YORK WATER CO - Quarter Report: 2016 June (Form 10-Q)

 

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THE YORK WATER COMPANY

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The York County Industrial Development Authority Series 2006 bonds are subject to optional redemption provisions that allow the Company to redeem all or a portion of the bonds on or after October 1, 2016.  The Company may refinance these bonds at some time to take advantage of lower interest rates.

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8.	Fair Value Measurements

 

The accounting standards regarding fair value measurements establish a fair value hierarchy which indicates the extent to which inputs used in measuring fair value are observable in the market.  Level 1 inputs include quoted prices for identical instruments and are the most observable.  Level 2 inputs include quoted prices for similar assets and observable inputs such as interest rates, commodity rates and yield curves.  Level 3 inputs are not observable in the market and include management's own judgments about the assumptions market participants would use in pricing the asset or liability.

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In March 2016, the Financial Accounting Standards Board (FASB)  issued Accounting Standards Update (ASU) No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.  This ASU involves multiple aspects of the accounting for share-based payment transactions, including income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows.   The ASU is effective for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years, with early adoption available.  The Company will assess the impact of the adoption of the standard on its financial position, results of operations, and cash flows upon its issuance of share-based payments.

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The primary business of the Company is to impound, purify to meet or exceed safe drinking water standards and distribute water.  The Company also owns and operates two wastewater collection and treatment systems.  The Company operates within its franchised water territory, which covers 39 municipalities within York County, Pennsylvania and nine municipalities within Adams County, Pennsylvania.  The Company's wastewater operations include portions of three municipalities in York County, Pennsylvania.  The Company is regulated by the Pennsylvania Public Utility Commission, or PPUC, in the areas of billing, payment procedures, dispute processing, terminations, service territory, debt and equity financing and rate setting.  The Company must obtain PPUC approval before changing any practices associated with the aforementioned areas.

Water service is supplied through the Company's own distribution system.  The Company obtains the bulk of its water supply from both the South Branch and East Branch of the Codorus Creek, which together have an average daily flow of 73.0 million gallons.  This combined watershed area is approximately 117 square miles.  The Company has two reservoirs, Lake Williams and Lake Redman, which together hold up to approximately 2.2 billion gallons of water.  The Company has a 15-mile pipeline from the Susquehanna River to Lake Redman which provides access to an additional supply of 12.0 million gallons of untreated water per day.  The Company also owns seven wells which are capable of providing a safe yield of approximately 366,000 gallons per day to supply water to its customers in Carroll Valley Borough and Cumberland Township, Adams County.  As of June 30, 2016, the Company's average daily availability was 35.4 million gallons, and average daily consumption was approximately 18.3 million gallons.  The Company's service territory had an estimated population of 194,000 as of December 31, 2015.  Industry within the Company's service territory is diversified, manufacturing such items as fixtures and furniture, electrical machinery, food products, paper, ordnance units, textile products, injectable drug delivery systems, air conditioning systems, laundry detergent, barbells and motorcycles.

The Company's water business is somewhat dependent on weather conditions, particularly the amount and timing of rainfall.  Revenues are particularly vulnerable to weather conditions in the summer months.  Prolonged periods of hot and dry weather generally cause increased water usage for watering lawns, washing cars, and keeping golf courses and sports fields irrigated.  Conversely, prolonged periods of dry weather could lead to drought restrictions from governmental authorities.  Despite the Company's adequate water supply, customers may be required to cut back water usage under such drought restrictions which would negatively impact revenues.  The Company has addressed some of this vulnerability by instituting minimum customer charges which are intended to cover fixed costs of operations under all likely weather conditions.

The Company's business does not require large amounts of working capital and is not dependent on any single customer or a very few customers for a material portion of its business.  Increases in revenues are generally dependent on the Company's ability to obtain rate increases from the PPUC in a timely manner and in adequate amounts and to increase volumes of water sold through increased consumption and increases in the number of customers served.  The Company continuously looks for water and wastewater acquisition and expansion opportunities both within and outside its current service territory as well as additional opportunities to enter into bulk water contracts with municipalities and other entities to supply water.

