California Water Service Group (CWT) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the California Water Service Group's second quarter 2007 earnings results conference call. (OPERATOR INSTRUCTIONS). As a reminder, ladies and gentlemen, this program is being recorded. I would now like to introduce your host for today's program, Mr. Marty Kropelnicki, CFO. Please go ahead, sir.

Good morning. I'm Marty Kropelnicki, Vice President and Chief Financial Officer. Welcome to the second quarter earnings call for California Water Service Group. I'm joined today with Peter Nelson, President and CEO.

I'd like to remind everyone that a replay of today's discussion is available from August 2 through October 1 at 1.888.266.2081, ID 1100221.

Before talking about our achieved results for the quarter, I'll take a brief moment to talk about forward-looking statements. In particular, during the course of this conference call, the Company may make certain forward-looking statements. 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. Because of this, the Company strongly advises all current shareholders, as well as all interested parties, to carefully read and understand the Company's disclosures on risk, risk factors and uncertainties found in our Form 10-K, 10-Q, and other reports filed from time to time with the Securities and Exchange Commission.

Having said that, why don't we stop and take a quick look at the quarterly results for the second quarter of 2007.

Revenue for the quarter was $95.8 million, up 18%, or $14.7 million, over the same period last year. Of the $14.7 million increase, $9.9 million was due to sales to existing customers, obviously driven by the drier weather we've had in California during the first six months of the year. We had $4 million attributable to rate increases or rate relief and $800,000 of sales to new customers.

Looking at the operating expense line, operating expenses were up $12.9 million, or 18%, to $84.4 million. Of that amount, $7.1 million was attributed to water production costs due to the increased demand. Other operating expenses increased $1.9 million, or 8%, to $25.3 million. The largest variance that we saw there, really, was about $700,000 due to outside services for a handful of projects that the Company currently is undertaking, one of which is filing our 2007 General Rate Case. Maintenance expense is up $1.8 million, or 53%, to $5.2 million. As you may recall, on the last call, we mentioned we had two freezes, as well as we've had dry weather, which has allowed the Company to do more maintenance as we've gone through the first six months of the year. Depreciation expense increased $700,000, or 10%, to $8.4 million, primarily due to the increased capital expenditures that the Company did last year, putting its third plant into service. Property taxes, other than income, were up $400,000, or 13%, to $3.4 million due to higher franchise tax fees and property taxes. We had price changes or tax increases that take effect each year. Income tax was up $1.3 million, or 32%, to $5.4 million due to higher pretax income.

Net income for the quarter was up $2 million, or 35%, to $7.7 million. And earnings per share on a diluted basis were $0.37 per diluted share.

On a six month ended June 30, '07, revenue increased 14%, or $21 million, to $167.4 million. Net income increased 42%, or $2.8 million, to $9.3 million. And earnings per share on a diluted basis increased $0.10 a share, or $0.27, to $0.45 per diluted share.

A couple of the balance sheet highlights that we wanted to point out. We ended the quarter with net utility plant of $974 million. This is up approximately 8%, or $73 million, from the same period last year. Capital expenditures through June-- Total CapEx was approximately $50 million. Of that amount, $39 million was Company funded, and we ended the quarter with an additional $68 million of work in progress. In short, we believe we are on track to hit our capital budget estimates for the year, which is between $75 and $85 million.

Looking at the balancing accounts, balancing accounts for the quarter were up approximately $1.9 million to $3.9 million from $2 million at the end of Q1. The majority of the swing associated in the balancing account had to do with power costs in our southern regions, where we are served by Southern California Edison. SoCal Edison has two energy portfolios that they blend together to get their rate. One's a fixed pool; the other one is a spot market pool. And we have daily rates as a result of the way they manage their power mix. In doing an energy audit for 2006 costs, we've noticed that there were some energy cost swings that we believe are recoverable through the balancing accounts, and those were booked during the quarter.

The other major event that I'll point out that happened during Q2 was we did sign a new bank facility with Bank of America. We signed a total $75 million facility. That's up from the $55 million facility that we had before. It's a five-year deal with much favorable credit in terms that we have as a Company. In particular, the new structure, we have LIBOR plus 25 basis points with unlimited LIBOR locks, or prime minus 1.5%. And then we've had a significant reduction in rates with the bank. So with the credit stuff all cleaned up and ready to go forward, we feel like we're in good position to continue to fund the Company's capital expenditure program, as well as any potential M&A opportunities that may come our way moving into the second half of the year.

