to customers, while earning a fair return for shareholders.  A number of challenges face the industry, including:





Economic Regulation

Most of our water and wastewater utility operations are subject to regulation by their respective state utility commissions, which have broad administrative power and authority to regulate billing rates, determine franchise areas and conditions of service, approve acquisitions, and authorize the issuance of securities.  The utility commissions also generally establish uniform systems of accounts and approve the terms of contracts with affiliates and customers, business combinations with other utility systems, and loans and other financings.  The policies of the utility commissions often differ from state to

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state, and may change over time.  A small number of our operations are subject to rate regulation by county or city government.  Over time, the regulatory party in a particular state may change, as was the case for our Texas operations where, in 2014, economic regulation changed from the Texas Commission on Environmental Quality to the Texas Public Utility Commission.  The profitability of our utility operations is influenced to a great extent by the timeliness and adequacy of rate allowances in the various states in which we operate.  One consideration we may undertake in evaluating which states to focus our growth and investment strategy is whether a state provides for consolidated rates, a surcharge for replacing and rehabilitating infrastructure and other systems, and other regulatory policies that promote infrastructure investment and efficiency in processing rate cases.



Rate Case Management Capability – We strive to achieve the industry’s mission by effective planning, efficient investments, and productive use of our resources.  We maintain a rate case management capability to pursue timely and adequate returns on the capital investments that we make in improving our distribution system, treatment plants, information technology systems, and other infrastructure.  This capital investment creates assets that are used and useful in providing utility service, and is commonly referred to as rate base.  Timely, adequate rate relief is important to our continued profitability and in providing a fair return to our shareholders, and thus providing access to capital markets to help fund these investments.  Accordingly, the objective of our rate case management strategy is to provide that the rates of our utility operations reflect, to the extent practicable, the timely recovery of increases in costs of operations (primarily labor and employee benefits, electricity, chemicals, transportation, maintenance expenses, insurance and claims costs, and costs to comply with environmental regulations), capital, and taxes.  In pursuing our rate case strategy, we consider the amount of net utility plant additions and replacements made since the previous rate decision, the changes in the cost of capital, changes in our capital structure, and changes in operating and other costs.  Based on these assessments, our utility operations periodically file rate increase requests with their respective state utility commissions or local regulatory authorities.  In general, as a regulated enterprise, our water and wastewater rates are established to provide full recovery of utility operating costs, taxes, interest on debt used to finance capital investments, and a return on equity used to finance capital investments.  Our ability to recover our expenses in a timely manner and earn a return on equity employed in the business helps determine the profitability of the Company.  As of December 31, 2016, the Company’s rate base is estimated to be $3,750,000, which is comprised of:





Our water and wastewater operations are composed of 53 rate divisions, each of which requires a separate rate filing for the evaluation of the cost of service and recovery of investments in connection with the establishment of tariff rates for that rate division.  When feasible and beneficial to our utility customers, we have sought approval from the applicable state utility commission to consolidate rate divisions to achieve a more even distribution of costs over a larger customer base.  All of the eight states in which we operate currently permit us to file a revenue requirement using some form of consolidated rates for some or all of the rate divisions in that state.  



Revenue Surcharges – Six states in which we operate water utilities, and five states in which we operate wastewater utilities, permit us to add a surcharge to water or wastewater bills to offset the additional depreciation and capital costs associated with capital expenditures related to replacing and rehabilitating infrastructure systems.  In all other states, water and wastewater utilities absorb all of the depreciation and capital costs of these projects between base rate increases without the benefit of additional revenues.  The gap between the time that a capital project is completed and the recovery of its costs in rates is known as regulatory lag.  This surcharge is intended to substantially reduce regulatory lag, which often acts as a disincentive to water and wastewater utilities to rehabilitate their infrastructure.  In addition, some states permit our subsidiaries to use a surcharge or credit on their bills to reflect allowable changes in costs, such as changes in state tax rates, other taxes and purchased water costs, until such time as the new costs are fully incorporated in base rates.



Effects of Inflation – Recovery of the effects of inflation through higher water and wastewater rates is dependent upon receiving adequate and timely rate increases.  However, rate increases are not retroactive and often lag increases in costs caused by inflation.  On occasion, our regulated utility companies may enter into rate settlement agreements, which require us to wait for a period of time to file the next base rate increase request.  These agreements may result in

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regulatory lag whereby inflationary increases in expenses may not yet be reflected in rates, or a gap may exist between when a capital project is completed and the start of its recovery in rates.  Even during periods of moderate inflation, the effects of inflation can have a negative impact on our operating results. 



Growth-Through-Acquisition Strategy

Part of our strategy to meet the industry challenges is to actively explore opportunities to expand our utility operations through acquisitions of water and wastewater utilities either in areas adjacent to our existing service areas or in new service areas, and to explore acquiring market-based businesses that are complementary to our regulated water and wastewater operations.  To complement our growth strategy, we routinely evaluate the operating performance of our individual utility systems, and in instances where limited economic growth opportunities exist or where we are unable to achieve favorable operating results or a return on equity that we consider acceptable, we will seek to sell the utility system and reinvest the proceeds in other utility systems.  Consistent with this strategy, we are focusing our acquisitions and resources in states where we have critical mass of operations in an effort to achieve economies of scale and increased efficiency.  Our growth-through-acquisition strategy allows us to operate more efficiently by sharing operating expenses over more utility customers and provides new locations for possible future growth.  Another element of our growth strategy is the consideration of opportunities to expand by acquiring other utilities, including those that may be in a new state if they provide promising economic growth opportunities and a return on equity that we consider acceptable.  The ability to successfully execute this strategy and meet the industry challenges is largely due to our core competencies, financial position, and our qualified and trained workforce, which we strive to retain by treating employees fairly and providing our employees with development and growth opportunities.



During 2016, we completed 19 acquisitions, which along with the organic growth in our existing systems, represents 15,282 new customers.  During 2015, we completed 16 acquisitions, which along with the organic growth in our existing systems, represents 17,747 new customers.  During 2014, we completed 16 acquisitions, which along with the organic growth in our existing systems, represents 12,120 new customers. 



In addition to acquisitions, from time to time, we sell utility systems or relinquish ownership in systems through condemnation.  Consistent with our strategy to evaluate future growth opportunities and the financial performance of our individual utility systems, we divested our wastewater treatment facility in Georgia in March 2014.  In addition, in December 2014, we sold our water utility systems in Fort Wayne, Indiana.  



The operating results, cash flows, and financial position of the Company’s water utility systems in Fort Wayne, Indiana and Georgia were presented in the Company’s consolidated financial statements as discontinued operations.



We believe that utility acquisitions, organic growth, and expansion of our market-based business will continue to be the primary sources of growth for us.  With approximately 53,000 community water systems in the U.S., 82% of which serve less than 3,300 customers, the water industry is the most fragmented of the major utility industries (telephone, natural gas, electric, water and wastewater).  In the states where we operate regulated utilities, we believe there are approximately 14,500 community water systems of widely-varying size, with the majority of the population being served by government-owned water systems.



