Essential Utilities - 10-Q quarterly report FY

The accompanying consolidated balance sheets and statements of capitalization of Aqua America, Inc. (the “Company”) at June 30, 2007, the consolidated statements of income and comprehensive income for the six months and three months ended June 30, 2007 and 2006, the consolidated statements of cash flow for the six months ended June 30, 2007 and 2006, and the consolidated statement of common stockholders’ equity for the six months ended June 30, 2007, are unaudited, but reflect all adjustments, consisting of only normal recurring accruals, which are, in the opinion of management, necessary to present fairly the consolidated financial position, the consolidated changes in common stockholders’ equity, the consolidated results of operations, and the consolidated cash flow for the periods presented. Because they cover interim periods, the statements and related notes to the financial statements do not include all disclosures and notes normally provided in annual financial statements and, therefore, should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 and the Quarterly Report on Form 10-Q for the quarter ended March 31, 2007. The results of operations for interim periods may not be indicative of the results that may be expected for the entire year.

The following table summarizes the changes in the Company’s goodwill, by business segment:

In January 2007, the Company recorded goodwill of $10,808 upon completing its acquisition of New York Water Service Corporation. In April 2007, the Company recorded goodwill of $1,040 upon completing the acquisition of Aquarion Water Company of Sea Cliff, Inc.

In January 2007, the Company’s Pennsylvania operating subsidiary, Aqua Pennsylvania, Inc., issued $50,000 of tax-exempt bonds secured by a supplement to its first mortgage indenture at the following terms: $25,000 at 4.43% due 2040 and $25,000 at 4.44% due 2041. The proceeds are restricted to funding certain capital projects during the period 2007 through 2009. In March 2007, the Company issued $30,000 of unsecured notes of which $15,000 are due in 2022 with an interest rate of 5.63% and $15,000 are due in 2037 with an interest rate of 5.83%. Proceeds from the sales of these notes were used to repay short-term borrowings. During the first half of 2007, our operating subsidiaries issued notes payable in aggregate of $7,851 at rates ranging from 1.0% to 5.5% due from 2017 to 2035.

Pursuant to our strategy to grow through acquisitions, on January 1, 2007 the Company completed the acquisition of the capital stock of New York Water Service Corporation (“New York Water”) for $28,866 in cash, as adjusted pursuant to the purchase agreement primarily based on working capital at closing, and the assumption of $23,000 of long-term debt. The acquired operation provides water service to 44,792 customers in several water systems located in Nassau County, Long Island, New York. The operating results of New York Water have been included in our consolidated financial statements beginning January 1, 2007. Under the purchase method of accounting, the purchase price is allocated to the net tangible and intangible assets based upon their estimate fair values at the date of the acquisition. The Company is in the process of finalizing the allocation of the purchase price. The purchase price allocation is as follows, subject to final adjustments:

Basic net income per common share is based on the weighted average number of common shares outstanding. Diluted net income per common share is based on the weighted average number of common shares outstanding and potentially dilutive shares. The dilutive effect of employee stock options and shares issuable under the forward equity sale agreement (from the date the Company entered into the forward equity sale agreement to the settlement date) is included in the computation of diluted net income per common share. The dilutive effect of stock options and shares issuable under the forward equity sale agreement is calculated using the treasury stock method and expected proceeds upon exercise of the stock options and settlement of the forward equity sale agreement. The following table summarizes the shares, in thousands, used in computing basic and diluted net income per common share:

For the six months and three months ended June 30, 2007, employee stock options to purchase 1,151,700 shares of common stock were excluded from the calculations of diluted net income per share as the calculated proceeds from the options’ exercise were greater than the average market price of the Company’s common stock during these periods. For the six months and three months ended June 30, 2006, employee stock options to purchase 610,100 shares of common stock were excluded from the calculations of diluted net income per share as the calculated proceeds from the options’ exercise were greater than the average market price of the Company’s common stock during these periods.

