California Water Service Group (CWT) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second-quarter 2010 earnings results conference call. At this time, all participants are in listen-only mode. Later, we will conduct question-and-answer session and instructions would be given at that time. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the call over to your host, Martin Kropelnicki. Sir, you may begin.

Thanks, Stephanie. Good morning, everybody, and welcome to the second-quarter 2010 earnings conference call for California Water Service Group. With me today is Peter Nelson, President and CEO of California Water Service Group. I'd like to remind everyone that a replay of today's discussion will be available from July 29 through September 27 at 1-866-253-6505, ID number 1469346.

Prior to looking at the results for the quarter, I'd like to take a brief moment to discuss 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 uncertainty and actual results could differ materially from the Company's current expectations.

Because of this, the Company strongly advises all current stockholders as well as all interested parties to carefully read and understand the Company's disclosures on risk and uncertainty found on our Form 10-K, Form 10-Q, and other reports filed from time to time with the Securities and Exchange Commission.

Having said that, let's jump into the quarter and go through the quarterly results, and after I go through the results, I will hand over to Pete, who will give you an update from an operational perspective.

For the quarter, the Company had revenue of $118.3 million, up $1.7 million or 1.4% over the same period last year. There are four main components that drove the change in revenue. One, we had a rate relief of $8 million. That rate relief can be broken into two buckets. Approximately $4 million of step increases. That would have gross margin associated with the step increase. And $4 million of offsets, and offsets basically go to cover increased costs, but there's no gross margin that goes to the bottom line on that.

New customer revenue added approximately $600,000. Usage by existing customers was down $12.7 million, and the net effect of the WRAM MCBA, and that WRAM is the water rate adjustment mechanism, and then the modified cost balancing account, was a positive $5.8 million. Included in that debt number for the WRAM was the $5.3 million negative adjustment, or reduction due, to production costs being lower than the adopted numbers.

Going down to the production costs, and looking at operating expenses, operating expenses were up 1% or $1.3 million to $102 million for the quarter. Looking at the production costs, these three components of the production cost -- purchased water, purchased power, and pump taxes -- are all covered by the modified cost balancing account, or the MCBA.

Purchased water was up $753,000 or 2.4% for the quarter. Overall, water production for the Company was down 14%, but that was -- in the purchased waterline was offset by higher wholesale water prices. Purchased power for the quarter was down $170,000 or 2.2% compared to last year. And pump taxes were down $451,000 or 18.3% compared to Q2 2009.

Admin and general expenses for the quarter were down $904,000 or 5% to $18.5 million. That has to do primarily with our increased capital spending and more expenses being allocated to construction projects. So people who work on construction, we allocate their time to the project and the overhead that follows or benefit costs follow that.

Looking at other operations, other operations for the quarter increased $400,000 or 3% to $14.7 million. That was driven primarily by three categories -- one, increased spending on conservation; two, costs associated with our front office and customer service; and three, increased purchases of chemicals and filters.

Maintenance expense for the quarter was up 20% or $800,000 to $5.2 million. This is driven by more maintenance on water mains, which is typical this time of year.

Depreciation and amortization increased $400,000 or 4% to $10.6 million, driven by the capital additions put into plants during 2009.

Income taxes were up $200,000 or 5% to $4.1 million, due to a slightly higher tax rate. And property and other taxes were up $200,000 as well, primarily due to increased franchise fees and property taxes.

Net operating income for the Company was $16.3 million, up $329,000 or 2% over the same period last year.

Going down to other income and expense, other income and expense was breakeven, and that compares to a positive $1.5 million (see press release) last year, so that's a pretty big swing. And that is primarily driven by a mark-to-market adjustment associated with assets that the Company has associated with some of its benefit plans. So the swing went from a positive $1.8 million to a negative $700,000, and that's properly reflected just in the volatility associated with the stock market that we saw during the quarter.

Interest expense for the quarter was up $582,000 or 11% to 5$.1 million, and that's driven by the long-term debt offering that was completed during 2009, plus the interest associated with the Company's short-term line of credit.

Earnings per share for the quarter were $0.50 per diluted share versus $0.58 per diluted share for the same period last year.