Although not as fragmented as the water industry, the wastewater industry in the U.S. also presents opportunities for consolidation.  According to the U.S. Environmental Protection Agency’s (“EPA”) most recent survey of wastewater treatment facilities (which includes both government-owned and privately-owned facilities) in 2012, there are approximately 15,000 such facilities in the nation serving approximately 76% of the U.S. population.  The remaining population represents individual homeowners with their own treatment facilities; for example, community on-lot disposal systems and septic tank systems.  The vast majority of wastewater facilities are government-owned rather than privately-owned.  The EPA survey also indicated that there are approximately 4,000 wastewater facilities in operation in the states where we operate regulated utilities.



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Because of the fragmented nature of the water and wastewater utility industries, we believe that there are many potential water and wastewater system acquisition candidates throughout the United States.  We believe the factors driving the consolidation of these systems are:





We are actively exploring opportunities to expand our water and wastewater utility operations through regulated utility acquisitions or otherwise, including the management of publicly-owned facilities in a public-private partnership.  We intend to continue to pursue acquisitions of government-owned and privately-owned water and wastewater utility systems that provide services in areas near our existing service territories or in new service areas.  It is our intention to focus on growth opportunities in states where we have critical mass, which allows us to improve economies of scale through spreading our fixed costs over more customers – this cost efficiency should enable us to reduce the size of future rate increases.  Currently, the Company seeks to acquire businesses in the U.S. regulated sector, which includes water and wastewater utilities and other regulated utilities, and to pursue growth ventures in market-based activities, such as infrastructure opportunities that are supplementary and complementary to our regulated businesses.  



Sendout

Sendout represents the quantity of treated water delivered to our distribution systems.  We use sendout as an indicator of customer demand.  Weather conditions tend to impact water consumption, particularly during the late spring, summer, and early fall when discretionary and recreational use of water is at its highest.  Consequently, a higher proportion of annual operating revenues are realized in the second and third quarters. In general, during this period, an extended period of hot and dry weather increases water consumption, while above-average rainfall and cool weather decreases water consumption.  Conservation efforts, construction codes that require the use of low-flow plumbing fixtures, as well as mandated water use restrictions in response to drought conditions can reduce water consumption.  We believe an increase in conservation awareness by our customers, including the increased use of more efficient plumbing fixtures and appliances, may continue to result in a long-term structural trend of declining water usage per customer.  These gradual long-term changes are normally taken into account by the utility commissions in setting rates, whereas significant short-term changes in water usage, resulting from drought warnings, water use restrictions, or extreme weather conditions, may not be fully reflected in the rates we charge between rate proceedings.  



On occasion, drought warnings and water use restrictions are issued by governmental authorities for portions of our service territories in response to extended periods of dry weather conditions, regardless of our ability to meet unrestricted customer water demands.  The timing and duration of the warnings and restrictions can have an impact on our water revenues and net income.  In general, water consumption in the summer months is affected by drought warnings and restrictions to a higher degree because discretionary and recreational use of water is highest during the summer months, particularly in our northern service territories. At other times of the year, warnings and restrictions generally have less of an effect on water consumption.  Currently, portions of our Pennsylvania (four counties), New Jersey, and Texas service areas are under drought warnings.  The entire Pennsylvania and New Jersey service areas are under drought watch.  Portions of our northern and central Texas service areas have conservation water restrictions.  Drought warnings and watches result in the public being asked to voluntarily reduce water consumption.     



The geographic diversity of our utility customer base reduces the effect of our exposure to extreme or unusual weather conditions in any one area of the country.  During the year ended December 31, 2016, our operating revenues were derived principally from the following states:  approximately 52% in Pennsylvania, 13% in Ohio, 9% in Texas, 8% in Illinois, and 7% in North Carolina.

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Performance Measures Considered by Management

We consider the following financial measures (and the period to period changes in these financial measures) to be the fundamental basis by which we evaluate our operating results:





In addition, we consider other key measures in evaluating our utility business performance within our Regulated segment:





 Furthermore, we review the measure of earnings before unusual items that are noncash and not directly related to our core business, such as the measure of adjusted earnings to remove the joint venture impairment charge, which was recognized in the fourth quarter of 2015.  Refer to Note 1 – Summary of Significant Accounting Policies – Investment in Joint Venture in this Annual Report for information regarding the impairment charge.  We review these measurements regularly and compare them to historical periods, to our operating budget as approved by our Board of Directors, and to other publicly-traded water utilities.



Our operating expense ratio is one measure that we use to evaluate our operating efficiency and management effectiveness of our regulated operations.  Our operating expense ratio is affected by a number of factors, including the following:







We continue to evaluate initiatives to help control operating costs and improve efficiencies.

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Consolidated Selected Financial and Operating Statistics

Our selected five-year consolidated financial and operating statistics follow:





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RESULTS OF OPERATIONS



Our income from continuing operations has grown at an annual compound rate of approximately 10.9% and our net income has grown at an annual compound rate of approximately 10.4% during the five-year period ended December 31, 2016.  During the past five years, operating revenues grew at a compound rate of 3.8% and operating expenses grew at a compound rate of 4.2%.    



Operating Segments

We have identified ten operating segments and we have one reportable segment based on the following: 





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Unless specifically noted, the following discussion and analysis provides information on our consolidated results of continuing operations.  The following table provides the Regulated segment and consolidated information for the years ended December 31, 2016, 2015, and 2014:



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Consolidated Results

Operating Revenues – Operating revenues totaled $819,875 in 2016, $814,204 in 2015, and $779,903 in 2014.  The growth in revenues over the past three years is a result of increases in our customer base and our water and wastewater rates.  The number of customers increased at an annual compound rate of 1.4% over the past three years due to acquisitions and organic growth, adjusted to exclude customers associated with utility system dispositions.  Acquisitions in our Regulated segment have provided additional water and wastewater revenues of $8,201 in 2016, $8,900, in 2015, and $2,732 in 2014.  Rate increases implemented during the past three years have provided additional operating revenues of $4,319 in 2016, $8,503 in 2015, and $5,250 in 2014.   



On June 7, 2012, Aqua Pennsylvania reached a settlement agreement in its last rate filing with the Pennsylvania Public Utility Commission, which in addition to a water rate increase, provided for a reduction in current income tax expense as a result of the recognition of qualifying income tax benefits upon Aqua Pennsylvania changing its tax accounting method to permit the expensing of qualifying utility asset improvement costs that historically had been capitalized and depreciated for book and tax purposes.  In December 2012, Aqua Pennsylvania implemented this change which provides for the flow-through of income tax benefits that resulted in a substantial reduction in income tax expense and greater net income and cash flow.  As a result, Aqua Pennsylvania was able to suspend its water Distribution System Improvement Charges in 2013 and lengthen the amount of time until the next Aqua Pennsylvania rate case is filed.  During 2016, 2015, and 2014, the income tax accounting change resulted in income tax benefits of $78,530, $72,944, and $69,048 that reduced the Company’ current income tax expense and increased net income.  The Company recognized a tax deduction on its 2012 Federal tax return of $380,000 for qualifying capital expenditures made prior to 2012, and based on the settlement agreement, beginning in 2013, the Company began to amortize 1/10th of these expenditures, or $38,000 annually, which reduced income tax expense and increased the Company’s net income by $16,734, which is included in the income tax benefits noted in the previous sentence.  In accordance with the settlement agreement, this amortization is expected to reduce income tax expense during periods when qualifying parameters are met.  Aqua Pennsylvania expects to file an infrastructure investment surcharge in 2017 and expects to file a rate case in 2018, with resolution of the rate case expected in 2019.     



