Making Waves at American Water Works
April 12 2012 by Jennifer Pellet
The Challenge: You’re a huge water utility company providing millions of Americans with water. Like other utilities, your upside profitability is limited by the sector’s contract operations model—rates are set by regulators at state public utility commissions rather than by service providers. Meanwhile the nation’s water supply infrastructure is in abysmal shape. In some states up to 40 percent of treated water is lost due to leakage and infrastructure issues. But your return on capital is just 3 percent—far too thin to justify investing in upgrades.
The Context: Based in Voorhees, New Jersey, $2.7 billion American Water Works Company is a publicly traded water and wastewater utility employing 7,000 and providing water to 15 million people across 30 states. CEO Jeff Sterba took the helm in August of 2010, 2.5 years after the IPO.
“Like any company that goes through an IPO, the company had gotten very focused on the IPO and not necessarily on operational efficiency,” explains Sterba. “This is a utility that frankly wasn’t making anywhere near its fair return. The allowed return [or the profit public commissions must allow water utilities the opportunity to earn] is roughly 10 percent return on equity, and that’s generally what you see in [the industry]. This company was earning between 3 percent and 4 percent.” Factor in the need to boost investment in infrastructure and American Water would soon need to make some changes.
The Resolution: To Sterba, the answer was simple: A relentless and meticulous focus on operational excellence. For example, by standardizing its supply chain across states, the company has seen up to a 14 percent reduction in the cost of pipes. On the larger end of the scale, American Water is testing new technology that reduces energy use in wastewater treatment facilities by 30 to 50 percent. “Taking operating costs out allows us to put in capital dollars that earn a return,” explains Sterba. “For every $1 of operating costs we take out, we can put $6 of capital into our systems without an impact on rates. Each $6 in capital then generates about $0.30 of earnings for our shareholders.”
Sterba also made the tough call to sell regulated operations in markets like Texas, Arizona and New Mexico, in which the company had long struggled to operate profitably. “When you go 10 years in a market without being able to generate a return, it’s time to put that money to work somewhere else,” says Sterba, who also plans to exit Ohio for the same reason.
The Endgame: Sterba’s efforts are paying off. American Water improved its earned ROE from 4.7 percent in 2008 to approximately 7.2 percent in 2011, due to both operating efficiency initiatives as well as a string of rate case awards that allowed the utility to bump up its rates in certain states. What’s more, the company’s stock has risen by more 26 percent since Sterba took office.
The Lesson: A culture of seeking out incremental increases in efficiency adds up to big results over time. “We want every employee to be asking these questions every day,” says Sterba. “Is what you’re doing adding value to our customers? If it’s not adding value, why are we doing it? If it’s adding value, is the process efficient? If not, how can we fix it, change it.” Once the process is streamlined to maximize efficiency, American Water focuses on reducing errors and reducing the cost of mitigating those errors that occur. “Every year, there are about 11,000 violations of safe drinking water in this country,” says Sterba. “Since we’re about 5 percent of the market that would suggest we have 550 violations a year. Last year, we had four. That demonstrates the kind of commitment that our folks have to the safety, the health and the quality of the product that they provide.”