I would now like to turn it over to Pete and then I'll come back and talk about the balance sheet after Pete is done. Pete?

Okay. Thanks, Marty, and good morning, everyone. I've got three or four issues I'm going to cover today. One is I am asked all the time about politics in California, and particularly the governor's race, so I'll talk about that. And that impacts our regulation here, so I will cover that subject.

That will lead me to our major rate case proceeding, which is our 2009 General Rate Case, which you've heard about in previous calls. We are approaching the finish line there. And then I will spend just a minute on a new operating contract that we announced in this quarter's press release, which was in Hawaii, which is a key contract for us.

So first, the governor's race. And this is important to us because the governor appoints commissioners to the Public Utilities Commission, as you know. The governor also names the President of the Commission. Now, his appointments have to be confirmed by the state senate, so they are not immediately effective, but people can serve as appointed without being confirmed by the state senate for about -- for a year.

Of the five seats on the Commission, we expect three new appointments right after the first of the year. If you haven't heard, the two candidates we have for governor are Jerry Brown, who is a long-time public servant, well-known in the state, past governor, past Mayor of Oakland; and Meg Whitman, the Republican candidate, past CEO of eBay. This is her first campaign for elected office. The polls are pretty close. It shows the race is a tossup at this point, but there's three months to go, so we've got a lot of time here for campaigning.

As far as the Commission seats, two Commissioners we expect to continue on. One is Timothy Simon. His term goes through 2012. And Mike Peevey, who is also the President of the Commission; his term extends through 2013.

One Commissioner, Nancy Ryan, has been appointed to the Commission to fill an open seat, but she has not been confirmed by the state senate yet. So she can serve, as I mentioned, one year without being confirmed by the senate.

Two Commissioners are termed out, and that is Commissioner John Bohn, who has been the Water Commissioner and Commissioner Dian Grueneich. Their terms end this year and we expect those seats to be open for appointment. So that's why I'm saying there's at least two and probably three seats to be filled on the Commission.

The Public Utility Commission in California is probably the most visible and I think the most powerful commission in the state. So we expect the appointments there not to linger. We expect the appointments to be made pretty quick after the governor's in place. And I am sure I will have a better handle on the election, I hope, by the next quarterly conference call.

Also in the news lately in California, at least in California, is the state's budget problems persist. We are in deficit again, and the Legislature is wrestling with the budget at the state capitol. Its impact on us is basically through the Public Utilities Commission staff budget.

The Commission here is funded by a fee on every utility customer's monthly bill. So in effect, you could say a large part of the Commission's budget is outside of the state budget deficit, but the Commission is still under pressure on staffing, of course.

I think this is good news for us because the last thing we need is a Commission staff that is understaffed or furloughed, which delays rate proceedings, which are important to us.

Which leads me to our major rate case proceeding that we're in the middle of, which is our 2009 General Rate Case. As you've heard from me in the last few calls, this is our first companywide General Rate Case covering the entire state, all 24 rate-making districts, and our corporate costs.

This, as you might recall, is the largest, most complex water case in the state's history to come in front of the Commission. It's an 18-month-long process. We filed the case 2009, in July, for new rates that should be effective January 1, 2011. And the decision covers rates effective 2011, 2012, and 2013. It's a three-year rate case.

I've struggled with an analogy here, because I know this can be a very dry subject, and the best I've heard is the Tour de France, which just concluded, which is also a long, difficult, arduous process in France. And in our case, we have been through the speed trials early on. We've been through the Alps. We've been out of the Pyrenees, and we can see Paris on the horizon. We've gotten through this race, our team has, without a major crash. And we've been through the usual expected flat tires and bumps in the road and poor weather.

Which is a long way to say that essentially we are on schedule. The team and the peloton is expected to cross the finish line in time for rates effective January 1, 2011. So in other words, we're on schedule and expect to be -- have new rates in effect January 1.

Also since our last call, on this rate case, we announced that we have settled with the Department of Ratepayer Advocates, which I will call the Commission staff, on this case. And that is important to us. The settlement agreement is 600 pages long. It's available. If you'd like a copy, we can send you an email copy. It's available to the public.