Our operating subsidiaries received rate increases representing estimated annualized revenues of $3,589 in 2016 resulting from seven rate decisions, $3,347 in 2015 resulting from four rate decisions, and $9,886 in 2014 resulting from twelve rate decisions,.  Revenues from these increases realized in the year of grant were $1,801 in 2016, $2,887 in 2015, and $5,375 in 2014.  As of December 31, 2016, our operating subsidiaries have filed two rate requests, which are being reviewed by the state utility commissions, proposing an aggregate increase of $7,976 in annual revenues.  During 2017, we intend to file three additional rate requests proposing an aggregate of approximately $13,425 of increased annual revenues; the timing and extent to which our rate increase requests may be granted will vary by state.



Currently, Pennsylvania, Illinois, Ohio, Indiana, New Jersey, and North Carolina allow for the use of a surcharge for replacing and rehabilitating infrastructure systems.  The rate increases under this surcharge typically adjust periodically based on additional qualified capital expenditures completed or anticipated in a future period.  This surcharge is capped as a percentage of base rates, generally at 5% to 12.75% of base rates, and is reset to zero when new base rates that reflect the costs of those additions become effective or when a utility’s earnings exceed a regulatory benchmark.  These surcharges provided revenues of $7,379 in 2016, $3,261 in 2015, and $4,598 in 2014.    



Our Regulated segment also includes operating revenues of $10,357 in 2016, $10,746 in 2015, and $9,934 in 2014 associated with contract operations that are integrated into the regulated utility business and operations.  These amounts vary over time according to the level of activity associated with the utility contract operations.



In addition to the Regulated segment operating revenues, we recognized market-based revenues that are associated with Aqua Resources and Aqua Infrastructure of $20,091 in 2016, $34,909 in 2015, and $24,189 in 2014.  The decrease in revenues in 2016 is due to the disposition of business units within Aqua Resources.    



Operations and Maintenance Expenses – Operations and maintenance expenses totaled $304,897 in 2016, $309,310 in 2015, and $288,556 in 2014.  Most elements of operating costs are subject to the effects of inflation and changes in the

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number of customers served.  Several elements are subject to the effects of changes in water consumption, weather, and the degree of water treatment required due to variations in the quality of the raw water.  The principal elements of operating costs are labor and employee benefits, electricity, chemicals, transportation, maintenance expenses, insurance and claims costs, and costs to comply with environmental regulations.  Electricity and chemical expenses vary in relationship to water consumption, raw water quality, and price changes.  Maintenance expenses are sensitive to extremely cold weather, which can cause water mains to rupture, resulting in additional costs to repair the affected main.

Operations and maintenance expenses decreased in 2016 as compared to 2015 by $4,413 or 1.4%, primarily due to:





Operations and maintenance expenses increased in 2015 as compared to 2014 by $20,754 or 7.2%, primarily due to: 





The increase in water production costs of $3,401 was impacted by an increase in energy costs resulting from the extreme cold temperatures experienced in many of our service territories in the first quarter of 2015.

   

Depreciation and Amortization Expenses – Depreciation expense was $130,987 in 2016, $125,290 in 2015, and $123,054 in 2014, and has increased principally as a result of the significant capital expenditures made to expand and improve our utility facilities, and our acquisitions of new utility systems.  The increase for 2015 was impacted by the absence of a credit recognized in 2014 for the effect of decreased depreciation rates implemented in our Texas operating subsidiary, offset by a decrease in depreciation rates, implemented in 2015, for Aqua Pennsylvania. 



Amortization expense was $2,021 in 2016, $3,447 in 2015, and $3,481 in 2014, and has decreased primarily due to the completion of the recovery of our costs associated with various rate filings.  Expenses associated with filing rate cases are deferred and amortized over periods that generally range from one to three years.



Taxes Other than Income Taxes – Taxes other than income taxes totaled $56,385 in 2016, $55,057 in 2015, and $50,453 in 2014.  The increase in 2016 was primarily due to an increase of $578 for pumping fees in Texas due to higher water production, a rate increase, and the addition of two water systems, and an increase in gross receipts, excise and franchise taxes of $502.  The increase in 2015 was primarily due to an increase in property taxes of $2,412 largely due to the effect of a non-recurring credit realized in 2014 that resulted in a reduction in property taxes for our Ohio operating subsidiary. 



Interest Expense, net – Net interest expense was $80,594 in 2016, $76,536 in 2015, and $76,397 in 2014.  Interest income of $217 in 2016, $272 in 2015, and $316 in 2014 was netted against interest expense.  Net interest expense increased in 2016 due to an increase in average short-term borrowings of $9,808 at higher short-term interest rates and an increase in average outstanding fixed rate long-term debt of $98,006 partially offset by a decline in long-term interest rates.  Net

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interest expense increased in 2015 due to an increase in average short-term borrowings of $13,977 and an increase in average outstanding fixed rate long-term debt of $91,785, partially offset by a decline in long-term interest rates.  Interest income decreased in 2015 due to lower investment rates.  The weighted average cost of fixed rate long-term debt was 4.26% at December 31, 2016, 4.57% at December 31, 2015, and 4.85% at December 31, 2014.  The weighted average cost of fixed and variable rate long-term debt was 4.23% at December 31, 2016, 4.44% at December 31, 2015, and 4.65% at December 31, 2014. 



Allowance for Funds Used During Construction – The allowance for funds used during construction (“AFUDC”) was $8,815 in 2016, $6,219 in 2015, and $5,134 in 2014, and varies as a result of changes in the average balance of utility plant construction work in progress, to which AFUDC is applied, changes in the AFUDC rate which is based predominantly on short-term interest rates, changes in the balance of short-debt, changes in the amount of AFUDC related to equity, and changes in the average balance of the proceeds held from tax-exempt bond issuances that are restricted to funding specific capital projects.  The increase in 2016 and 2015 is primarily due to an increase in the AFUDC rate as a result of an increase in the amount of AFUDC related to equity and in 2016 and 2015 an increase in the average balance of utility plant construction work in progress, to which AFUDC is applied.  The amount of AFUDC related to equity was $6,561 in 2016, $4,621 in 2015, and $3,640 in 2014.      



(Gain) Loss on Sale of Other Assets – (Gain) loss on sale of other assets totaled $(378) in 2016, $(468) in 2015, and $4 in 2014, and consists of the sales of property, plant and equipment and marketable securities. 



Gain on Extinguishment of Debt – The gain on extinguishment of debt of $678 in 2015 results from the recognition of the unamortized issuance premium for the early redemption of $95,985 of tax-exempt bonds at 5.00% that were originally maturing between 2035 and 2038.



