California Water Service Group (CWT) 2006 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter 2006 earnings results conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. If anyone should require assistance during the conference, please press star then 0 on your touch-tone telephone. As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Mr. Marty Kropelnicki, Vice President and Chief Financial Officer of California Water Service Group. Sir, you may begin.

Thank you, Fayad, and good afternoon, everybody. Thank you for joining us for our Q2 2006 conference call covering our results for the second quarter. With me here today is Pete Nelson, President and Chief Executive Officer of California Water Service Group.

Prior to our discussion here today, I'd like to remind everyone that during the course of this conference call, the Company may make certain forward-looking statements regarding certain matters. Because these statements deal with future events, they are subject to various risks and uncertainties and actual results could differ materially from the Company's current expectations. Accordingly, the Company strongly advises all current and potential shareholders to read and understand our discussion of risks and risk factors and other disclosures found in our 10-Q, 10-K and 8-K and other reports filed from time to time with the Securities and Exchange Commission.

In addition, we'd like to remind everyone that this call is being recorded. A replay is available through October 2nd, 2006 at 1-888-266-2081, pass code 832268.

Now with that, we will move on with the financial highlights for the second quarter of 2006. Revenue for the quarter was $81.1 million, down $400,000 or 1% from the same quarter last year. Included within the revenue number is $2.6 million of approved rate increases, $800,000 of sales to new customers, and a decrease in revenue of $3.8 million from sales to existing customers.

Total operating expenses for the quarter increased $1.8 million or 2% to $71.9 million for the same period last year. Water production costs increased $800,000 or 3% to 30.2 million over the same period. Other operating expenses increased 1.8 million or 8% due to costs associated with employee health and welfare plans as well as other insurance programs. During the quarter, maintenance expense decreased $300,000 or 9% to $3.4 million compared to the second quarter of 2005.

Depreciation increased $600,000 or 9% to 7.6 million due to our higher capital expenditures that took place in 2005. Income taxes declined $1.1 million, or 21%, due to lower pretax income for the quarter. Interest expense as well as capitalized interest in the quarter were both up due to the increased spending in the Company's current capital program. Interest expense was up $317,000 to $4.97 million. Capitalized interest was up $400,000 to $625,000 compared to $225,000 for the second quarter last year.

Net income for the quarter was 5.7 million or $0.31 a share for the second quarter of 2006 compared to $7.6 million and earnings per share of $0.41 for the same period last year. In addition for the quarter, and this will be found in our 10-Q that will be filed next week, work in progress was up 92% from $35.3 million last year to $67.7 million this year and from a cash flow perspective, cash expenditures related to CapEx were 55.3 million, up from 34.1 million from last year.

Now I'd like to turn it over to Pete Nelson to give an update on what's happening on the regulatory side.

Okay. Thanks, Marty, and welcome everybody to the call this afternoon. I'm going to speak to regulation as Marty mentioned and specifically regulation in California because I think it's important to remind everyone how the process still works in California because it hasn't really changed for awhile, and it's so key to our results, how regulation in California works. So I'll speak to three items first and one is, of course, the California PUC and its regulations and how it works for what we call ourselves is a multi-district company, where there still is a significant regulatory lag issue.

Second, I'll talk about the new policy guidance that the Commission has put out which is the water action plan. Very important document, still in its infancy.

And then third, I'll just spend a minute on another organization that's nicknamed NARUC, which some people may or may not know much about, and this is the National Association of Regulatory Utility Commissioners. Seems like every organization has their trade group, and this is the trade group for Public Utility Commissioners and staffs nationwide, those who regulate electric and gas and telecommunications and water, and this group just had an annual meeting in San Francisco this week.

Following that, I will speak to our rate cases, what's recently happened and what we're looking at in the next couple of months.

So first, how regulation works in California. Since 2004, which is the latest change in what I'll call the rate case plan, this has been the process of how rates work. The Commission mandates that each rate district file a general rate case every three years. Now, we at Cal Water are the most multi-district company in California. We have 24 rate districts so that means we file eight districts every year for rate increases.

Importantly, though, the corporate costs, the headquarter costs, are filed also once every three years. So I'll call that the 25th district, in essence. Now, the corporate costs rate case is very important to us because this is where all those centralized costs are collected. Sarbanes-Oxley costs, pension costs, healthcare costs, engineering, accounting, computers, rate making, all those centralized costs are collected and filed for in the corporate cost or general office rate case every three years.