With that, I'm going to turn it over to Pete Nelson, who will give everyone an update on what's happening on the regulatory front. Pete?

Thanks, Marty, and good morning, everyone. These days, as Marty just mentioned, the action outside financial results is in ratemaking in California. So if I could have put a theme on last quarter's ratemaking issues, I'd say that was probably what's going to happen. And that was at the end of the first quarter. This quarter-- into the second quarter, the theme, to me, is more like what has happened. So I'll update you on five issues or proceedings very quickly. First is the rate case plan that the Commission adopted in May of this year. Second is our 2007 General Rate Case, which we have now filed. The third issue is our 2006 General Rate Case that we have an interim decision on. Fourth is the generic conservation proceeding. And fifth, which is related to the conservation proceeding, are conservation number and an account. I've mentioned each of these before. It's time for an update.

So the first issue is the rate case plan. The California Public Utilities Commission formally adopted a new rate case plan May 24, 2007 by a 5-0 vote. And this rate case plan basically sets the schedule for a transition to one rate case for each company every three years. You'll recall that we have 24 separate ratemaking districts in the state, plus our headquarters, which gives us 25 rate cases that are filed on a staggered basis every three years. Our schedule, according to the new rate case plan, is we will be on cycle, meaning the entire Company will be filed July 2009. That will be the first Company filing for the entire Company. But important to us in this rate case plan decision is the ability for us to reflect in rates recovery of our general office corporate costs, which are the pensions, benefits, healthcare, or health and welfare, and all the other typical corporate costs-- reflect those costs in all of our 24 districts in our 2007 General Rate Case filings.

So I'll talk about that next, which is our 2007 General Rate Case. We officially filed this in early July. The total request for the first year's revenue is $67.5 million. That would be effective July 2008. In this filing is our eight normal General Rate Case districts that are on cycle to be filed, plus the general office costs to be reflected in all 24 districts, effective July 2008. If this proceeding is adopted as filed, it would go a long way to mitigate the regulatory lag in recovering our corporate costs that we've been plagued with - up to seven years' delay in getting those costs reflected into rates.

The third issue is our 2006 General Rate Case, which is for 8 of our 24 districts. We filed this back in July 2006 for July 2007 rates. We have no proposed decision yet from the Commission, so they're late in issuing a decision on this by at least a month. However, we did get a decision that allows us to start interim rates effective July 1, 2007 for about, I'll say, inflation, which is about $2 million of annual revenues. That's important but, probably more important, is that we now have an effective date for the entire rate case of July 1, 2007. So when a decision is rendered, which we expect in the third quarter, we'll have the ability to essentially back bill back to July 1 for any collect revenues that were delayed in being recovered. Generally, those are collected over a 12-month period. So we feel very good about having the effective date established for that rate case.

The fourth issue or proceeding is the conservation proceeding, which is a generic proceeding that applies to all water companies in the state. This has been ongoing for months. And the real impact once this is decided is to remove the disincentives for water companies to promote conservation. Included in the proceeding are two important changes in rate mechanisms, and I'll talk about each of these two. The first is some form of a water revenue adjustment mechanism, or a RAM, which decouples sales and revenues the way electric and gas companies are able to do now. The second mechanism in this proceeding that's important to us is what we call the modified cost balancing account. You may recall that our balancing accounts now, which cover purchased water, pump taxes and electricity used to produce water-- these balancing accounts reflect a change in prices for those commodities, purchased water, electric costs. So, if PG&E or SoCal Edison or Metropolitan Water District changed their price for the commodity, those changes are reflected in the balancing accounts. But, if the supply mix between purchased water, surface water, groundwater changes, that supply mix is not reflected in the balancing accounts if there are any cost increases in the supply mix. So you can see, outside of Cal Water, that, in some cases, water companies in California will see increasing sales, which forces them to purchase more expensive wholesale water, which would then increase their production costs and probably deteriorate their financial results. That's a phenomenon that can happen easily. The modified cost balancing account, if it's finally adopted in the proceeding, would allow the recovery of not only the price change for those commodities but also allow recovery for the change in mix of the supply sources. That's very important. We expect a decision on this conservation proceeding in late 2007.