Equity (Earnings) Loss in Joint Venture – Equity (earnings) loss in joint venture totaled $(976) in 2016, $35,177 in 2015, and $3,989 in 2014.  The equity earnings in 2016 resulted from the recognition of a connection fee earned by the joint venture in 2016 for which our share was $1,831 and a reduction in depreciation expense resulting from the noncash impairment charge recognized by the joint venture on its long-lived assets in 2015.  The increase in equity loss in joint venture in 2015 of $31,188 is primarily due to a noncash impairment charge recognized by the joint venture on its long-lived assets for which our share was $32,975, partially offset by a decrease in depreciation expense resulting from the 2015 increase in depreciable life for the joint venture’s pipeline assets.  The impairment charge was recognized in the fourth quarter of 2015 as a result of a determination that the long-lived assets, primarily consisting of a pipeline and pump station, had become impaired due to a marked decline in natural gas prices in 2015, and in particular a further decline in the fourth quarter of 2015, a distinguishable reduction in the volume of water sales by the joint venture which led to a lowered forecast in the fourth quarter of 2015 on future water sales volumes by the joint venture, as well as changes in the natural gas industry and market conditions.  These market conditions were largely associated with natural gas prices, which sharply declined in the fourth quarter and this downturn no longer appeared to be temporary and instead may be a long-term condition. 



Income Taxes – Our effective income tax rate was 8.2% in 2016, 6.9% in 2015, and 10.5% in 2014.  The effective income tax rate for 2016, 2015, and 2014 was affected by the 2012 income tax accounting change for qualifying utility asset improvements at Aqua Pennsylvania which resulted in a $78,530, $72,944, and $69,048 net reduction to the Company’s 2016, 2015, and 2014 Federal and state income tax expense, respectively.  As of December 31, 2016, the Company has an unrecognized tax benefit related to the Company’s change in its tax accounting method for qualifying utility asset improvement costs, of which $20,674 of these tax benefits would further reduce the Company’s effective income tax rate in the event the Company does sustain all, or a portion, of its tax position in the period this information is determined.        



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Summary –





The changes in the per share income from continuing operations in 2016 and 2015 over the previous years were due to the aforementioned changes.   



Although we have experienced increased income in the recent past, continued adequate rate increases reflecting increased operating costs and new capital investments, as well as a continuation of income tax benefits related to eligible utility asset improvement costs are important to the future realization of improved profitability.

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Fourth Quarter Results – The following table provides our fourth quarter results:









The decrease in operating revenues of $268 was primarily due to a decrease in market-based activities revenue of $4,945 due to dispositions, offset by an increase in customer water consumption, additional revenues of $1,235 associated with a larger customer base due to utility acquisitions, and an increase in water and wastewater rates of $1,124. 



The decrease in operations and maintenance expense of $306 is due primarily to a decrease in market-based activities expenses of $4,169, and a decrease in the Company’s self-insured employee medical benefit program expense of $1,229, partially offset by an increase in postretirement benefits expense of $1,533, and additional operating costs associated with acquisitions of $500. 



Depreciation expense increased by $1,582 primarily due to the utility plant placed in service since December 31, 2015. 



The increase in other taxes of $1,313 is primarily due to an increase in property taxes of $900. 



Interest expense increased by $726 due to an increase in the average outstanding debt balance. 



The gain on extinguishment of debt recognized in 2015 is due to the recognition of the unamortized premium associated with the early redemption of long-term debt. 



The decrease in equity loss in joint venture of $33,514 is primarily due to the effect of the noncash impairment charge recognized in 2015 by the joint venture (discussed below under “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Consolidated Cash Flow and Capital Expenditures – Joint Venture”) for which our share was $32,975. 



The provision for income taxes increased by $8,180 primarily as a result of the change in income before income taxes.

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LIQUIDITY AND CAPITAL RESOURCES



Consolidated Cash Flow and Capital Expenditures

Net operating cash flows from continuing operations, dividends paid on common stock, capital expenditures used in continuing operations, including allowances for funds used during construction, and expenditures for acquiring water and wastewater systems for our continuing operations for the five years ended December 31, 2016 were as follows:





Included in capital expenditures for the five-year period are: expenditures for the rehabilitation of existing water and wastewater systems, the expansion of our water and wastewater systems, modernization and replacement of existing treatment facilities, water meters, office facilities, information technology, vehicles, and equipment.  During this five-year period, we received $31,166 of customer advances and contributions in aid of construction to finance new water mains and related facilities that are not included in the capital expenditures presented in the above table.  In addition, during this period, we have made repayments of debt of $914,684, and have refunded $22,029 of customers’ advances for construction.  Dividends increased during the past five years as a result of annual increases in the dividends declared and paid and increases in the number of shares outstanding.



Our planned 2017 capital program, exclusive of the costs of new mains financed by advances and contributions in aid of construction, is estimated to be more than $450,000 in infrastructure improvements for the communities we serve.  The 2017 capital program is expected to include $206,900 for infrastructure rehabilitation surcharge qualified projects, of which $175,800 is for Aqua Pennsylvania.  On January 1, 2013, Aqua Pennsylvania reset its water infrastructure rehabilitation surcharge to zero resulting from the change in its tax method of accounting for qualifying utility asset improvements as described below.  Although we were not eligible to use an infrastructure rehabilitation surcharge with our Aqua Pennsylvania water customers since 2012, we were able to use the income tax savings derived from the qualifying utility asset improvements to continue to maintain a similar capital investment program as 2012.  Our planned 2017 capital program in Pennsylvania is estimated to be approximately $304,000 a portion of which is expected to be eligible as a deduction for qualifying utility asset improvements for Federal income tax purposes.  Our overall 2017 capital program, along with $150,671 of debt repayments, and $200,395 of other contractual cash obligations, as reported in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Contractual Obligations”, has been, or is expected to be, financed through internally-generated funds, our revolving credit facilities, and the issuance of long-term debt.



Future utility construction in the period 2018 through 2019, including recurring programs, such as the ongoing replacement or rehabilitation of water meters, water mains, water treatment plant upgrades, storage facility renovations, and additional transmission mains to meet customer demands, exclusive of the costs of new mains financed by advances and contributions in aid of construction, is estimated to require aggregate expenditures of approximately $826,000.  We anticipate that less than one-half of these expenditures will require external financing.  We expect to refinance $193,532 of long-term debt during this period as they become due with new issues of long-term debt, internally-generated funds, and our revolving credit facilities.  The estimates discussed above do not include any amounts for possible future acquisitions of water and wastewater systems or the financing necessary to support them.



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Our primary sources of liquidity are cash flows from operations (including the allowed deferral of Federal income tax payments), borrowings under various short-term lines of credit and other credit facilities, and customer advances and contributions in aid of construction.  Our cash flow from operations, or internally-generated funds, is impacted by the timing of rate relief, water consumption, and changes in Federal tax laws with respect to accelerated tax depreciation or deductions for utility construction projects.  We fund our capital and typical acquisitions through internally-generated funds, supplemented by short-term lines of credit.  Over time, we partially repay or pay-down our short-term lines of credit with long-term debt.  The ability to finance our future construction programs, as well as our acquisition activities, depends on our ability to attract the necessary external financing and maintain internally-generated funds.  Rate orders permitting compensatory rates of return on invested capital and timely rate adjustments will be required by our operating subsidiaries to achieve an adequate level of earnings and cash flow to enable them to secure the capital they will need to operate and to maintain satisfactory debt coverage ratios.