Now, what's important and what is key to this regulatory lag situation we still have is that the rates to support the general office rate case are phased in over three years. Reason being is that rates are only collected in those 24 rate districts. There is no general office rate case, or rate district, and so when the general office rate case is filed, and decided, about one-third of those cost increases are reflected in the first year. The second, third, and the second year and the last third and third year. So right now our last general office rate case filing was in 2004 and was decided in mid-2005 so we're ending our first third of the general office rate case cycle.

You can see that this situation, phasing in the rates for all the corporate costs, really creates a regulatory lag situation for those multi-district companies. For other companies in California that have one rate district, this situation doesn't present a problem to them.

So the Commission here has recognized that the rate process could be improved for a lot of reasons, and last December the Commission, in fact, all five commissioners had a part of this and they all voted yes, but the Commission adopted what they call the water action plan. This is only seven or eight months old and still a plan and, of course, the devil is in the implementation and the details, but there are several elements of the plan that are very important, and we are very happy with the plan as guidance for policy and in California. If you haven't seen the plan, it's a 28-page document, and you can either log on to the California PUC website or we can send you a copy. Either way is fine.

But there are certain elements in this plan that really give us optimism to the future. It's really a good solid policy plan. Among those elements that are in this plan are things like a distribution system improvement charge, which is fairly common back east for water utilities. This allows essentially the quarter by quarter true-up of capital expenditures. Very common, as I said, back east.

Another element that's in the plan is a revenue adjustment mechanism, which is very common in the electric and gas business. This essentially what we call de-couples sales and revenues. It's designed to minimize the impact of customer usage changes on revenue. Customer uses can change due to weather or conservation or just normal usage patterns, and this mechanism is designed to minimize those impacts on the water utilities and revenue. As I said, very common in the electric and gas business. Not common anywhere in the water business yet.

Another element of the plan is streamlining the rate case process. This is where they would look at the situation we have for regulatory lag on a multi-district company, and so we're very happy with the plan. But again, it is a plan and there has been no implementation of the plan as yet. In fact, the way it is implemented is as each water company files for a rate increase, they file for elements in the plan, and then those are dealt with in the rate application.

So, my third issue, or the third thing I mentioned was the National Association of Regulatory Utility Commissioners, NARUC. This water action plan was a topic of interest at their convention this week in San Francisco. In fact, copies were handed out all over the conference. And at that conference, the California Commission water staff made it very clear that they are very excited about implementing all the elements of this plan as quickly as the regulatory body and process allows. So I'm guardedly optimistic. I think this plan is a good one, good policy guidance, and we'll just have to see how this thing plays out as it's implemented in each company over time.

Now moving from California regulation to California Water Service, and what rate changes we have recently received and are on our short-term horizon. This early July this year, we did have approved our what we call step rate increases, which I will call the equivalent of an inflationary increase, for about $5 million annual revenue that's new. And our 2005 general rate cases, there are eight districts that were filed last year, we are approaching a decision on those eight.

There is a proposed decision out from the administrative law judge. In fact, there's two proposed decisions. One of those proposed decisions would call for adopting rates with an -- with a return on equity of 10.16, which is the highest ROE we have seen in years. The second part of the proposed decision makes an effective date of July 20th for these new rates. Now, the proposed decisions are on the Commission's calendar for August 24th, so that's the earliest date they would make a decision on our 2005 applications.

Of interest here is that we included in our filing, in fact, we were the first water company to include the revenue adjustment mechanism, asking for that mechanism to be in place for the 2006 rates. The proposed decisions coming out are recommending that we do another filing for the revenue adjustment mechanism. This is a whole new situation for the California Commission. They want to be very careful, I'm sure, to implement it correctly, so they are recommending that we do another filing for this adjustment mechanism. We are doing our best to speed up that revenue adjustment mechanism application and are attempting to make it part of the decision that the Commission would make at the earliest August 24th on our rate cases.

So that's the situation in California. Part of it hasn't changed for years. Part of it is new to us with this water action plan. I know there's a lot of talk about the expectation of regulation improving in California. I'm guardedly optimistic. We operate now under the same, I'll say, old rules, but with this water action plan and the elements in it, particularly the revenue adjustment mechanism, I'm looking forward to the application of the water action plan in the near term future. So thanks. I'll turn this back to Marty to wrap up the call.

Thanks, Pete. Speaking of revenue and weather, as everyone noted in our press release, our sales to existing customers was down slightly and I think it's worth noting that as you may recall at the end of Q1, we were ending a time when we had tied the average for the wettest Q1 on record, and I want to share a couple of statistics that will help understand what the situation was in Q2.