The Company has agreements with several municipalities to provide sewer billing and collection services.  The Company also has a service line protection program on a targeted basis in order to further diversify its business.  Under this optional program, customers pay a fixed monthly fee, and the Company will repair or replace damaged customer service lines, as needed, subject to an annual maximum dollar amount.  Opportunities to expand both initiatives are being pursued.

Results of Operations

Three Months Ended June 30, 2016 Compared

With Three Months Ended June 30, 2015

Net income for the second quarter of 2016 was $2,847, a decrease of $78, or 2.7%, from net income of $2,925 for the same period of 2015.  The primary contributing factors to the decrease were higher income taxes, lower operating revenues and higher depreciation expense, which were partially offset by lower operation and maintenance expenses.

Operating revenues for the three months ended June 30, 2016 decreased $75, or 0.6%, from $11,895 for the three months ended June 30, 2015 to $11,820 for the corresponding 2016 period.  The primary reason for the decrease was lower consumption due in part to the prior year non-recurring interconnection with a neighboring municipality to provide water during an emergency event.  Total per capita consumption for the second quarter of 2016 was 3.5% lower than the same period of last year.  The decrease was partially offset by an increase in customers, and higher sewer collection service revenue.  The average number of customers served in the 2016 period increased as compared to the 2015 period by 988 customers, from 65,591 to 66,579 customers.

Operating expenses for the second quarter of 2016 decreased $88, or 1.4%, from $6,213 for the second quarter of 2015 to $6,125 for the corresponding 2016 period.  The decrease was due to lower water treatment chemical expense of approximately $44 due to prior year adverse weather conditions, $39 for higher capitalized overhead and $31 for reduced power expense.  Also adding to the decrease were prior year non-recurring expenses of $32 for information technology strategic planning and $18 for a survey of piping at the water treatment plant.  Other expenses decreased by a net of $11.  The decrease was partially offset by increased expenses of approximately $50 for depreciation and $37 primarily for annual shareholder reports.

Interest on debt for the second quarter of 2016 increased $30, or 2.3%, from $1,286 for the second quarter of 2015 to $1,316 for the corresponding 2016 period.  The increase was due to an increase in long-term debt outstanding resulting from the bond issuance in July 2015.

Allowance for funds used during construction decreased $6, from $53 in the second quarter of 2015 to $47 in the 2016 period, due to a lower volume of eligible construction.

Other income (expenses), net for the second quarter of 2016 reflects decreased expenses of $75 as compared to the same period of 2015.  Higher earnings on life insurance policies of $45 and lower charitable contributions of $42 were the primary reasons for the decrease.  Other expenses of approximately $12 increased as compared to the same period of 2015.

Income taxes for the second quarter of 2016 increased $130, or 9.6%, compared to the same period of 2015 due to higher taxable income and a lower volume of asset improvements eligible for the tax benefit of the Internal Revenue Service, or IRS, tangible property regulations, or TPR.  The Company's effective tax rate was 34.2% for the second quarter of 2016 and 31.6% the second quarter of 2015.

Six Months Ended June 30, 2016 Compared

With Six Months Ended June 30, 2015

Net income for the first six months of 2016 was $5,333, a decrease of $120, or 2.2%, from net income of $5,453 for the same period of 2015.  The primary contributing factors to the decrease were higher income taxes and depreciation expense, which were partially offset by lower operation and maintenance expenses.

Operating revenues for the six months ended June 30, 2016 were $23,098 as compared to $23,104 for the corresponding 2015 period.  Lower consumption due in part to the prior year non-recurring interconnection with a neighboring municipality was partially offset by an increase in customers, and higher sewer billing and collection service revenue.  Total per capita consumption for the first six months of 2016 was 2.9% lower than the same period of last year.  The average number of customers served in the 2016 period increased as compared to the 2015 period by 1,003 customers, from 65,412 to 66,415 customers.  For the remainder of the year, the Company expects revenues to increase slightly due to higher summer demand and an expected increase in the number of water and wastewater customers from acquisitions and growth within the Company's service territory.  Other regulatory actions and weather patterns could impact results.