On June 7, 2012, Aqua Pennsylvania reached a settlement agreement in its rate filing with the Pennsylvania Public Utility Commission, which in addition to a water rate increase, provided for a reduction in current income tax expense as a result of the recognition of qualifying income tax benefits upon Aqua Pennsylvania changing its tax accounting method to permit the expensing of qualifying utility asset improvement costs that have historically been capitalized and depreciated for book and tax purposes.  In December 2012, Aqua Pennsylvania implemented this change, which resulted in a substantial reduction in income tax expense and greater net income and cash flow, and as a result allowed Aqua Pennsylvania to suspend its water Distribution System Improvement Charges in 2013 and lengthen the amount of time until the next Aqua Pennsylvania rate case is filed.  As a result of the Pennsylvania rate order, income tax benefits reduced the Company’s current income tax expense and increased net income by $69,048 in 2014, $72,944 in 2015, and $78,530 in 2016.  The Company recognized a tax deduction on its 2012 Federal tax return of $380,000 for qualifying capital expenditures made prior to 2012, and based on the settlement agreement, beginning in 2013, the Company began to amortize 1/10th of these expenditures or $38,000 annually, which reduced income tax expense and increased the Company’s net income by $16,734.  In accordance with the settlement agreement, this amortization is expected to reduce income tax expense during periods when qualifying parameters are met.  During 2013, our Ohio and North Carolina operating divisions implemented this change in tax accounting method.  These divisions currently do not employ a method of accounting that provides for a reduction in current income taxes as a result of the recognition of income tax benefits, and as such the change in the Company’s tax method of accounting in these operating divisions has no impact on our effective income tax rate.



The deduction for qualifying utility asset improvements is anticipated to continue in 2017 and beyond.  Our 2017 earnings will be impacted by the following factors in Aqua Pennsylvania:  the deduction for qualifying utility asset improvements in 2017 is expected to reduce current income tax expense and the ten year amortization of the qualifying capital expenditures made prior to 2012 is also expected to reduce current income tax expense; offset by the effect of regulatory lag. 

    

Acquisitions

During the past five years, we have expended cash of $189,273 and issued 439,943 shares of common stock, valued at $12,845 at the time of acquisition, related to the acquisition of utility systems, both water and wastewater utilities, as well as investments in supplying raw water to the natural gas drilling industry. 



In January 2016, we acquired the water and wastewater utility system assets of Superior Water Company, Inc., which provided public water service to approximately 3,900 customers in portions of Berks, Chester, and Montgomery counties in Pennsylvania.  The total purchase price for the utility system was $16,750, which consisted of the issuance of 439,943 shares of the Company’s common stock and $3,905 in cash.  Additionally, during 2016, we completed 18 acquisitions of water and wastewater utility systems for $5,518 in cash in eight of the states in which we operate in. 



In April 2015, we acquired the water and wastewater utility system assets of North Maine Utilities, located in the Village of Glenview, Illinois.  The total purchase price consisted of $23,079 in cash.  Additionally, during 2015, we completed 14 acquisitions of water and wastewater utility systems for $5,210 in cash in six of the states in which we operate. 



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During 2014, we completed 16 acquisitions of water and wastewater utility systems for $10,530 in cash in seven of the states in which we operate.  Further, in 2014, we acquired two market-based businesses that specialized in inspecting, cleaning and repairing storm and sanitary sewer lines, as well as providing water distribution system services and training to waterworks operators.  The total purchase price in aggregate was $4,810 and both these businesses were subsequently sold in November 2016 and January 2017. 



During 2013, we completed 15 acquisitions of water and wastewater utility systems for $14,997 in cash in four of the states in which we operate. 



As part of the Company’s growth-through-acquisition strategy, in July 2011, the Company entered into a definitive agreement with American Water to purchase all of the stock of the subsidiary that held American Water’s regulated water and wastewater operations in Ohio.  American Water’s Ohio operations served approximately 59,000 customers.  On May 1, 2012, the Company completed its acquisition of American Water’s water and wastewater operations in Ohio.  The total purchase price at closing consisted of $102,154 in cash plus specific assumed liabilities, including debt of $14,281, as adjusted pursuant to the purchase agreement based on book value at closing.  The transaction has been accounted for as a business combination.  The Ohio acquisition was financed primarily from the proceeds from the January 1, 2012 sale of our Maine subsidiary, the May 1, 2012 sale of our New York subsidiary, and by the issuance of long-term and/or short-term debt.  In addition to our Ohio acquisition, during 2012, we completed 16 acquisitions of water and wastewater utility systems for $19,094 in cash in six of the states in which we operate.  We included the operating results of these acquisitions in our consolidated financial statements beginning on the respective acquisition dates. 



We continue to pursue the acquisition of water and wastewater utility systems, and explore other utility acquisitions that may be in a new state.  Our typical acquisitions are expected to be financed with short-term debt with subsequent repayment from the proceeds of long-term debt, retained earnings, or equity issuances.



Joint Venture

In September 2011, one of our subsidiaries entered into a joint venture with a firm that operates natural gas pipelines and processing plants for the construction and operation of a private pipeline system to supply raw water to natural gas well drilling operations in the Marcellus Shale in north-central Pennsylvania (the “Joint Venture”).  We own 49% of the Joint Venture.  The initial 18-mile pipeline commenced operations in 2012.  The initial pipeline system was expanded for an additional 38 miles with a permitted intake on the Susquehanna River, which extended the pipeline to additional drillers.  The total cost of this pipeline was $109,000.    The Joint Venture has entered into water supply contracts with natural gas drilling companies.  As of December 31, 2016, our capital contributions since inception totaled $53,643 in cash.  This investment has been financed through the issuance of long-term debt.   Our 49% investment in the Joint Venture is as an unconsolidated affiliate and is accounted for under the equity method of accounting.  Our investment is carried at cost, including capital contributions or distributions and our equity in earnings and losses since the commencement of the system’s operations.  In the fourth quarter of 2015 an impairment charge was recognized by the joint venture on its long-lived assets, of which the Company’s share totaled $32,975 ($21,433 after-tax), representing our share of the noncash impairment charge as further described in Note 1 – Summary of Significant Accounting Policies – Investment in Joint Venture in this Annual Report.       



Dispositions

We routinely review and evaluate areas of our business and operating divisions and, over time, may sell utility systems or portions of systems.  In 2016, the Company sold two business units within Aqua Resources, which resulted in total proceeds of $4,459, and recognized a net loss of $543.  In 2013 and 2012, in accordance with our strategy to focus our resources on states where we have critical mass to improve our economies of scale and expect future economic growth, we sold water and wastewater systems in the following states:  Florida, New York, and Maine.  With respect to the sale of our systems in New York and the sale of our systems in Missouri to American Water, we acquired additional utility systems from American Water in Ohio and in Texas.  Additionally, in March, 2014, we completed the sale of our wastewater treatment facility in Georgia.