In August 2006, the Company entered into a forward equity sale agreement for 3,525,000 shares of common stock with a third-party (the “forward purchaser”). In connection with the forward equity sale agreement, the forward purchaser borrowed an equal number of shares of the Company’s common stock from stock lenders and sold the borrowed shares to the public. The Company will not receive any proceeds from the sale of its common stock by the forward purchaser until settlement of the forward equity sale agreement. The actual proceeds to be received by the Company will vary depending upon the settlement date, the number of shares designated for settlement on that settlement date and the method of settlement. The Company intends to use any proceeds received upon settlement of the forward equity sale agreement to fund the Company’s future capital expenditure program and acquisitions, and for working capital and other general corporate purposes. The forward equity sale agreement is accounted for as an equity instrument and was recorded at a fair value of $0 at inception. It will not be adjusted so long as the Company continues to meet the accounting requirements for equity instruments.

The Company may elect to settle the forward equity sale agreement by means of a physical share settlement, net cash settlement, or net share settlement, on a settlement date or dates, no later than August 1, 2008. The forward equity sale agreement provides that the forward sale price will be computed based upon the initial forward sale price of $21.857 per share. Under limited circumstances or certain unanticipated events, the forward purchaser also has the ability to require the Company to physically settle the forward equity sale agreement in shares prior to the maturity date. The maximum number of shares that could be required to be issued by the Company to settle the forward equity sale agreement is 3,525,000 shares. As of June 30, 2007, a net cash settlement under the forward equity sale agreement would have resulted in a payment by the Company to the forward purchaser of $1,008 or a net share settlement would have resulted in the issuance of 44,827 shares by the Company to the forward purchaser. For each increase or decrease of one dollar in the average market price of the Company’s common stock above or below the forward sale price on June 30, 2007, the cash settlement option from the Company’s perspective would decrease or increase by $3,525 and the net share settlement option would decrease by 150,064 shares or increase by 164,030 shares, respectively.

Under the Company’s 2004 Equity Compensation Plan (the “2004 Plan”), as approved by the shareholders to replace the 1994 Equity Compensation Plan (the “1994 Plan”), qualified and nonqualified stock options may be granted to officers, key employees and consultants at prices equal to the market price of the stock on the day of the grant. Officers and key employees may also be granted dividend equivalents and restricted stock. Restricted stock may also be granted to non-employee members of the Board of Directors. The 2004 Plan authorizes 4,900,000 shares for issuance under the plan. A maximum of 50% of the shares available for issuance under the 2004 Plan may be issued as restricted stock and the maximum number of shares that may be subject to grants under the plans to any one individual in any one year is 200,000. Awards under the 2004 Plan are made by a committee of the Board of Directors. At June 30, 2007, 2,910,837 shares underlying stock option and restricted stock awards were still available for grant under the 2004 Plan, although under the terms of the 2004 Plan, terminated, expired or forfeited grants under the 1994 Plan and shares withheld to satisfy tax withholding requirements under the plan may be re-issued under the plan.

Stock Options—During the six months ended June 30, 2007 and 2006, the Company recognized compensation cost associated with stock options as a component of operations and maintenance expense of $1,634 and $1,490, respectively. During the three months ended June 30, 2007 and 2006, the Company recognized compensation cost associated with stock options as a component of operations and maintenance expense of $867 and $828, respectively. For the six months ended June 30, 2007 and 2006, the Company recognized income tax benefits associated with stock options in its income statement of $239 and $183, respectively. For the three months ended June 30, 2007 and 2006, the Company recognized income tax benefits associated with stock options in its income statement of $132 and $21, respectively. In addition, the Company capitalized compensation costs associated with stock options within property, plant and equipment of $284 and $222 during the six months ended June 30, 2007 and 2006; and $132 and $125 during the three months ended June 30, 2007 and 2006, respectively.

The fair value of options was estimated at the grant date using the Black-Scholes option-pricing model. The per share weighted-average fair value at the date of grant for stock options granted during the six months ended June 30, 2007 and 2006 was $5.52 and $7.82 per option, respectively. There were no stock options granted during the three months ended June 30, 2007 and 2006. The following assumptions were used in the application of this valuation model:

Historical information was the principal basis for the selection of the expected term and dividend yield. The expected volatility is based on a weighted-average combination of historical and implied volatilities over a time period that approximates the expected term of the option. The risk-free interest rate was selected based upon the U.S. Treasury yield curve in effect at the time of grant for the expected term of the option.