Operating expenses for the first six months of 2016 decreased $99, or 0.8%, from $12,288 for the first six months of 2015 to $12,189 for the corresponding 2016 period.  The decrease was primarily due to lower expenses of approximately $75 for health insurance, $71 for higher capitalized overhead, and $60 for reduced water treatment chemical usage.  Other expenses decreased by a net of $21.  The decrease was partially offset by increased expense of approximately $128 for depreciation.  For the remainder of the year, the Company expects depreciation expense to continue to rise due to additional investment in utility plant, and other expenses to increase at a moderate rate as costs to maintain and extend the distribution system continue to rise and as additional water and wastewater systems are acquired.

Interest on debt for the first six months of 2016 increased $51, or 2.0%, from $2,570 for the first six months of 2015 to $2,621 for the corresponding 2016 period.  The increase was due to an increase in long-term debt outstanding resulting from the bond issuance in July 2015.  Interest expense for the remainder of the year is expected to remain consistent, but could be higher with possible line of credit borrowings.

Allowance for funds used during construction decreased $8, from $108 in the first six months of 2015 to $100 in the 2016 period, due to a lower volume of eligible construction.  Allowance for funds used during construction for the remainder of the year is expected to increase based on a projected increase in the amount of eligible construction.

Other income (expenses), net for the first six months of 2016 reflects decreased expenses of $53 as compared to the same period of 2015.  Lower charitable contributions of $59 and higher earnings on life insurance policies of $31 were the primary reasons for the decrease.  The decreased expenses were partially offset by higher outside services of approximately $23.  Other expenses increased by approximately $14 as compared to the same period of 2015.  For the remainder of the year, other income (expenses) will be largely determined by the change in market returns and discount rates for retirement programs and related assets.

Income taxes for the first six months of 2016 increased $207, or 8.0%, compared to the same period of 2015 due to higher taxable income and a lower volume of asset improvements eligible for the tax benefit of the IRS TPR.  The Company's effective tax rate was 34.4% for the first six months of 2016 and 32.2% the first six months of 2015.  The Company expects the effective tax rate to fall to approximately 28% to 32% for 2016 due to the continued expensing of asset improvements that would have been capitalized for tax purposes prior to the implementation of the TPR.  The Company's effective tax rate will vary depending on the level of eligible asset improvements that are placed in service each period.

Rate Matters

See Note 12 to the financial statements included herein for a discussion of rate matters.

The benefit from the implementation of the IRS TPR impacts the rate matters of the Company.  Earnings in excess of the regulatory benchmark prevent the collection of a distribution system improvement charge, which is likely to remain throughout 2016.  It may also lengthen the amount of time until filing the next rate increase request.  As a result, the Company does not expect to file a rate increase request in 2016.  When the Company does file for its next rate increase, the PPUC will take into account the lower income taxes which resulted from the implementation of the IRS TPR, effectively reducing the amount of revenue required in future years and lowering the Company's rate increase request.

Acquisitions

See Note 10 to the financial statements included herein for a discussion of completed acquisitions included in financial results.

On October 8, 2013, the Company signed an agreement to purchase the wastewater assets of SYC WWTP, L.P. in Shrewsbury and Springfield Townships, York County, Pennsylvania.  Completion of the acquisition is contingent upon receiving approval from all required regulatory authorities.  Due to unforeseen delays, closing is not expected until 2017 at which time the Company will add approximately 30 commercial and industrial wastewater customers.

On July 20, 2015, the Company signed an agreement to purchase the water assets of the Westwood Mobile Home Park in York County, Pennsylvania.  Completion of this acquisition is contingent upon receiving approval from all required regulatory authorities.  The Company expects to begin serving approximately 200 new customers through an interconnection with its current distribution system in the fourth quarter of 2016.  These customers are currently served by the Company through a single customer connection to the park.

On January 18, 2016, the Company signed an agreement to purchase the wastewater collection assets of West York Borough in York County, Pennsylvania.  Completion of the acquisition is contingent upon receiving approval from all required regulatory authorities.  Closing is expected in the fourth quarter of 2016 at which time the Company will add approximately 1,700 wastewater customers.