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In December 2014, we completed the sale of our water utility system in southwest Allen County Indiana to the City of Fort Wayne, Indiana for $67,011, which is comprised of $50,100 in addition to $16,911 the city initially paid the Company towards its water and wastewater system assets in the northern part of Fort Wayne in 2008.  We recognized a gain on sale of $29,210 ($17,611 after-tax) in the fourth quarter of 2014.  In addition, as a result of this transaction, Aqua Indiana will expand its sewer customer base by accepting new wastewater flows from the City.  Refer to Note 3 – Discontinued Operations and Other Disposition in this Annual Report for further information on this sale. 



In March, April, and December 2013, through five separate sales transactions, we completed the sale of our water and wastewater utility systems in Florida, which concluded our regulated operations in Florida.  The Company received total net proceeds from these sales of $88,934, and recognized a gain on sale of $21,178 ($13,766 after-tax).        

In June 2013, the Company sold a water and wastewater utility system in Texas for net proceeds of $3,400.  The sale resulted in the recognition of a gain on sale of these assets, net of expenses, of $1,025 ($615 after-tax).  The utility system represented approximately 0.04% of the Company’s total assets. 



In July 2011, the Company entered into a definitive agreement with American Water to sell its operations in New York for its book value at closing plus specific assumed liabilities, including debt of approximately $23,000.  On May 1, 2012, the Company completed the sale for net proceeds of $36,688 in cash as adjusted pursuant to the sale agreement based on book value at closing.  The Company’s New York operations served approximately 51,000 customers.  The sale of our New York operations concluded our regulated operations in New York.  The proceeds were used to finance a portion of our acquisition of American Water’s Ohio subsidiary, pay-down a portion of our short-term debt, and other general corporate purposes. 



In July 2011, the Company entered into a definitive agreement with Connecticut Water Service, Inc. to sell its operations in Maine, which served approximately 16,000 customers, for cash at closing plus specific assumed liabilities, including debt of $17,364.  On January 1, 2012, we completed the sale for net proceeds of $36,870, and recognized a gain on sale of $17,699 ($10,821 after-tax).  The sale of our Maine operations concluded our regulated operations in Maine.  The proceeds were used to finance a portion of our acquisition of American Water’s Ohio subsidiary, pay-down a portion of our short-term debt, and other general corporate purposes. 

 

Despite these transactions, one of our primary strategies continues to be to acquire additional utility systems, to maintain our existing systems where there is a strategic business benefit, and to actively oppose unilateral efforts by municipal governments to acquire any of our operations.



Sources of Capital

Since net operating cash flow plus advances and contributions in aid of construction have not been sufficient to fully fund cash requirements, we issued $1,335,239 of long-term debt and obtained other short-term borrowings during the past five years.  At December 31, 2016, we have a $250,000 long-term revolving credit facility that expires in February 2021, of which $17,561 was designated for letter of credit usage, $207,439 was available for borrowing and $25,000 of borrowings were outstanding at December 31, 2016.  In addition, we have short-term lines of credit of $135,500, of which $128,965 was available as of December 31, 2016.  These short-term lines of credit are subject to renewal on an annual basis.  Although we believe we will be able to renew these facilities, there is no assurance that they will be renewed, or what the terms of any such renewal will be.   



Our consolidated balance sheet historically has had a negative working capital position, whereby routinely our current liabilities exceed our current assets.  Management believes that internally-generated funds along with existing credit facilities and the proceeds from the issuance of long-term debt will be adequate to provide sufficient working capital to maintain normal operations and to meet our financing requirements for at least the next twelve months. 



Our loan and debt agreements require us to comply with certain financial covenants, which among other things, subject to specific exceptions, limit the Company’s ratio of consolidated total indebtedness to consolidated total capitalization, and require a minimum level of earnings coverage over interest expense.  During 2016, we were in compliance with our debt covenants under our credit facilities.  Failure to comply with our debt covenants could result in an event of default, which

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could result in us being required to repay or finance our borrowings before their due date, possibly limiting our future borrowings, and increasing our borrowing costs. 



The Company has a universal shelf registration statement, which was filed with the Securities and Exchange Commission, (“SEC”) on February 27, 2015, which allows for the potential future offer and sale by us, from time to time, in one or more public offerings, of an indeterminate amount of our common stock, preferred stock, debt securities, and other securities specified therein at indeterminate prices.  The Company’s Board of Directors has authorized the Company to issue up to $500,000 of our common stock, preferred stock, debt securities, and other securities specified therein under this universal shelf registration statement.  The Company has not issued any securities to date under this universal shelf registration statement. 



In addition, we have a shelf registration statement, which was filed with the SEC on February 27, 2015, to permit the offering from time to time of an aggregate of $500,000 of our common stock and shares of preferred stock in connection with acquisitions.  During 2016, we issued 439,943 shares of common stock totaling $12,845 to acquire a water system.  The balance remaining available for use under the acquisition shelf registration as of December 31, 2016 is $487,155. 



We will determine the form and terms of any securities issued under the universal shelf registration statement and the acquisition shelf registration statement at the time of issuance.



We offer a Dividend Reinvestment and Direct Stock Purchase Plan (the “Plan”) that provides a convenient and economical way to purchase shares of the Company.  Under the direct stock purchase portion of the Plan, shares are issued throughout the year.  The dividend reinvestment portion of the Plan offers a five percent discount on the purchase of shares of common stock with reinvested dividends.  As of the December 2016 dividend payment, holders of 10.7% of the common shares outstanding participated in the dividend reinvestment portion of the Plan.  The shares issued under the Plan are either original issue shares or shares purchased by the Company’s transfer agent in the open-market.  During the past five years, we have sold 1,218,407 original issue shares of common stock for net proceeds of $25,093 through the dividend reinvestment portion of the Plan, and we used the proceeds to invest in our operating subsidiaries, to repay short-term debt, and for general corporate purposes.  In 2016, 2015, and 2014, 484,645, 535,439, and 558,317 shares of common stock were purchased under the dividend reinvestment portion of the Plan by the Company’s transfer agent in the open-market for $14,916, $14,380, and $14,148, respectively.



The Company’s Board of Directors has authorized us to repurchase our common stock, from time to time, in the open market or through privately negotiated transactions.  In 2014, we repurchased 560,000 shares of our common stock in the open market for $13,280.  In December 2014, the Company’s Board of Directors authorized a share buyback program of up to 1,000,000 shares to minimize share dilution through timely and orderly share repurchases.  In December 2015, the Company’s Board of Directors added 400,000 shares to this program.  In 2016, we did not repurchase any shares of our common stock in the open market under this program.  In 2015, we repurchased 805,000 shares of our common stock in the open market for $20,502.  This program expired on December 31, 2016. 



Off-Balance Sheet Financing Arrangements

We do not engage in any off-balance sheet financing arrangements.  We do not have any interest in entities referred to as variable interest entities, which includes special purpose entities and other structured finance entities.