And then fifth, and last, which is really a compendium to the water revenue adjustment mechanism is the conservation memorandum account. I mentioned this last quarter. You may have heard that certain parts of the state, especially southern California, had a very dry winter this year. And there are some locations in California that are calling for customers to conserve water because of the relatively dry year. In our service territories, the Hetch Hetchy system, which supplies wholesale water to our peninsula districts, the San Francisco peninsula, has asked for a voluntary 10% reduction in usage. We filed for and the Commission granted in June what we call the conservation memorandum account for those districts that are supplied by Hetch Hetchy water. What this basically does is allow us to record any change in sales from what the adopted rate case in those districts had with the intent is for us to file for recovery of any drop in revenues at some future date.

So, I guess, in summary, again, ratemaking dominates our radar screen. It's very encouraging to us to note that the Commission is following through on their policy planning, which is the California Water Action Plan. They're following through on that policy with decisions. Just in this second quarter, their decision on adopting a rate case plan, which streamlines the process and transitions each water company to one rate case for the entire company every three years, which, of course, as I mentioned, allows us to file for recovery of corporate costs in our 2007 rate case. This is very important to us because it will mitigate, we expect, that regulatory lag in recovering corporate costs. The Commission also this quarter allowed us to start interim rates and have an effective date for a 2006 General Rate Case because they were not able to render a decision on time. And, also, the Commission approved the conservation memorandum account for those districts that have been asked to conserve water from the wholesale suppliers. And this, of course, goes a long way to allow us to promote conservation in the future.

So that's the ratemaking picture for the quarter, and I'll now turn this back to Marty.

Thanks, Pete. And, just to remind everyone, as we've talked to the analysts all individually, our ratemaking is very complex because of the multiple districts that we have. Essentially, we keep a separate set of books and a separate set of balancing accounts for every district plus GO. In the Q that will be filed here no later than August 9, we have a lot of information, starting on page 24-4, that will break out all the rate proceeding filings and the status of them.

Keeping with tradition, I think it's worth it to give you guys some weather information, kind of where we ended up during the quarter and compare that to 2007. I think I've used this analogy before; when I interviewed with Pete and I asked about the predictability of this business. He said the only thing predictable about our business is the unpredictability of the weather, and certainly that speaks going forward, as we had in Q2. The Company has four major regions that we operate in.

So, starting off with the Bay area districts, the precipitation that fell during Q2 was 0.86 inches, and we had precipitation days of 7.3. You can compare that to Q2 last year, and we had 4.02 inches of precipitation and 19 precipitation days.

Going down to the Los Angeles metropolitan area, for 2007, Q2 was 0.42 inches of rain and 2.7 precipitation days compared to Q2 of [2007] that had 3 inches of rain and 10.7 precipitation days.

Moving up to the valley, the central valley for Q2 of [2006] had 1.8 inches of rain and 8.5 precipitation days compared to 3.3 inches of rain and 15.8 precipitation days in 2006.

The Salinas Valley for 2007 had 1.4 inches of rain during the second quarter and 13 precipitation days, and that compares with 3.6 inches of rain in Q2 of last year and 22 precipitation days.

So, as you can see, the rainfall on a year over year basis and the precipitation is just the opposite this year as what we had last year.

The other thing that's probably noteworthy, even though we are seeing some voluntary conservation measures requested in different parts of the state of California, the Company continues to believe that we have adequate supply to meet our customer demands.

So, with that, Jonathan, why don't we open it up for Q&A with the people on the call, please.

Certainly. (OPERATOR INSTRUCTIONS). Our first question comes from Jim Lykins from Hilliard Lyons. Your question, please.

With your rate case plan on cycle for July of '09, does that mean there will be one more time when you file for eight districts?

Actually, yes, that does mean we will be filing July '08 for eight districts, plus headquarters costs again. And then the entire Company would be filed July '09. And, actually, the effective date for the rates for that filing would be-- Actually, we ended up being a January rate case district, which would be January of 2011. Makes sense.