The following table summarizes stock option transactions for the six months ended June 30, 2007:

Restricted Stock—During the six months ended June 30, 2007 and 2006, the Company recorded stock-based compensation related to restricted stock awards as operations and maintenance expense in the amounts of $710 and $439, respectively. During the three months ended June 30, 2007 and 2006, the Company recorded stock-based compensation related to restricted stock awards as operations and maintenance expense in the amounts of $513 and $334, respectively. The following table summarizes nonvested restricted stock transactions for the six months ended June 30, 2007:

The Company maintains qualified defined benefit pension plans, nonqualified pension plans and other postretirement benefit plans for certain of its employees. The net periodic benefit cost is based on estimated values provided by independent actuaries. The following tables provide the components of net periodic benefit costs:

The Company contributed $805 in April 2007 and $1,421 in July 2007 to its defined benefit pension plans and intends to contribute $6,202 during the balance of 2007. In addition, the Company expects to contribute approximately $3,382 for the funding of its other postretirement benefits during 2007.

During the first six months of 2007, certain of the Company’s operating divisions in New Jersey, Ohio, Virginia and four other states were granted rate increases designed to increase total operating revenues on an annual basis by approximately $5,321.

In December 2006, the Company’s operating subsidiaries in Florida filed an application with the Florida Public Service Commission (“FPSC”) designed to increase water and wastewater rates by $7,298 on an annual basis. The application is currently pending before the FPSC and in April 2007 the Company commenced billing for a portion of the requested rates, in accordance with authorization from the FPSC. The additional revenue billed and collected prior to the final ruling is subject to refund based on the outcome of the ruling. The revenue recognized by the Company reflects an estimate of the final outcome of the ruling. As of June 30, 2007, the Company has deferred $2,073 of rate case expenses and recognized $571 of revenue that is subject to refund based on the outcome of the final commission order. In the event the Company’s request is denied completely or in part, it could be required to refund some or all of the revenue billed to date, and write-off some or all of the rate case expense deferral. Based on the Company’s review of the present circumstances, no additional reserve or change in estimate adjustments are required for the revenue recognized to date or to the deferred rate case expense.

In 2004, the Company’s operating subsidiaries in Texas filed an application with the Texas Commission on Environmental Quality (“TCEQ”) to increase rates by $11,920 over a multi-year period. The application seeks to increase annual revenues in phases and is accompanied by a plan to defer and amortize a portion of the Company’s depreciation, operating and other tax expense over a similar multi-year period, such that the impact on operating income approximates the requested amount during the first years that the new rates are in effect. The application is currently pending before the TCEQ and several parties have joined the proceeding to challenge the rate request. The Company commenced billing for the requested rates and implemented the deferral plan in 2004. The additional revenue billed and collected prior to the final ruling is subject to refund based on the outcome of the ruling. The revenue recognized and the expenses deferred by the Company reflect an estimate of the final outcome of the ruling. As of June 30, 2007, the Company has deferred $12,382 of operating costs and $3,169 of rate case expenses and recognized $20,247 of revenue that is subject to refund based on the outcome of the final commission order. Based on the Company’s review of the present circumstances, no additional reserve or change in estimate adjustments are required for the revenue recognized to date or to the deferred rate case expense.

The following table provides the components of taxes other than income taxes:

Property taxes increased during the six months and three months ended June 30, 2007 primarily as a result of the acquisition of New York Water and the associated property taxes of $3,462 and $1,731, respectively.

The Company has identified fourteen operating segments and has one reportable segment named the Regulated segment. The reportable segment is comprised of thirteen operating segments for our water and wastewater regulated utility companies which are organized by the states where we provide these services. In addition, one segment is not quantitatively significant to be reportable and is comprised of the businesses that provide on-site septic tank pumping, sludge hauling services and certain other non-regulated water and wastewater services. This segment is included as a component of “Other” in the tables below. Also included in “Other” are corporate costs that have not been allocated to the Regulated segment and intersegment eliminations.