In total, these acquisitions are expected to be immaterial to Company results.  The Company is also pursuing other bulk water contracts and acquisitions in and around its service territory to help offset any further declines in per capita water consumption and to grow its business.

Capital Expenditures

For the six months ended June 30, 2016, the Company invested $5,009 in construction expenditures for routine items, further upgrades to water treatment facilities and information technology, as well as various replacements of infrastructure.  In addition, the Company invested $29 in the acquisition of water systems.  The Company was able to fund construction expenditures using internally-generated funds and proceeds from its stock purchase plans.

The Company anticipates construction expenditures for the remainder of 2016 of approximately $12,000 exclusive of any potential acquisitions not yet approved.  In addition to routine transmission and distribution projects, a portion of the anticipated expenditures will be for additional main extensions, an additional raw water pumping station and force main, and various replacements and improvements to infrastructure.  The Company intends to use primarily cash on hand and internally-generated funds for its anticipated construction and fund the remainder through line of credit borrowings, proceeds from its stock purchase plans and customer advances and contributions.  Customer advances and contributions are expected to account for less than 5% of funding requirements during the remainder of 2016.  The Company believes it will have adequate credit facilities to meet its anticipated capital needs in 2016 and 2017.

Liquidity and Capital Resources

Cash

The Company manages its cash through a cash management account that is directly connected to one of its lines of credit.  Excess cash generated automatically pays down outstanding borrowings under the line of credit arrangement.  If there are no outstanding borrowings, the cash is used as an earnings credit to reduce banking fees.  Likewise, if additional funds are needed beyond what is generated internally for payroll, to pay suppliers, to fund capital expenditures, or to pay debt service, funds are automatically borrowed under the line of credit.  The Company utilized a significant portion of its cash on hand for cash outflows, specifically a $2,300 contribution to its pension trusts and its quarterly dividend payments, but did not use its lines of credit during the first six months of 2016.  The Company has rebuilt its cash through internally-generated funds, accumulating a cash balance of $5,009 as of June 30, 2016.  The Company expects the cash balance to be fully utilized in 2016, after which the cash management facility and other lines of credit are expected to provide the necessary liquidity and funding for the Company's operations, capital expenditures, acquisitions and potential buybacks of stock.

Accounts Receivable

The accounts receivable balance tends to follow the change in revenues but is also affected by the timeliness of payments by customers and the level of the reserve for doubtful accounts.  This quarter, higher revenue levels as compared to the end of 2015 resulted in an increase in accounts receivable.  A reserve is maintained at a level considered adequate to provide for losses that can be reasonably anticipated based on inactive accounts with outstanding balances.  Management periodically evaluates the adequacy of the reserve based on past experience, agings of the receivables, adverse situations that may affect a customer's ability to pay, current economic conditions, and other relevant factors.  If the status of these factors deteriorates, the Company may incur additional expenses for uncollectible accounts and experience a reduction in its internally-generated funds.

Internally-generated Funds

The amount of internally-generated funds available for operations and construction depends on the Company's ability to obtain timely and adequate rate relief, changes in regulations including taxes, customers' water usage, weather conditions, customer growth and controlled expenses.  In the first six months of 2016, the Company generated $8,256 internally from operations as compared to the $7,983 it generated in the first six months of 2015 due primarily to lower income taxes paid.

Credit Lines

Historically, the Company has borrowed $15,000 to $20,000 under its lines of credit before refinancing with long-term debt or equity capital.  As of June 30, 2016, the Company maintained unsecured lines of credit aggregating $31,500 with three banks at interest rates ranging from LIBOR plus 1.20% to LIBOR plus 1.25%.  The Company had no outstanding borrowings under any of its lines of credit as of June 30, 2016.  In the second quarter of 2016, the Company renewed two of its committed lines of credit aggregating $24,000 and extended the maturity date to May 2018.  In addition, the Company renewed its $5,000 committed line of credit increasing the available amount to $7,500, lowering the interest rate from LIBOR plus 1.50% to LIBOR plus 1.25%, and extending the maturity to June 2017.  In July 2016, the Company entered into an agreement with a fourth bank for a $10,000 unsecured committed line of credit at an interest rate of LIBOR plus 1.20% maturing in July 2017, increasing the aggregate available amount to $41,500.