But the settlement covers virtually every part of the rate case. What we have agreed to -- and I will round off the numbers here to the nearest million -- is about $34 million in new annual revenues starting the first of the year, and then an additional $7 million in annual revenue for capital projects that we call advice letters.

What that means is the staff and we agree that these projects -- and there's a lot of these projects in this category -- these projects are needed, but the schedule is uncertain. And so we will build the projects and then file what is called an advice letter for each project before we put them into rate base and then ultimately into rates.

So I'd say overall we are pleased with the settlement. We think it's reasonable. I think especially in the capital area, where the capital expenditures that have been adopted in the settlement are consistent with our capital forecasts. And you've heard from Marty for the years 2011, 2012, and 2013. So that looks good to us.

The settlement also contains a couple of new things that we haven't had in past cases, and one is pension costs -- balance sheet accounting for pension costs. Which is a cost category that is very difficult to predict, and that's what rate cases try to do, is to predict future expenses. In the case of pension costs, these have been probably the least predictable -- one of the least predictable costs, and so we agreed with the Commission staff to a balancing account payment for pension costs, which means we will collect the costs and then fully recover them, assuming they are prudently incurred, in rates.

So the settlement now is in front of the administrative law judge. The outcome is not certain of course yet, because you need a proposed decision from the administrative law judge, and then ultimately a decision from the Commission, which we expect in the fourth quarter.

The last item I have is a new contract we announced in the press release, which is for a water and wastewater system in Hawaii, on the Big Island, on the West Coast of the Big Island, in a resort area that is known as Hualalai. This is a residential area plus a resort and a Four Seasons Hotel. About 700 customers, but some of those are large customers.

The term is three years, and the numbers are small, but this is a very good fit for us strategically because it's adjacent to our own systems at Kukio and close to our headquarters at the Waikoloa and Waikoloa Village part of the Kona and Kohala coasts.

So this purchase -- pardon me -- this contract gives us a much broader footprint, fills in a service area for us and gives us a chance to have a better economy of scale on the Big Island.

That's my issues, and I'll turn this back to Marty to talk about the balance sheet.

Great. Thanks, Pete. A couple highlights of the balance sheet for the quarter. Company-funded CapEx for the quarter -- or for the six months ended, I should say, is about $48 million on a year-to-date basis. Net utility plants is up approximately 9.4%. We're at $1.253 million; that is up from $1.145 million for the same nine-month period -- or six-month period last year.

Work in progress balance -- so this is Web construction work in progress -- was $124 million, up 6% during the quarter. Cash flow from operations was up 6.5%. Again, this is the first line on the cash flow statement just from operations. We ended the quarter with $33 million in cash flow from operations, up from $31 million last year.

The Company's line of credit, we have borrowed about $55 million on a year-to-date basis on a $300 million line of credit. So now that we are into the higher summer months, where typically have more billings, that will be used to fund our capital program for the remainder of the year.

So looking back at the quarter, overall, happy with the balance sheet. Usage was down $12.7 million. The WRAM MCBA is working. The net benefit was booked at $5.8 million for the quarter. And really kind of the swing that we saw this year versus last year on an EPS perspective was driven, one, primarily by the mark-to-market adjustment that shows up below the line in other income and expense, coupled with an increase, about $0.01, from other operations, $0.02 from maintenance and then a $0.02 increase on a per-share basis for interest costs.

So with that, Stephanie, why don't we open it up for questions from people on the call, please?

(Operator Instructions) Garik Shmois, Longbow Research.

Thank you. Good morning. First question is on the mark-to-market -- is this something that you do quarterly, and it just showed up significantly here in the second quarter? How should we think about that going forward?

It is something we have to book quarterly, and again, these are assets that are held as part of the Company's retirement plans, the non-qualified retirement plans. So yes, we are required under GAAP to book any mark-to-market adjustments. We look at it -- frankly, it's monthly.

So it does move around, and as I'm sure you know, the stock market was very volatile and did not have the best performance during the month of June. So when that tends to happen, the mark-to-market adjustment goes the way we don't like it to go, it goes negative. The flipside is a year ago, that mark-to-market adjustment was a positive $1.8 million.

So it does bounce around. That's why we have it kind of below the line in other income and expense, so you get a clear sense of how the utility is operating versus some of the other assets owned by the Company. So it will bounce around every month.