So March is one of the wettest Marches on record for various parts of the state of California. That continued well into April for us, and in some of our service areas into May. And looking at the precipitation that fell during the second quarter total on average for our service area for 2005, we had 2.46 inches of rain on average. For 2006, we had 3.44. That's a 40% increase in precipitation within our service areas.

Looking at the precipitation days, the actual days that it rained, we went from 13.6 days in Q2 of 2005 to almost 16 days in 2006 so that's about a 16% increase in days precipitation as well.

So part of the revenue effect that we saw this quarter was just the wetness that we saw in Q1 carried on well into Q2. We started drying out, I would say, probably mid-May, but by the time the quarter started drying out, it wasn't enough to offset what we typically see demand for this time of year in the second quarter. So with that said, we will open it up for questions to the people on the call.

Thank you, sir. [OPERATOR INSTRUCTIONS] Our first question comes from Jim Lykins from Hilliard Lyons.

Good afternoon, gentlemen. Thanks for refreshing us on the rate making process in California. That's very helpful. I wanted to ask you about the wastewater treatment plant in New Mexico. I'm wondering if this is going to be considered regulated or unregulated operations and if it's going to be regulated, the expenses for upgrade can be included in rate base.

Thanks, Jim. Pete Nelson here. Yes, our wastewater treatment plant, not many people may know about this, but this was a treatment plant that was retrofitted and rebuilt and just finished, I'm going to say, about a month ago.

I'll give a little commercial here. It's the first of its kind in that we were able to retrofit this treatment plant with a new technology that's much cleaner and much less expensive and takes a much smaller footprint than the old technology. While we were retrofitting it, within its existing footprint, we kept the existing plant working, meeting all water quality standards during the construction period. But to answer your question, yes, this is included in rate base and rates in the wastewater system in New Mexico but keep in mind that's a very small subsidiary for us so it would not move the needle much for the California Water Service Group. It is regulated, you're right.

Okay. Are you guys still looking to do an equity offering in the third quarter, and if so, could you just give us an idea of how much capital you're looking to raise and what that money is going to be used for?

Sure. We haven't set any tentative time lines yet to complete a financing but as we covered on the call, our capital expenditures are significantly up year-over-year. So we're currently still reviewing those plans, and when -- I anticipate sometime within the next six months to 12 months, we will have to do some financing activities that we will put a press release out and share that with everyone at the same time.

One last thing. Back to the regulatory side, I'm just wondering if Rachel Chong has been around long enough for you guys to have a feel on what kind of impact she's going to be making on the Commission. Any general comments at all that you might be able to make regarding her?

I'd say it's too early to tell. She's only been on the Commission for a few months. But to me, this is my opinion, very qualified, very sharp, very intelligent commissioner, and our discussions with her, she seems very balanced, and they're willing to look at all sides of an issue. So that's all you can really ask for with a Commission appointment.

Thanks, guys.

Thanks, Jim. Have a good day.

Our next question comes from Alan Seymour from Columbia Management.

Hi. Two kind of regulatory questions. One is, both for the California Commission and maybe for the commissioner kind of meeting, was there any sense of how they looked at consolidation, among other things? In other words, I think most people felt that no consolidation could happen in California because it all went to the rate payer. Is there any change in that, either in California or in terms of your feelings on the kind of Commissioner body as a whole in the United States?

And then the second question is, related to -- it sounds like a change in the way they think about regulatory for capital spending in the water utilities. And I guess the question is, is that because in the past, the water -- the CapEx is primarily for expansion as opposed to rebuilding, and now the people are thinking that they need to rebuild more and they have to figure out a way for paying for that? Is that -- maybe you could give me some sense of what your thinking is?

Sure. Alan, I'll take the first question first, and that's consolidation of small systems in California. You're right, there's been very, very few consolidations of small systems in California in the last few years, maybe one or two a year. We were able to purchase one last year. The Los Tran water district, but there's very few.

In the water action plan, one of the elements of the plan calls for incentives for large companies to purchase small troubled systems. So the policy is in line, but again, we haven't seen any action yet on that, as opposed to other states, maybe in the eastern seaboard, who are much more effective at giving incentives to large systems to take on smaller systems.