The Company has taken steps to manage the risk of reduced credit availability.  It has maintained committed lines of credit that cannot be called on demand and obtained a 2-year revolving maturity on its larger facilities.  One of the Company's banks recently increased the available amount and reduced the interest rate on its line of credit, and a new relationship was established with another bank for a committed line of credit at an interest rate matching the lowest rate currently offered.  Despite these factors, there is no guarantee that the Company will be able to obtain sufficient lines of credit with favorable terms in the future.  If the Company is unable to obtain sufficient lines of credit or to refinance its line of credit borrowings with long-term debt or equity when necessary, it may have to eliminate or postpone capital expenditures.  Management believes the Company will have adequate capacity under its current lines of credit to meet anticipated financing needs throughout 2016 and 2017.

Long-term Debt

The Company's loan agreements contain various covenants and restrictions.  Management believes it is currently in compliance with all of these restrictions.  See Note 4 to the Company's Annual Report on Form 10-K for the year ended December 31, 2015 for additional information regarding these restrictions.

 

Income Taxes, Deferred Income Taxes and Uncertain Tax Positions

The Company has a substantial deferred income tax asset primarily due to the differences between the book and tax balances of the pension and deferred compensation plans.  The Company does not believe a valuation allowance is required due to the expected generation of future taxable income during the periods in which those temporary differences become deductible.

The Company has seen an increase in its deferred income tax liability amounts as a result of the accelerated and bonus depreciation deduction available for federal tax purposes which creates differences between book and tax depreciation expense.  The Company expects this trend to continue as it makes significant investments in capital expenditures subject to accelerated and bonus depreciation or TPR.

The Company filed for a change in accounting method under the IRS TPR effective in 2014.  Under the change in accounting method, the Company is permitted to deduct the costs of certain asset improvements that were previously being capitalized and depreciated for tax purposes as an expense on its income tax return.  This ongoing deduction results in a reduction in the effective income tax rate, a net reduction in income tax expense, and a reduction in the amount of income taxes currently payable.  It also results in increases to deferred tax liabilities and regulatory assets representing the appropriate book and tax basis difference on capital additions.  The Company expects an effective tax rate of 28% to 32% each year based on current asset improvement estimates.  The effective tax rate will vary depending on the level of eligible assets improvements that are placed in service each period.

The Company has determined there are no uncertain tax positions that require recognition as of June 30, 2016.

Common Stock

Common stockholders' equity as a percent of the total capitalization was 56.1% as of June 30, 2016, compared with 55.5% as of December 31, 2015.  The volume of share repurchases and line of credit borrowings, among other things, could reduce this percentage in the future.  It is the Company's general intent to target a ratio between fifty and fifty-four percent.

Credit Rating

On March 30, 2016, Standard & Poor's affirmed the Company's credit rating at A-, with a stable outlook and adequate liquidity.  The Company's ability to maintain its credit rating depends, among other things, on adequate and timely rate relief, which it has been successful in obtaining, its ability to fund capital expenditures in a balanced manner using both debt and equity and its ability to generate cash flow.  The Company's objectives are to continue to maximize its funds provided by operations and maintain a strong capital structure in order to be able to attract capital.

Critical Accounting Estimates

The methods, estimates and judgments the Company used in applying its accounting policies have a significant impact on the results reported in its financial statements.  The Company's accounting policies require management to make subjective judgments because of the need to make estimates of matters that are inherently uncertain.  The Company's most critical accounting estimates include regulatory assets and liabilities, revenue recognition and accounting for its pension plans.  There has been no significant change in accounting estimates or the method of estimation during the quarter ended June 30, 2016.

Off-Balance Sheet Arrangements

The Company does not use off-balance sheet transactions, arrangements or obligations that may have a material current or future effect on financial condition, results of operations, liquidity, capital expenditures, capital resources or significant components of revenues or expenses.  The Company does not use securitization of receivables or unconsolidated entities. The Company uses a derivative financial instrument, an interest rate swap agreement discussed in Note 7 to the financial statements included herein, for risk management purposes.  The Company does not engage in trading or other risk management activities, does not use other derivative financial instruments for any purpose, has no material lease obligations, no guarantees and does not have material transactions involving related parties.