And as long as the VIX index is high and as long as there's a lot of volatility in the stock market, it's going to affect those assets.

Okay. And on the settlement agreement, understanding that the Commission isn't locked into going forward with the agreement, can you just talk historically how the Commission has viewed these settlement agreements and if you've had any discussions with the Commission on it, any indications that might be providing one way or the other?

A good question, Gary. Actually, we cannot have discussions with the Commissioners about this because it's an open proceeding. And probably more key to the settlement is initially we have a law judge's position. Because he would be taking the settlement and then writing a proposed decision.

And as the case as unfolded here, this judge has been very encouraging for us and the staff to settle all the issues. And so that's a very good -- that's a very good indication that he wants to see a settlement, and does not want to make up new issues or rule on issues or litigate issues. So I think that's a good sign that the settlement is pretty good.

It's long, 600 pages long. It took us weeks and weeks to work through with the DRA staff. But I think the signs are all good.

Great, and congratulations on that. Just my last question is on CapEx, could we just get the number for the quarter and if you are still on target for your 2010 guidance?

Yes, the 2010 guidance I gave this year was $125 million, so we've completed $45 million year-to-date. Typically, if you look at our cycle, we do more CapEx in the second half of the year than the first half of the year. So I think we feel like we're on track right now.

The other point -- I will just emphasize what Pete said -- in the General Rate Case, we did get the bulk of the capital that we requested, and we have approximately $380 million of capital projects that were approved. Some [via] advice letter crux, approximately $61 of it advice letter, some other projects that are covered by separate proceedings, and $45 million of new capital that's covered in the General Rate Case.

Okay, to be clear, the $7 million, you can recognize that only after the project has been completed?

That's true. And there are multiple projects in that category. We build the project, put it in operations, close it, and then file an advice letter with the Commission for new rates.

Okay, great. Thank you very much.

So what this essentially does, for everyone on the call, the capital spending that Pete and I talk about when we are out on the road, we've talked about the fact that we don't see that coming down anytime in the next four to five years. And basically, the capital that we're getting as part of these proceedings, I think, supports the position we have been taking and advising the Street on.

Tim Winter, Gabelli.

Good morning, guys. I was wondering if there is any possibility that immediately following the election that there could be new Commissioners appointed that would rule on this case, or if there is a possibility it could become -- could be pushed into next year and there would be new Commissioners.

There is always that possibility, because of course we can't control the schedule here. We don't expect that to happen. And the Commission's own timeline calls for a decision before the end of the year. So it's possible it would go further, but we don't expect that to happen.

We do expect -- if that were to happen, we would expect rates to back-billed to the first of the year. And the Commission, I would say, likes to see settlements. They don't like to see litigated cases. And I think that's consistent with all the five current Commissioners. So I feel pretty good about the expectation that it should be decided and concluded this year.

Okay, great. And I was wondering if there is any big pieces of the difference between the $70 million request of the $34 million settlement. If you could reconcile maybe some of the bigger pieces of what you agreed to.

Yes, I think that's a really good question, Tim. As you know, like most people on this call, we have been in a transition period as California has been adopting the Water Action Plan.

So this is the first time we've filed all 24 districts in the state of California. The original request that was filed was for $70.6 million. Now, since that filing, we did receive $9.2 million of step increases in 2009, so you've got to take the $70.6 billion, subtract the $9.2 million. We're about to file $4.2 million of new steps for 2010, so you've got to back that off the $70.6 billion.

So you've got to take those things into consideration when you look at that, plus the revenue requirement associated with the advice letter projects. You know, when you look at those projects that were put on an advice letter basis, and you add this all up and compare the original request to what we ended up, we got about 79% of what we requested, which we think is a very, very good number.

And you've got to really sit down and pencil out the numbers to have that number come up, because this is stretched over longer period, given the fact that the transition period, almost like a stub period, that we're going to the 24 districts and there's an extra six months of no rate relief.

But overall, I will echo Pete's point. I think we are very happy with the settlement agreement. We are very happy with the process. As predicted, 2010 would be one of the more tighter years for Cal Water in some time because you have this extra six-month delay of rate relief. But the flipside of that is the Company is doing a good job at managing its SG&A. So we feel really good going into the second half of the year.