And do you know at this point what the amount of those filings would be?

No, we don't. We just filed the 2007. We originally prepared a General Rate Case for the whole Company to be filed in 2007, and then, a couple days before we filed that rate case, the Commission came out with their Commission Issue D0705062 that adopted the new rate case plan. So we ended up taking the eight districts at that point, plus the GO costs, with the idea that we'll be able to spread those GO costs. So you can almost think of it, Jim, as a phase-in. Phase one is we're doing the eight districts as we normally do, plus our GO costs. But those GO costs should get allocated across the whole Company, if adopted. And then the next step will be to do the whole Company, as Pete said, beginning in July 2009.

Okay. And one last thing. Could I just get the purchased and pumped mix for the quarter?

Sure. I have year to date. Is that okay?

Sure.

Year to date purchased water-- and I have a year over year number, so I think you can pop the variances out. The purchased water was 28,467,468 this year as compared to 22,364,873 in 2006. Purchased power was 6,402,531, and it was 5,657,977 for the same period last year. Pump taxes - approximately $2.4 million, up from approximately $2.2 million the previous year.

Great. All right. Thank you, gentlemen.

Thank you. Our next question comes from Jonathan Lanfear from A.G. Edwards.

I've got a few questions, obviously, on all the rate action that is taking place; first, on the 2007 rate case filed for $67.5 million. What's the requested ROE?

I believe it's 10.2%. What happened is they piggybacked off the ROE from the last cost of capital proceeding that we did. And I believe we're still waiting for the final approval from the Commission on that. But the DRA and the Company were in agreement on the 10.2%.

But you're talking about the 2006 settlement that you have.

Yes.

What about what you filed for for the new 2007 General Rate Case? What was that premised upon?

I believe it was premised upon the same outcome.

Okay. So you didn't file for any higher ROE, like in the 11% range or anything like that? You're just assuming 10.2% is kind of what you're going to get going forward, and there's no need to distort, I guess, the rate increase amount that way?

Right. Right. I believe we had a verbal agreement with the DRA at that point - that we would move forward with the 10.2%. We're going to grab Stan real quick to get clarification on that. So, here he is.

The rate case that we filed this year, the '07 GRC, is based on the rate of return, which we have settled with the staff from last year's GRC, which is 10.2% ROE. Now, the Commission's new rate case plan calls for a generic proceeding next year to deal with cost of capital for several large water companies, including Cal Water. So we'll be making a filing at that time, asking for something greater than 10.2%.

Okay. But then-- Is that the way it's going to work going forward? Are they going to kind of give you what they think an appropriate ROE is, and then you base your filings on that?

Yes. We're going to see-- there's a bifurcation here, and that will continue going forward, where we do cost of capital in a separate proceeding, apart from the General Rate Case proceeding.

Okay. And, right now, the 2006 settlement that you have includes implementation of a RAM, does it not?

No.

It does not?

No. The Commission kicked that out into another proceeding. So we filed an application in October of last year, requesting a RAM Companywide. And they bifurcated that issue. We asked for it in the 2006, but they kicked it into this other proceeding.

Okay.

On the conservation proceeding, which is a generic proceeding.

Right. Okay. I must have misunderstood. I thought your settlement agreement with the staff had included implementation of the RAM. That just moved to the conservation proceeding.

Right. We had done that in a 2005 proceeding, but the Commission-- and it was bundled with doing conservation rate design. And the Commission punted on that issue. So both the RAM and the conservation rate design got eventually kicked into this generic proceeding. In fact, we have hearings going on this week dealing with that issue.

Okay. And then, lastly, there's the conservation memorandum account, the last thing you talked about, Pete. Is that-- Essentially, is that implementation of kind of a temporary RAM for any kind of, I guess, voluntary conservation measures that are put in place throughout the service territory? Is that the way you kind of view that?

Yes. That's exactly correct. I'd say an early adoption of a revenue adjustment mechanism for the districts that have been asked to conserve water by the wholesaler.

Okay. All right. Thank you, gentlemen. I believe that's all I have.

Thank you. Our next question comes from Michael Gresens from Robert W. Baird.