 

The Company's operations are exposed to market risks primarily as a result of changes in interest rates under its lines of credit.  The Company has unsecured lines of credit with four banks having a combined maximum availability of $41,500.  The first line of credit, in the amount of $13,000, is a committed line of credit with a revolving 2-year maturity (currently May 2018), and carries an interest rate of LIBOR plus 1.20%.  The second line of credit, in the amount of $11,000, is a committed line of credit, which currently matures in May 2018 and carries an interest rate of LIBOR plus 1.25%.  The third line of credit, in the amount of $7,500, is a committed line of credit, which matures in June 2017 and carries an interest rate of LIBOR plus 1.25%.  The fourth line of credit, in the amount of $10,000, is a committed line of credit, which matures in June 2017 and carries an interest rate of LIBOR plus 1.20%.  The Company had no outstanding borrowings under any of its lines of credit as of June 30, 2016.  Other than lines of credit, the Company has long-term fixed rate debt obligations that are not subject to interest rate risk as shown in Note 6 to the financial statements included herein, and a variable rate PEDFA loan agreement, which is subject to minimal market risk, described below.

In May 2008, the PEDFA issued $12,000 aggregate principal amount of PEDFA Exempt Facilities Revenue Bonds, Series A (the "2008 Bonds").  The proceeds of this bond issue were used to refund the $12,000 PEDFA Exempt Facilities Revenue Bonds, Series B of 2004 which were refunded due to bond insurer downgrading issues.  The PEDFA then loaned the proceeds to the Company pursuant to a variable interest rate loan agreement with a maturity date of October 1, 2029.  The interest rate under this loan agreement averaged 0.45% during the three months ended June 30, 2016 and 0.26% during the six months ended June 30, 2016.  In connection with the loan agreement, the Company retained its interest rate swap agreement whereby the Company exchanged its floating rate obligation for a fixed rate obligation.  The purpose of the interest rate swap is to manage the Company's exposure to fluctuations in the interest rate.  If the interest rate swap agreement works as intended, the receive rate on the swap should approximate the variable rate the Company pays on the PEDFA Series A 2008 Bond Issue, thereby minimizing its risk.  See Note 7 to the financial statements included herein for additional information regarding the interest rate swap.

In addition to the interest rate swap agreement, the Company entered into a Reimbursement, Credit and Security Agreement with PNC Bank, National Association ("the Bank"), dated as of May 1, 2008, in order to enhance the marketability of and to minimize the interest rate on the 2008 Bonds.  This agreement provides for a direct pay letter of credit issued by the Bank to the trustee for the 2008 Bonds.  The current expiration date of the letter of credit is June 30, 2018.  It is reviewed annually for a potential extension of the expiration date.  The Company's responsibility under this agreement is to reimburse the Bank on a timely basis for interest payments made to the bondholders and for any tendered bonds that could not be remarketed.  The Company has fourteen months from the time bonds are tendered to reimburse the Bank.  If the direct pay letter of credit is not renewed, the Company would be required to pay the Bank immediately for any tendered bonds and reclassify a portion of the bonds as current liabilities.  In addition, the interest rate swap agreement would terminate causing a potential payment by the Company to the counterparty.  Both the letter of credit and the swap agreement can potentially be transferred upon this type of event.

 

 

Evaluation of Disclosure Controls and Procedures

The Company's management, with the participation of the Company's President and Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company's disclosure controls and procedures as of the end of the period covered by this report.  Based upon this evaluation, the Company's President and Chief Executive Officer along with the Chief Financial Officer concluded that the Company's disclosure controls and procedures as of the end of the period covered by this report are effective such that the information required to be disclosed by the Company in reports filed under the Securities Exchange Act of 1934, as amended, is (i) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and (ii) accumulated and communicated to the Company's management, including the President and Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure.  A controls system cannot provide absolute assurance, however, that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

No change in the Company's internal control over financial reporting occurred during the Company's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.

Part II – OTHER INFORMATION

 

 

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

EXHIBIT INDEX