Okay, great. And then I was wondering -- I know that you have the revenue adjustment mechanism to mitigate any earnings impact. But I was wondering if you could talk a little bit more about consumption patterns and what you're seeing as far as conservation and --.

Sure, overall, that's why we -- every quarter, we go around and around how to explain kind of what's going on. Because you've got kind of two things intertwined. You have overall conservation and what are the effects of conservation, coupled with still the effects of the weather. Frankly, for Cal Water in California, we really didn't see a big pickup in demand until we really got to June.

And I think that was driven by the fact that we had a wet year this year. Spring seemed to be kind of prolonged. And really we didn't see a change in our unbilled revenue. And the unbilled revenue is really the accrued revenue.

So when we close out the month, we have revenue that's covered by the WRAM, and that is actual billed consumption. And then we have the unbilled revenue, which is accrued revenue which is outside the WRAM. So that unbilled revenue is a key indicator. And so in May, that number continued to go down, and then finally in June it reversed and started going up.

In terms of what's the bigger piece, conservation or weather, we don't have an answer for that. But overall, it was down about $12.7 million for the quarter.

Okay, thanks, guys.

Jim Lykins, Hilliard Lyons.

I think it's nice that you didn't say you represent Lance Armstrong in your analogy.

No, we are the Cal Water team here.

That's good to hear. First of all, I was wondering if you could maybe walk through a little bit more with the WRAM and the MCBA. I'm wondering about the $5.3 million decrease from -- for reduction of customer usage. I guess I kind of thought you might be a little more insulated there, and maybe if there is just any comments you could make on how we might want to think about that in Q3.

Sure, that's a very good question. And in fact, at our Board meeting yesterday, we spent a lot of time talking about this with our audit committee, explaining this to them as well.

Essentially, in the General Rate Case, when you have General Rate Case and you are decoupled, you have adopted revenue numbers and you have adopted production costs. The revenue is covered by the WRAM. The production costs are covered by the MCBA. So adopted revenue less adopted production costs give you gross margin dollars.

Those gross margin dollars are fixed. So if demand -- instead of having $118 million in sales, say we had a $1 billion of sales in Q3, the way the mechanisms work, we would have the same gross margin dollars. So it wouldn't necessarily affect EPS from a gross margin perspective.

So with customer demand being down and customer consumption being down, for the quarter, production costs came in below the adopted numbers. So you have a WRAM number, right -- the net amount, and you net the two out, and that's what you book -- the net amount was $5.8 million. But included in that $5.8 million was the $5.3 million adjustment, or frankly, give-back, to the ratepayers due to production costs being below the adopted number.

And I know this is a fuzzy concept and it's newer to the water industry, but really essentially what we are saying are the gross margin dollars are fixed. When you get a General Rate Case result, really you can look at what the gross margin dollars are for the year and look how the company is tracking to those gross margin dollars on a year-to-date basis.

And for Cal Water and where we are, there are approximately $271 million gross margin dollars that have been allocated as part of our last General Rate Case for the state of California. We've achieved $127 million of those gross margins; we have attained those. That's what we've concluded so far. So we've hit about 46.9% of our target.

That means essentially in the second half of the year, there's $143 million gross margin dollars available, or approximately $17 million more than what we had in the first half of the year. And the reason being you have a curve that's kind of -- that shifts kind of mid-year to the second half of the year, because the allocation follows our historical sales pattern. So we historically have had better sales in the second half of the year, and the distribution of those gross margin dollars follow that curve.

Okay, that's very helpful.

If that doesn't confuse the hell out of you, I don't know what (multiple speakers).

Well, it still helps, but, sure, it is still a little confusing at the same time.

What about the $7 million for the capital projects? Is there anything you could tell us on when we might anticipate those coming online?

Those are over -- I forget how many there are in that category. About -- I'm asking -- there's -- anyway, scores of projects in there, and they are split out over the three-year period. So of course, they are important to us to get built and put in place early.

Let me ask it another way. Will some of that happen in 2010, do you think most of this will come in 2011 or is this more of a 2012 event?

I think it's more 2012, late 2011 or early 2012. There are 66 projects, I see in my notes here, a total of 66. So you can see that they are all -- I mean, there's no huge project in there, but they're ones that we'd build normally in our process.