A couple of questions; first, in terms of the '07 rate case filed, the $67.5 million. How much of that relates to the 8 districts, and how much of it relates to the 24 districts with the GO costs?

Michael, the way that breaks down is the 8 districts is $44-- I'll round it off to the nearest million-- $44 million, and then the GO costs reflected in all the districts is $23 million.

Okay. All right. And the $3.9 million balancing accounts balance at the end of the quarter - how is that eventually going to be recovered? Or is there any filings that are out there? And then, secondly, how will it work, or will there be any potential recoverability issues with the generic conservation rate case in the modified balancing accounts?

That's a good question. Actually, we applied last week to recover some of those balances. Typically, there's an earnings test, and I believe it's 2% of the revenue for the district. Once the balancing account gets to that level, we can apply for recovery. Clearly, this energy cost issue with the spot market with SoCal Edison rates, that was a pretty big thing that went into the accounts during the quarter. We do have a couple districts where that cost-- their balance has to go above $1 million, and we are applying to get that surcharged back to the customers. Typically, it's between anywhere from 12 months' to 36 months' recovery, depending on what we are allowed by the Commission.

And then, in terms of your second part of your question, you're absolutely right. With conservation and the RAM on the horizon here, there are a lot of detailed mechanisms that have to be kind of flushed out. For example, when we talk about balancing accounts, those costs are all incurred within a quarter in expense. So the P&L is whole, and they're really off the books. With the concept of implementing a RAM for the Company, we'll probably have to start booking those accounts on a monthly basis. And Stan and myself and a couple outside consultants who worked on RAMs for other companies are starting that detailed design work, actually, in the month of August, this month.

Good. One final question in terms of the $1.9 million increase in the balancing accounts. The $1.1 million - that was actually expensed in 2006? Would that be correct?

That's correct.

And then it's just more of a note to the balancing accounts this quarter?

That's right. So, $1.1 million had to do with the energy costs, and then, for year to date this year, you have about $800,000 of items that are kind of flowing through the balancing accounts that we believe will be recoverable at a future date.

Got it. Thanks, guys.

Thank you. (OPERATOR INSTRUCTIONS). Our next question comes from Heike Doerr from Janney Montgomery.

Thank you for being so thorough on the regulation stuff. That's always extremely helpful. A quick point of clarification. When we talk about how much of the revenue increase is being driven by weather, this $9.9 million, is that on a year over year basis, or are you trying to normalize that off of what we would consider a "normal weather year?"

That's basically on a year over year basis. We don't try to normalize it for the weather because the weather is so unpredictable. One of the reasons why I like to give the weather stats out-- I know some of you track it. But you just see really big, dramatic swings in the weather pattern. And not having a RAM in place, we are basically demand-driven. So the more people consume, the higher our revenue and, frankly, the more money we tend to make. So that's not normalized. We've never attempted to normalize it. That is just kind of where it is and driven from where we are on the demand side.

Okay. So, trying to read the tea leaves here, I believe, last year in the second quarter, it was rainier than normal. That cost you about $4 million. So, when we look at this net/net, is it safe to say that about half of this, let's call it, $10 due to weather is really based off of just recovering from last year, so it's only about $5 million that we would say is a true weather bump? Or is it just too difficult to quantify.

I think it's too difficult to quantify. Frankly, one of the things I've tried to do is do a regression analysis between temperature and demand. And I start to get a fairly decent correlation, like, at 80% or 85%. But even that still has a margin of error of 15% to 20%.

Okay. And regarding the timing of this 2006 General Rate Case, I understand that it's effective back to July. How does that get implemented? If that doesn't get implemented during this quarter and that's something that only gets decided in the fourth quarter, would you take the gains that you would have seen in the third quarter as kind of a lump sum, or is that ease that in in an 18-month period? How does that work?

I'd say, Hica, that's eased in. The period is yet to be decided, 12 or 18 months or even more. But, essentially, you end up figuring out how much revenue you've lost because of the delayed decision. And then that is surcharged to customers' bills in future periods, usually over 12 months. Does that make sense?

It does. But, if we get a decision here during the third quarter, is that something that we would then see recognized in your third quarter earnings?