The following tables present information about the Company’s reportable segment:

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109,” which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company adopted the provisions of FIN 48 as of January 1, 2007 and has analyzed filing positions in its federal and state jurisdictions where it is required to file income tax returns, as well as for all open tax years in these jurisdictions. The Company’s reserve for uncertain tax positions was insignificant upon adoption of FIN 48 and the Company did not record a cumulative effect adjustment related to the adoption of FIN 48. The Company believes its income tax filing positions and deductions will be sustained under audit and it believes it does not have significant uncertain tax positions that, in the event of adjustment, will result in a material effect on its results of operations or financial position. The Company has elected to recognize accrued interest and penalties related to uncertain tax positions as income tax expense. As of June 30, 2007, the Company’s Federal income tax returns for all years through 2002 have been closed. Tax years 2003 through 2006 remain open to examination by the major taxing jurisdictions to which we are subject, however, 2004 and 2005 Federal income tax returns have been settled through examination.

We are subject to market risks in the normal course of business, including changes in interest rates and equity prices. There have been no significant changes in our exposure to market risks since December 31, 2006. Refer to Item 7A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 for additional information.

In December 2006, the Company’s operating subsidiaries in Florida filed an application with the Florida Public Service Commission (“FPSC”). The application is currently pending before the FPSC and in April 2007 the Company commenced billing for a portion of the requested rates, in accordance with authorization from the FPSC. The additional revenue billed and collected prior to the final ruling is subject to refund based on the outcome of the ruling. The revenue recognized by the Company reflects an estimate of the final outcome of the ruling. In the event the Company’s request is denied completely or in part, it could be required to refund some or all of the revenue billed to date, and write-off some or all of the rate case expense deferral. For more information, refer to “Note 9 — Water and Wastewater Rates” to the Consolidated Financial Statements of Aqua America, Inc. and subsidiaries in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2007.

In 2004, our subsidiaries in Texas filed an application with the Texas Commission on Environmental Quality to increase rates over a multi-year period. In accordance with authorization from the Texas Commission on Environmental Quality, our subsidiaries commenced billing for the requested rates and deferred recognition of certain expenses for financial statement purposes. Several parties have joined the proceeding to challenge the rate request. In the event our request is denied completely or in part, we could be required to refund some or all of the revenue billed to-date, and write-off some or all of the regulatory asset for the expense deferral. For more information, see the description under the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2006, and refer to “Note 9 — Water and Wastewater Rates” to the Consolidated Financial Statements of Aqua America, Inc. and subsidiaries in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2007.

There are no other pending legal proceedings to which we or any of our subsidiaries is a party or to which any of their properties is the subject that are material or are expected to have a material effect on our financial position, results of operations or cash flows.

There have been no material changes to the risks disclosed in our Annual Report on Form 10-K for the year ended December 31, 2006 (“Form 10-K”) under “Part 1, Item 1A — Risk Factors”. The risks described in our Form 10-K are not the only risks facing the Company. Additional risks that we do not presently know or that we currently believe are immaterial could also impair our business or financial position.

The following table summarizes Aqua America’s purchases of its common stock for the quarter ended June 30, 2007:

The Annual Meeting of Shareholders of Aqua America, Inc. was held on May 24, 2007 at the Springfield Country Club, 400 West Sproul Road, Springfield, Pennsylvania, pursuant to the Notice sent on or about April 10, 2007 to all shareholders of record at the close of business on April 2, 2007. At that meeting the following nominees were elected as directors of Aqua America, Inc. for terms expiring in the year 2010 and received the votes set forth after their names below:

Since the Board of Directors is divided into three classes with one class elected each year to hold office for a three-year term, the term of office for the following directors continued after the Annual Meeting: Mary C. Carroll; Nicholas DeBenedictis; Richard H. Glanton, Esq.; Lon R. Greenberg; Dr. Constantine Papadakis; and Ellen T. Ruff.