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Contractual Obligations

The following table summarizes our contractual cash obligations as of December 31, 2016:



















In addition to these obligations, we pay refunds on customers’ advances for construction over a specific period of time based on operating revenues related to developer-installed water mains or as new customers are connected to and take service from such mains.  After all refunds are paid, any remaining balance is transferred to contributions in aid of construction.  The refund amounts are not included in the above table because the refund amounts and timing are dependent upon several variables, including new customer connections, customer consumption levels and future rate increases, which cannot be accurately estimated.  Portions of these refund amounts are payable annually through 2026 and amounts not paid by the contract expiration dates become non-refundable.



In addition to the obligations disclosed in the contractual obligations table above, we have uncertain tax positions of $28,099.  Although we believe our tax positions comply with applicable law, we have made judgments as to the sustainability of each uncertain tax position based on its technical merits.  Due to the uncertainty of future cash outflows, if any, associated with our uncertain tax positions, we are unable to make a reasonable estimate of the timing or amounts that may be paid.  See Note 7 – Income Taxes in this Annual Report for further information on our uncertain tax positions. 



We will fund these contractual obligations with cash flows from operations and liquidity sources held by or available to us.



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The Company is routinely involved in legal matters, including both asserted and unasserted legal claims, during the ordinary course of business.  See Note 9 – Commitments and Contingencies in this Annual Report for a discussion of the Company’s legal matters.  It is not always possible for management to make a meaningful estimate of the potential loss or range of loss associated with such litigation.  Also, unanticipated changes in circumstances and/or revisions to the assessed probability of the outcomes of legal matters could result in expenses being incurred in future periods as well as an increase in actual cash required to resolve the legal matter.



Capitalization

The following table summarizes our capitalization during the past five years:







Over the past five years, the changes in the capitalization ratios primarily resulted from the issuance of common stock, the issuance of debt to finance our acquisitions and capital program, growth in net income, and the declaration of dividends. 

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES



Our financial condition and results of operations are impacted by the methods, assumptions, and estimates used in the application of critical accounting policies.  The following accounting policies are particularly important to our financial condition or results of operations, and require estimates or other judgments of matters of uncertainty.  Changes in the estimates or other judgments included within these accounting policies could result in a significant change to the financial statements.  We believe our most critical accounting policies include revenue recognition, the use of regulatory assets and liabilities, the valuation of our long-lived assets, which consist primarily of utility plant in service, regulatory assets, and goodwill, our accounting for post-retirement benefits, and our accounting for income taxes.  We have discussed the selection and development of our critical accounting policies and estimates with the Audit Committee of the Board of Directors.



Revenue Recognition  ─ Our utility revenues recognized in an accounting period include amounts billed to customers on a cycle basis and unbilled amounts based on estimated usage from the last billing to the end of the accounting period.  The estimated usage is based on our judgment and assumptions; our actual results could differ from these estimates, which would result in operating revenues being adjusted in the period that the revision to our estimates is determined. 

In Virginia, we commence the billing of our utility customers, under new rates, upon authorization from the respective utility commission and before the final commission rate order is issued.  The revenue recognized reflects an estimate based on our judgment of the final outcome of the commission’s ruling.  We monitor the applicable facts and circumstances regularly, and revise the estimate as required.  The revenue billed and collected prior to the final ruling is subject to refund based on the commission’s final ruling.



Regulatory Assets and Liabilities ─ We defer costs and credits on the balance sheet as regulatory assets and liabilities when it is probable that these costs and credits will be recognized in the rate-making process in a period different from when the costs and credits were incurred.  These deferred amounts, both assets and liabilities, are then recognized in the income statement in the same period that they are reflected in our rates charged for water or wastewater service.  In the event that our assessment as to the probability of the inclusion in the rate-making process is incorrect, the associated regulatory asset or liability would be adjusted to reflect the change in our assessment or change in regulatory approval.



Valuation of Long-Lived Assets, Goodwill and Intangible Assets ─ We review our long-lived assets for impairment, including utility plant in service and investment in joint venture.  We also review regulatory assets for the continued application of the Financial Accounting Standards Board’s (“FASB”) accounting guidance for regulated operations.  Our review determines whether there have been changes in circumstances or events, such as regulatory disallowances, or abandonments, that have occurred that require adjustments to the carrying value of these assets.  Adjustments to the carrying value of these assets would be made in instances where their inclusion in the rate-making process is unlikely.  For utility plant in service, we would recognize an impairment loss for any amount disallowed by the respective utility commission.  For our equity method investment in joint venture, the Company evaluates whether it has experienced a decline in the value of its investment that is other than temporary in nature.  We would recognize an impairment loss if the fair value of our investment is less than the carrying amount of the investment, and the decline in value is considered other than temporary.  Additionally, the Company would recognize its share of an impairment loss if the joint venture determines that the carrying amount of the joint venture’s assets exceeds the sum of the joint venture’s undiscounted estimated cash flows. 



Our long-lived assets, which consist primarily of utility plant in service, regulatory assets and investment in joint venture, are reviewed for impairment when changes in circumstances or events occur.  These circumstances or events could include a decline in the market value or physical condition of a long-lived asset, an adverse change in the manner in which long-lived assets are used or planned to be used, a change in historical trends, operating cash flows associated with the long-lived assets, changes in macroeconomic conditions, industry and market conditions, or overall financial performance.  When these circumstances or events occur, we determine whether it is more likely than not that the fair value of those assets is less than their carrying amount.  If we determine that it is more likely than not (that is, the likelihood of more than 50 percent), we would recognize an impairment charge if it is determined that the carrying amount of an asset exceeds the sum of the undiscounted estimated cash flows.  In this circumstance, we would recognize an impairment

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charge equal to the difference between the carrying amount and the fair value of the asset.  Fair value is estimated to be the present value of future net cash flows associated with the asset, discounted using a discount rate commensurate with the risk and remaining life of the asset. This assessment requires significant management judgment and estimates that are based on budgets, general strategic business plans, historical trends and other data and relevant factors.  These estimates include significant inherent uncertainties, since they involve forecasting future events.  If changes in circumstances or events occur, or estimates and assumptions that were used in this review are changed, we may be required to record an impairment charge on our long-lived assets. 



We have an investment in a joint venture, for which we own 49%, and use the equity method of accounting to account for this joint venture.  The joint venture operates a private pipeline system to supply raw water to natural gas well drilling operations in the Marcellus Shale in north central Pennsylvania.  In the fourth quarter of 2015, the joint venture recognized an impairment charge on its long-lived assets, of which the Company’s share totaled $32,975 ($21,433 after-tax), representing our share of the noncash impairment charge.  Refer to Note 1 – Summary of Significant Accounting Policies – Property, Plant and Equipment and Depreciation, and Investment in Joint Venture in this Annual Report for additional information regarding the review of long-lived assets for impairment.  See also Consolidated Results – Equity (Earnings) Loss in Joint Venture above in this Annual Report. 