Something like a new well, it's pretty hard to determine when you can get the permits to drill the well, will it be a good well, can you get treatment on -- all those kinds of things. So the projects are solid; it's the scheduling that is uncertain.

Jim, as we talked about in the past, too, this can be fairly lumpy. By the time you get a project that you have a project you want to get done, you've got to go find -- sink a well, find the land to drill the well. Then you have to get the permits to drill the well. Then you have to drill the well. Then the Department of Health Services has to sign off. Then you put it in operations.

So it can be fairly lumpy. But as we've talked about and I think as we've proven over time here, we've gotten pretty good at scheduling our capital and budgeting our capital, and hitting our capital targets every year.

The other kind of, I think, interesting fact from the General Rate Case is that we do have fairly -- we got a nice, big slug of capital in the General Rate Case, but then we have a nice big slug of advice letter projects. And so when you look at the capital spend going out for the next four years, we are going to be right about at -- say, $125 million to $150 million a year going out.

So we feel real good about the allocation of capital dollars we are getting, and we have no shortage of good projects where to spend those capital dollars at.

Okay. And one last question. Is there anything else you can tell us about the O&M contract in Hawaii, anything about revenues or what do you think the impact will be?

Jim, it's pretty small. You won't see it move the needle here. More of a strategic issue for us to fill in that area and just give us a better footprint and make us -- better economy of scale.

Okay. Thanks, guys.

Michael Gaugler, Brean Murray, Carret.

My questions have all been answered, so I'll just jump back in the queue.

(Operator Instructions) Heike Doerr, Janney Montgomery Scott.

Thank you. Good morning, gentlemen. A quick question. Not to beat a dead horse, but I'm still trying to understand this life insurance contract and the mark-to-market treatment.

I wondered, Marty, did you say it was a $1.8 million gain in the second quarter last year and a negative 7 this quarter?

That's correct.

And are those net or is that a gross number?

That is your -- well, there's no net or gross. It's just the overall swing. So I kind of gave the two goalposts, so you can see what the swing was from last year to this year, because it explains a big part of the variance in earnings per share.

Yes, well, that's my question. So if we look at this on an EPS basis, it was an almost $0.09 gain last quarter -- last year. And now it's a negative $0.03 loss, so our swing is $0.12. Is that right?

That's pretty close, yes.

And what is keeping you on an accounting basis from making this kind of a below the net income line item so that we can see the Company's true earnings potential with this removed a bit more cleanly?

You know, that's exactly why we have it in the other income and expense line, so it shows up with kind of nonregulated business. It doesn't comingle with the utility business per se. And there are accounting standards around this and we have to follow those accounting standards.

But there are other items that fall into the other income, right? This isn't -- what wouldn't keep you from making this its own line item?

No, no, it wouldn't. At least not yet. But your point is valid in that there is -- there is a sizable asset or set of assets that are sitting there that are swinging due to the volatility in the market. I have to do the GAAP research and see if that's something we can break out on a separate line item basis, but that has not come up yet with our public accountants.

Okay. Thanks. That's been helpful.

I'm showing no further questions at this time.

Great. Well, if there's no other questions, we covered a lot of topics and we shared a lot of data here today. Certainly, the WRAM and the MCBA can be confusing. If anyone has any questions on that, please feel free to give us a call, especially now that we've announced earnings.

As we've talked about throughout, starting in the third quarter of last year, 2010, as predicted, would be a tighter year for Cal Water. The fact that we've had deflation, that's affected our steps, as we've had lower-than-expected steps. We have this extra six months of not having a rate relief due to the transition with the General Rate Case.

The flipside of it is we feel the Company is doing a good job of managing its SG&A and understanding the WRAM components and how they work. And that, coupled with the General Rate Case result that's in the proposed settlement, the increased capital that we're getting and our strong balance sheet, we believe we are positioned very well for the next four years, assuming the settlement goes through Commission.

So we want to thank everyone for hanging with us, and if you have any questions, feel free to give us a call. Have a good day. Thanks.

Ladies and gentlemen, that does conclude today's conference. You may all disconnect and have a wonderful day.