AWK

Business Context and Reporting Period

Company: American Water Works Company, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: March 31, 2008
Business Overview: The Company is the largest investor-owned United States water and wastewater utility company. Operations are divided into two segments: Regulated Businesses (water and wastewater utilities subject to state regulation) and Non-regulated Businesses (contract operations, homeowner services, and applied water management).
Key Event: The Company completed its Initial Public Offering (IPO) on April 28, 2008, shortly after the reporting period. Prior to the IPO, the Company was a wholly-owned subsidiary of RWE Aqua Holdings GmbH.

Key Financial Metrics

Note: Total Debt calculated as Long-term debt ($4,642,315) + Current portion of long-term debt ($90,188) + Short-term debt ($368,137) for Q1 2008.

Material Changes vs. Prior Period

• Net Loss vs. Net Income: The Company reported a net loss of $732.5 million in Q1 2008 compared to a net income of $2.7 million in Q1 2007. This drastic shift is primarily due to a non-cash goodwill impairment charge of $750.0 million.
• Revenue Growth: Operating revenues increased by $38.3 million (8.2%) year-over-year. Regulated Businesses revenues rose $30.3 million due to rate increases, while Non-regulated Businesses revenues increased $7.9 million.
• Operating Expenses: Total operating expenses increased by $781.9 million. Excluding the impairment charge, operating expenses increased by $31.9 million, driven by higher employee-related costs ($17.1 million increase) and production costs.
• Goodwill Impairment: Following the IPO pricing, management determined the carrying value of goodwill was impaired. A charge of $750.0 million was recorded against the Regulated Businesses segment, reducing total goodwill from $2.46 billion to $1.71 billion.
• Working Capital: The Company reported a net working capital deficit at March 31, 2008, consistent with its capital-intensive utility model.

Guidance, Outlook, Risks, and Unusual Items

Unusual Items

• Goodwill Impairment: The $750 million charge was triggered by the IPO price ($21.50/share) and subsequent trading levels being lower than anticipated in the 2007 annual test, combined with a decline in the fair value of debt due to rising interest rates.
• Subsequent Cash Transfer: As a result of the impairment, RWE transferred $245.0 million to the Company on May 13, 2008, to be used for debt reduction.

Outlook and Guidance

• Dividend Policy: Upon the consummation of the IPO, the Board adopted a policy to distribute 50% to 70% of annual net income as regular quarterly dividends.
• Capital Expenditures: Construction expenditures increased to $188.4 million in Q1 2008. Major projects include a new water treatment plant on the Kentucky River (estimated cost $162-$168 million) and a potential $100 million acquisition of the Trenton, NJ water system assets (pending regulatory approval).
• Rate Cases: The Company received authorizations for $26.0 million in annualized revenues in Q1 2008 and has filed cases requesting an additional $231.1 million in annualized revenues.

Risks and Contingencies

• Internal Controls: Management concluded that disclosure controls and procedures were not effective as of March 31, 2008, due to material weaknesses identified during the transition to a public company (e.g., inadequate staffing, controls over financial reporting, and tax accounting). Remediation costs incurred were $54.9 million, with an estimated additional $3.4 million required.
• Auction Rate Securities: The Company holds $169.6 million in auction rate tax-exempt debt. Failed auctions in February 2008 triggered a 10% interest rate on these instruments. The Company redeemed $144.7 million of this debt in April/May 2008 using commercial paper.
• Legal Proceedings: A joint venture (OMI/TW) terminated a contract with the City of Stockton, CA. The Company has a loss reserve of approximately $4.0 million related to potential fines and transition costs.

Investor Verification Checklist

• Impairment Methodology: Verify the assumptions used in the goodwill impairment test, specifically the weighting of the IPO price versus discounted cash flow analysis.
• Internal Control Remediation: Monitor the progress of remediation for the six identified material weaknesses in internal controls over financial reporting.
• Auction Rate Debt Exposure: Confirm the status of remaining auction rate securities and the cost of carrying the 10% failed-auction interest rate.
• Regulatory Approvals: Track the approval status of the $100 million Trenton, NJ acquisition and the $231.1 million in pending rate case requests.
• Debt Covenants: Verify continued compliance with the debt-to-capitalization ratio covenant (0.70 to 1.00), which stood at 0.53 as of March 31, 2008.