No, it's recognized as the revenue is billed over the future 12-month period, say.

Okay. Okay. Understood. And just a quick housekeeping item. I noticed that the tax rate was a bit lower than we had been expecting.

Yes.

What drove that this quarter, and what could we use as a--? What do you suggest we use as an effective tax rate going forward?

You know, that's a very, very good question. That's very, very technical. Two things. One, on the pre-'82 assets, you have the effect of what's called flow-through accounting, where the Company in the past has had an accelerated deduction. And then some of the tax holds were moved around and changed, so it pushed the tax rate back up. That's going to bump around, I would say, between, say, 40.5% and 41.8% as we have items that have "costs to remove," so assets that we take out of plant. We're allowed to pick up a deduction for that. So you're going to see the tax rate bump around kind of quarter to quarter based on those pre-'82 assets and the flow-through accounting, as well as the deductions taken for the costs to remove.

So it will keep things exciting, I guess.

Well, if you're a tax accountant, yes, this is life in the fast lane. I think for a CFO or for someone like you who tries to build a model, it will drive you nuts. But it really is the pre-'82 assets and the flow-through accounting effect.

But we would loosely stay in a range here 38% to 42% in any given quarter?

Yes. I would tighten that range. I think-- I would say you're going to stay between 40.5% and 41.8%.

Okay. That's helpful. Thank you.

Thank you. Our next question comes from , pardon the mispronunciation, [Bishal Katrawal from the Sanford

Your 50%-plus increase in the maintenance costs - could you give us some more details on that? Is that just because of more maintenance at your end, or is it because of more than usual water main breaks during this quarter?

Sure. You know what? In fact, we did a kind of a detailed review of the maintenance items, and kind of two things popped out. One, any time you have a freeze, you typically end up doing more maintenance work. If you recall, towards the end of Q1 and the beginning of Q2, we had two major freezes. In particular, in southern California, you may recall, a lot of the citrus crop was damaged because of the freeze. So, clearly, we had extra work we had to do around those two freezes. In addition to that, because it's a dry year, we've been able to do more maintenance early on in the year. Typically, in the first, let's call it, five months of the year when it's wet, it's hard to do the preventative maintenance that you like to do. But, since we had drier weather, we were able to do more maintenance kind of early on in the process. Anything with our infrastructure, as you know, and there's a lot of media coverage on water conservation now in California-- We believe maintenance is good. The last thing we want to be is on the evening news with a main break someplace because it wasn't serviced or it wasn't maintained.

So, in terms of as we go into the second half of the year, we hope to have the maintenance items come down a little bit, since we spent more in the first half of the year. But let's make sure we're really clear. In terms of making sure our water system is working correctly and we're minimizing leaks and we're serving the customers well, that's our first priority.

When you say it will come down next year, do you mean come down compared to--?

To our budget.

To your budget. So, compared to last year, it will be along those lines.

Yes. What we try to do, basically-- We try to set a maintenance budget every year. But, as I'm sure you can imagine, being an infrastructure company, you could probably never spend enough on maintenance. So, in terms of us building our internal business model and building our projections, we have to make some maintenance assumptions. We try to be accurate with those assumptions. This year, clearly, is an off year that we've done more maintenance in the first six months of the year.

Thanks. That's the only question I had.

(OPERATOR INSTRUCTIONS). I'm not showing any further questions in the phone queue at this time.

Great, Jonathan. Well, I'll take just a couple quick moments to wrap up. Again, as we've talked about this quarter and last quarter, there are a lot of exciting things happening on the regulatory front. The Company has been keenly focused on the California Water Action Plan and our rate case proceedings that we're moving forward with. We're really putting a lot of effort into that. We think it's a very dynamic and changing time. And you see definite improvements in terms of water policy within the state of California. In addition, now that we're into summer, we're kind of getting back to what I would call a normal weather pattern, and I think you'll see us get back to a normal kind of demand-driven consumption pattern here for the second half of the year.

So, with that, I want to thank everyone for your time and your interest in Cal Water, and look for the 10-Q to be filed here, sometime before August 9. You'll find a lot of good information on the ratemaking issues that we're working on as well. So, thank you, and have a good day.

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.