We test the goodwill attributable for each of our reporting units for impairment at least annually on July 31, or more often, if circumstances indicate a possible impairment may exist.  When testing goodwill for impairment, we may assess qualitative factors, including macroeconomic conditions, industry and market considerations, cost factors, overall financial performance, and entity specific events, for some or all of our reporting units to determine whether it’s more likely than not that the fair value of a reporting unit is less than its carrying amount.  Alternatively, we may bypass this qualitative assessment for some of our reporting units and perform a quantitative goodwill impairment test by determining the fair value of a reporting unit based on a discounted cash flow analysis.  If we perform a quantitative test and determine that the fair value of a reporting unit is less than its carrying amount, we would determine the reporting unit’s implied fair value of its goodwill and compare it with the carrying amount of its goodwill to measure such impairment.  The assessment requires significant management judgment and estimates that are based on budgets, general strategic business plans, historical trends and other data and relevant factors.  If changes in circumstances or events occur, or estimates and assumptions that were used in our impairment test change, we may be required to record an impairment charge for goodwill.  Refer to Note 1 – Summary of Significant Accounting Policies – Goodwill in this Annual Report for information regarding the results of our annual impairment test. 



Accounting for Post-Retirement Benefits ─ We maintain a qualified defined benefit pension plan and plans that provide for post-retirement benefits other than pensions.  Accounting for pension and other post-retirement benefits requires an extensive use of assumptions about the discount rate, expected return on plan assets, the rate of future compensation increases received by our employees, mortality, turnover and medical costs.  Each assumption is reviewed annually with assistance from our actuarial consultant, who provides guidance in establishing the assumptions.  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.  These differences will impact the amount of pension and other post-retirement benefits expense that we recognize.   



Our discount rate assumption, which is used to calculate the present value of the projected benefit payments of our post-retirement benefits, was determined by selecting a hypothetical portfolio of high quality corporate bonds appropriate to match the projected benefit payments of the plans.  The selected bond portfolio was derived from a universe of Aa-graded corporate bonds, all of which were noncallable (or callable with make-whole provisions), and have at least $50,000 in outstanding value.  The discount rate was then developed as the rate that equates the market value of the bonds purchased to the discounted value of the projected benefit payments of the plans.  A decrease in the discount rate would increase our post-retirement benefits expense and benefit obligation.  After reviewing the hypothetical portfolio of bonds, we selected a discount rate of 4.13% for our pension plan and 4.25% for our other post-retirement benefit plans as of December 31, 2016, which represent a 35 basis-point decrease as compared to the discount rates selected at December 31, 2015, respectively.  Our post-retirement benefits expense under these plans is determined using the discount rate as of the

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beginning of the year, which was 4.48% for our pension plan and 4.60% for our other-postretirement benefit plans for 2016, and will be 4.13% for our pension plan and 4.25% for our other post-retirement benefit plans for 2017.      



Our expected return on plan assets is determined by evaluating the asset class return expectations with our advisors as well as actual, long-term, historical results of our asset returns.  The Company’s market-related value of plan assets is equal to the fair value of the plans’ assets as of the last day of its fiscal year, and is a determinant for the expected return on plan assets, which is a component of post-retirement benefits expense.  The allocation of our plans’ assets impacts our expected return on plan assets.  The expected return on plan assets is based on a targeted allocation of 25% to 75% domestic equities, 0% to 10% international equities, 25% to 50% fixed income, 0% to 5% alternative investments, and 0% to 20% cash and cash equivalents.  Our post-retirement benefits expense increases as the expected return on plan assets decreases.  We believe that our actual long-term asset allocations on average will approximate our targeted allocations.  Our targeted allocations are driven by our investment strategy to earn a reasonable rate of return while maintaining risk at acceptable levels through the diversification of investments across and within various asset categories.  For 2016, we used a 7.25% expected return on plan assets assumption which will decrease to 7.00% for 2017.



In October 2014, the Society of Actuaries issued an updated set of mortality tables and a mortality improvement scale.  The updated mortality tables extend the assumed life expectancy of participants in defined benefit plans, and the updated mortality improvement scale projects how mortality rates will improve into the future based on anticipated medical innovations and a reduction in unhealthy behaviors.  We considered the mortality data at the December 31, 2014 measurement of our post-retirement benefit obligations in relation to our plans’ participant population experience and adopted the updated mortality table and mortality improvement scale.  Because mortality is a key assumption in developing actuarial estimates, the impact of adopting the mortality data was, an increase in our post-retirement benefit obligation as of December 31, 2014 of $14,400 and an increase in our 2015 net periodic benefit costs of $2,500, of which approximately $900 had an impact on our 2015 post-retirement benefits expense, due to the regulatory treatment of our net periodic benefit costs.



Funding requirements for qualified defined benefit pension plans are determined by government regulations and not by accounting pronouncements.  In accordance with funding rules and our funding policy, during 2017 our pension contribution is expected to be $15,421.  Future years’ contributions will be subject to economic conditions, plan participant data and the funding rules in effect at such time as the funding calculations are performed, though we expect future changes in the amount of contributions and expense recognized to be generally included in customer rates. 



Accounting for Income Taxes ─ 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 specific items, such as depreciation, for tax and financial statement reporting.  Generally, these differences result in 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 estimates occur.



Our determination of what qualifies as a capital cost versus a tax deduction, for qualifying utility asset improvements, as it relates to our income tax accounting method change beginning in 2012, is subject to subsequent adjustment as well as IRS audits, changes in income tax laws,  including regulations regarding tax-basis depreciation as it applies to our capital expenditures, or qualifying utility asset improvements, the expiration of a statute of limitations, or other unforeseen matters could impact the tax benefits that have already been recognized.  We establish reserves for uncertain tax positions based upon management’s judgment as to the sustainability of these positions.  These accounting estimates related to the uncertain tax position reserve require judgments to be made as to the sustainability of each uncertain tax position based on its technical merits.  We believe our tax positions comply with applicable law and that we have adequately recorded reserves as required.  However, to the extent the final tax outcome of these matters is different than our estimates recorded, we would then need to adjust our tax reserves which could result in additional income tax expense or benefits in the period that this information is known.

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IMPACT OF RECENT ACCOUNTING PRONOUNCEMENTS



We describe the impact of recent accounting pronouncements in Note 1 – Summary of Significant Accounting Policies in this Annual Report. 

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We are subject to market risks in the normal course of business, including changes in interest rates and equity prices.  The exposure to changes in interest rates is a result of financings through the issuance of fixed rate long-term debt.  Such exposure is typically related to financings between utility rate increases, since generally our rate increases include a revenue level to allow recovery of our current cost of capital. Interest rate risk is managed through the use of a combination of long-term debt, which is at fixed interest rates, and short-term debt, which is at floating interest rates.  As of December 31, 2016, the debt maturities by period, in thousands of dollars, and the weighted average interest rate for long-term debt are as follows:









*Weighted average interest rate of 2021 long-term debt maturity is as follows:  fixed rate debt of 5.34% and variable rate debt of 2.79%.



From time to time, we make investments in marketable equity securities.  As a result, we are exposed to the risk of changes in equity prices for the “available-for-sale” marketable equity securities.  As of December 31, 2016, we have assets of, in thousands of dollars, $17,072 that are classified as “available-for-sale” securities to fund our deferred compensation plan liability.  The market risk of these assets is borne by the participants in the deferred compensation plan.