Your second question about the capital improvements for water and the rate making mechanism. I mentioned the distribution system improvement charge. I'll speak for the nationwide regulatory body as a whole. There's such huge demand for replacing infrastructure in the water business, I think the -- that this mechanism is a very good way to approach in changing infrastructure, replacing infrastructure, without the accompanying rate shock. It's because the rates are trued up each quarter, you may see a 1% rate change per quarter, up to maybe 4 or 5% per year, but that avoids a multi-percentage increase every couple, three years. Does that help?

Yes. It sounds like they're trying to figure out a way to make it easier to upgrade the infrastructure, if you will, or replace it because obviously, well I happen to be in the east, so every time I see a New York City street flood because the thing is 100 years old, that's got to be an issue, I think.

That is, and there's two objectives. One is to replace the infrastructure that's aging, and also to minimize the rate impact at any one time on the customer.

Our next question comes from Selman Akyol from Stifel.

Thanks, good afternoon. Couple questions as I'm sitting here. First of all, when you guys said that you wanted to include a revenue adjustment mechanism and they wanted you to come back and do another filing, can you tell me why you went for the revenue adjustment mechanism as opposed to getting the system improvement charge, which would help you recover your CapEx? Is one more valuable than the other is the way you look at it?

Sure, I'll take that. The distribution system improvement charge is most effective in states that have a historical test year. This is getting much more technical than maybe you need. California does have a prospective looking forward rate case test year. So it's debatable whether the distribution system improvement charge will be much of a difference in California but it just hasn't been tested yet here. There's not been any design even considered by the Commission yet.

The revenue adjustment mechanism, on the other hand, really does, I think, do a good job of minimizing the impact of customer sales or usage on revenue. And the reason why the Commission ALJ asked for a separate filing is this is the first time they've tried something like this. The ratepayer advocate is part of the Commission staff, would like to see increasing rate blocks, like you'll see in electric and gas, to encourage conservation. And there's a lot of devil in that detail as to how big you make that swing when you increase the rate block. Should it be 10%? 20%? To encourage conservation. So since it hasn't been tried here, I think that's what's delaying the implementation.

Got it. Then as it relates to CapEx, I know you said 55 million for the quarter but can you refresh us on what the plan is for the full year?

Sure. For the full year, we're scheduled to do 80 to 85 million. The one caveat on that is that some of these are large projects, and things could get tied up in permitting, et cetera, but what's on schedule for this year, and so far the way we're tracking, looks like we have a chance of coming in at that 80 to 85 million, and we have a corporate initiative to try to get it all closed out and bundled up before the end of the year.

Got it. And I know you said weather was a factor this quarter, but also wasn't it a factor in 2Q '05 as well too? Wasn't usage down pretty significantly back then as well?

I believe it was. I'd have to go back and look at the historical. The reason why I gave the stats that I did, that highlights what the change was between Q2 of last year and Q2 of this year. And so clearly there was a significant increase in terms of the days precipitation that we had as well as the actual rainfall, and that's one of the reasons why we think we saw that fall in demand by existing customers.

Okay, great. Thanks.

All right, Sel. Thank you.

Our next question comes from Michael Gaugler from Brean Murray Carret.

Good afternoon, everyone. First off, I was wondering if you could talk a little bit about the acquisition environment, what you're seeing out there in terms of smaller and medium-size systems coming up for sale.

Sure. I think I'll separate this California versus the other states we're in. That market has definitely slowed down for small and medium companies interested in being acquired in California. So you're seeing probably maybe one or two a year in the entire state being acquired. As opposed to in New Mexico, we have several being acquired each year, just a different state, but the numbers are relatively much smaller than California, so you won't see that moving the needle too much.

Okay. And just kind of to wrap it up, have you seen any change in outlook with regards to future costs to comply with new water quality mandates? Are those costs tracking about what you thought they would be in the beginning of the year, or a little more, a little less?

They're about on target. And I don't see any huge disjoints in water quality regulations in the future that we'd have trouble handling. I feel pretty good about the water quality area. It's coming in as expected.

All right. Thank you, gentlemen.

Thank you, Michael. Have a good day.

Our next question comes from Jonathan Reider from A.G. Edwards.

Good afternoon, gentlemen.

Jonathan.

How's it going? I'm doing great. Got a question going back to the rain issue which I'm sure you guys love. Do you have like an EPS impact during the quarter, or can you quantify it versus normal, at least on the revenue basis?

That's a good question, and officially the Company has never done any regression testing to compare the rainfall to revenue. I think that's something here in the future we might do to try to build a model out but we've never officially done that.

