Bryn Mawr water utility giant out $60 million on interest-rate bet

Aqua America, the Bryn Mawr for-profit water and sewer utility, says it has taken a $59.8 million charge in its fourth-quarter earnings due to a drop in the value of interest-rate swaps.

The interest-rate swaps were supposed to protect Aqua from increases in the cost of financing the $4.3 billion deal announced last fall to buy Peoples Gas Co. of Pittsburgh and its affiliates.

The company reported a loss of $3.6 million for the three months ended Dec. 31, down from a gain of $53.4 million during the same quarter a year earlier.

Over time, Aqua expects to boost sales and profits from its six recent deals for systems including a sewer network that connects five wealthy Chester County townships to the Valley Creek treatment system in Tredyffrin Township, chief executive Chris Franklin told investors in a conference call. Besides Peoples, seven more municipal water or sewer purchases are underway, as states make it easier for for-profit companies to buy public utilities, Franklin added.

Critics say private companies charge more. Aqua has a rate-increase request pending before the Pennsylvania Public Utilities Commission so it can boost charges this May. Pittsburgh’s Peoples Gas has also asked for rate increases, in part to replace aging gas mains. “Customers don’t like sharp rate increases,” but they understand the need for “incremental” increases to fund improvements, Franklin told investors.

Franklin also said he planned to put Aqua on Peoples’ SAP software platform, spreading the cost among customers. He said Aqua was the last major U.S. utility that didn’t run either Oracle or SAP, making Peoples “a great fit" from an IT perspective.

According to Aqua, the nearly $60 million fourth-quarter charge was “associated with our interest-rate swap agreements for future debt" to buy Peoples. There may be more swaps charges ahead, if interest rates drop again before the Peoples deal is done.

Borrowers use interest-rate swaps as a hedge against rate changes. It locks in current interest rates in exchange for promised payments if, for example, U.S. interest rates go up. Aqua’s swaps were purchased under new chief financial officer Daniel Schuller, a former JPMorgan asset manager who joined Aqua in 2015 and was promoted when David Smeltzer retired last fall.

“At the time, we believed interest rates would rise,” but instead rate and swap values “have gone the other direction,” Schuller told investors.

The Federal Reserve expected to raise rates more aggressively last year but cut back amid pressure from financiers, business groups, and President Donald Trump, who worried that high interest rates could slow the U.S. economy and affect stock-market rallies.

So, instead of rising, the U.S. Treasury rates that Aqua’s swaps were pegged to fell late last year -- 10-year rates by 0.0045 percent, 30-year rates by 0.0055 percent -- forcing Aqua to write down their value and potentially pay banks extra, instead of the other way around.

“If you had a crystal ball, a lot of things would be different,” Franklin said in an interview. He noted that the write-down so far represents just a change in investment value, not a cash payment by the company. The payment comes when the Peoples deal is financed: Aqua could have to pay more than $60 million if rates keep falling -- or banks could end up paying Aqua, after all, if rates reverse and rise a lot.

But either way, the bank locked in last year’s borrowing terms, which Aqua knew it could afford, he added.

“Lots of firms were caught off guard by the Fed’s reversal,” said veteran utilities analyst Ryan M. Connors, managing director for water and environment equities at Boenning & Scattergood Inc. in West Conshohocken. “This was a special case, given the pending acquisition of Peoples – normally Aqua doesn’t get involved in swaps” and other financial derivatives, “but the overriding consensus at the time was that rates were going to begin accelerating upward, and they [needed to raise] up to $800 million in debt to fund the Peoples deal. So they wanted to hedge, understandable. Of course, hindsight is always 20/20.”

Not all public utilities have welcomed Aqua and other would-be acquirers such as American Water Works of Voorhees. The 40-town Chester Water Authority has resisted past Aqua offers, noting that private water companies tend to charge customers more so they can send profits to their investors.

But Aqua is still interested in the Chester Water Authority, Franklin said. He accused the Chester utility, whose board includes representatives of Chester and Delaware Counties as well as the City of Chester, of using suburban ratepayer funds to help the depressed former industrial city pay down its debt, and added that Aqua may challenge the utility’s city payments in court, “as a customer.”