Okay. Yes, that would be pretty helpful from our end, I think. If you could maybe clarify, what caused the water procurement cost during the quarter to go up if usage was so significantly down?

Jonathan, we see production increasing, especially late in the second quarter, and that's recorded daily. So we see those production costs increasing. Billed revenue tends to lag that, in that if you produce more water today, you won't read that meter for a week or two or three later. So the weather did turn better, I'd say mid-June, and that was driving up production costs.

Okay. What was the breakdown between purchased and pumped?

You may have to hang on for a second here. I don't have that information with me, Jonathan. But certainly you can give me a call and I can look that up.

Okay. Are there any items during the quarter that you guys would consider one-time that weren't singled out in the release?

There was a couple things that I think are significant. Everyone please keep in mind when you look at our press release, you're looking at the consolidated statement of income, so you have a lot of accounts that roll into a single account. We do have a deferred comp plan. We do have a serp. Those are subject to mark to market adjustments. We did see the market go, a lot of market volatility overall in Q2 and there was some mark to market adjustments there. We had an increase, a slight increase, in legal fees associated with some GRC work, general rate case work, that took place last year. Then, as we mentioned in the press release, we saw a general increase in the cost for health and welfare plans overall. Being self-insured, the marginal cost of adding employees to our plan is not very much, because we are self-insured, but when they utilize the plan, we tend to take a bigger expense as we are self-insured.

Were the mark to market expenses, were those anything significant or not worth breaking out?

They're probably, ultimately in the long run, in fact, I've just started looking at this should we reclass and management is going to consider reclassing some of our current liabilities out, so it's a little bit clearer to the general public. I'd have to go back and look, but I think between the two, the deferred comp and the serp, the mark to market adjustment for the quarter was right around $0.5 million.

Okay. And then going back to the 2005 GRC, did you say there were two proposed decisions out there or just that one?

Well, there's two. One is to establish effective rates for July 20th so that goes back about a month to make the effective date for the new rates. That's an important decision to us. And the second is to adopt the new rates with a new return on equity of 10.16%.

And the retroactive rates would -- is it safe to assume that the increase would be the same essentially on, I guess, a usage basis as the adopted rates going forward?

Yes. What we do is we collect the cost or the rate increases that would have been realized if the rates would have started July 20th, and then collect those from customers and how that's done depends on how the Commission decides. It could be one month, one year, two years. We've seen all over the map there. But important thing is that we capture those revenues and do get them in the future.

Okay. And then I guess lastly, I don't know if you guys can try to put a handicap on the probability of getting the revenue adjustment mechanism approved on the second filing. Did the staff or the ALJ, did he seem supportive of implementing this? Just wanting to get a little more background on it. Is there a lot of opposition to it?

I guess I'd characterize it as everyone is of one mind on Venice Avenue that we do need this revenue adjustment, that that's a good policy decision. The difficulty is in how you implement it and how you set rates to achieve some conservation by customers. So even if we were forced to make a separate filing 60 days after the general rate case is decided, that's not all bad, but then it just takes longer to get the revenue adjustment mechanism in place. We'd like it as soon as we can.

Okay, and you can file for it outside of the general rate case?

That's, I think the proposed decision asks us to file within 60 days for the revenue adjustment mechanism. That's the filing, but the decision could be anybody's guess. That's why we're trying to speed things up and get it done as part of the same decision.

Okay. That takes all my questions. Good luck on getting that adjustment mechanism in there.

Hey, Jonathan, just coming back to your first question. I was able to find the data here with me. The breakouts on purchased water versus production water here, I'm going to give you the '05 number first. For purchased water, it was about 22.38 million for '05. For '06, it was 22.36. So purchase water has gone down about 1/10th of 1%. Purchased power in '05 was about 5.2 million, and that's about 5.7 million in 2006. So power costs are up. And then on a pump tax basis, pump taxes went from about 1.8 million in '05 to about 2.2 at '06. So I think what you're kind of striking at is an important point, and that's we're pumping more of our water. We tend to, in the long run we'll have higher margins on our own water that we produce versus purchased water overall.

Thanks, Marty.

You bet. Thanks, Jonathan.

Thanks.

[OPERATOR INSTRUCTIONS] I'm showing no further questions at this time, sir.

Okay. Great. Well, again, thank you for joining us today. Our 10-Q will get filed here next week, and any information about the PUC decisions Pete talked about you can find at the PUC website. We'll look forward to talking to everyone next quarter. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program for today. You may all disconnect, and have a wonderful day.