California Water Service Group (CWT) 2012 Q1 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to the California Water Service Group first quarter 2012 earnings results conference call. Today's conference is being recorded. I would now like to turn the meeting over to Mr. Martin Kropelnicki.

Thanks, Jessica. Good evening, everyone, and welcome to the first quarter 2012 earnings call for California Water Service Group. With me today is Pete Nelson, President and CEO. As a reminder, a replay of today's proceedings will be available from today, May 8th, through July 7th at 1-888-203-1112 passcode pound 4304013.

Prior review and the results for the quarter, I would like to remind everyone that 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 stockholders, as well as all interested parties, to carefully read and understand the Company's disclosures on risks and uncertainties and other information found in the Form 10-K, 10-Q, and other reports filed from time to time with the Securities and Exchange Commission.

Now let's go through the results of the quarter. The press release is out on our website, as well, the earnings release came out close of business last night.

Revenue for the quarter was up 19%, or $18.6 million to $116.7 million. Included in revenue was an increase of $8.7 million due to the reversal of deferred WRAM revenue from year end.

Water production costs increased $7 million, or 21.9%, to $39 million. As a reminder, water production costs are covered by the modified cost balancing account. The Company does not get any margin on it but does true-up that balancing account every month.

The following three components make up the modified cost balancing account. Purchased water was up $6.3 million, or $24.8%, to $31.9 million. Purchase power increased $300,000, or 6%, to $5.1 million. And pump taxes increased $380,000, or 24%, to $2 million. The increases that we experienced in purchased water costs and production costs was driven by, one, increased demand by our customers, as well as increased costs associated with purchased water.

Looking at the demand year-over-year for purchased water or for water production overall for California Water Service Group, we produced approximately 8,000 more acre feet during Q1 2012 over Q1 2011. Looking at A&G, or admin and general, for the quarter of 2012, it increased $2.5 million, or 12.3%, to $23 million. This is primarily driven by wage increases that took effect January 1, 2012, as well as increased benefit costs.

When we talk about increased benefit costs, please keep in mind that the pension cost is covered by a balancing cost and, more specifically, the cost increases were associated with medical, workers' comp, and other fringe benefits that the Company provides for its employees.

Other operations increased $9.2 million, or 62.8%, going to $23.8 million. That was primarily driven by the increase in production costs, which includes the reversal of $7.1 million of deferred net cost associated with the WRAM, as well as increased costs with associate with water production that was experienced because of the increased demand noted in the quarter.

Maintenance costs for the quarter increased $600,000, or 10.8%, to $5.8 million, driven by increased maintenance associated with pumping and mains. Depreciation and amortization for the quarter increased $1.4 million, or 10.8%, to $14 million, and that was driven by the increases in the utility plant that the Company put into the ground last year.

Income taxes for the quarter increased $1.3 million, driven by, one, a favorable one-time adjustment recorded in Q1 2011 of $1.6 million, that's Q1 of last year, and also driven by higher income tax rates driven by bonus depreciation, which has reduced our QPAD deduction, so it takes that deduction away and it increases the tax rate, as well as our estimates that have to do with the changes in tax laws associated with repairs of mains.

Property taxes were slightly higher at $4.6 million. Looking at other income and expense net or other operations, they increased $670,000, or 124%, to $1.2 million. It was primarily driven by a favorable mark-to-market adjustment associated with the change of long-term assets held by the Company in its non-qualified retirement plans.

Interest expense for the quarter was down approximately $1 million, or 13.3%, to $6.7 million. That was driven primarily by lower financing costs as a result of the Company renegotiating its line of credit last year, as well as we are getting more plant in service. So as you may recall, we had a couple of projects last year that got deferred or delayed, new capitals come in behind that and those dollars have now been allocated to that new plant. Net income for the quarter was $1.1 million, or $0.03 for the quarter.

So just to summarize, there's a couple of important changes that have taken place in the quarter in the analysis. One, again to remind everyone, in Q1 2011 as disclosed in the previous 10-Q, the Company included a $0.04 or a $1.6 million one-time tax adjustment in Q1 of last year. And then in Q1 of this year, as a result of the April 2012 WRAM decision, the Company recognized $8.7 million of deferred WRAM revenue, $7.1 million of deferred net costs, and $900,000 of deferred net income.

And I'm now going to turn it over to Pete Nelson. Pete?

Okay. Thanks, Marty, and welcome, everyone. For those of you who follow us regularly know that the first quarter is always our slowest. Results came in within our expected range and, in fact, we expect to break even in the first quarter, especially in years two or three of a rate case, and we're now in year two of the 2009 General Rate Case.

So as everyone who knows who follows us, that we make the vast majority of our income in the spring, summer, and fall of the year. So today, I'm going to touch on four issues quickly; they're all regulatory.

First, I'll talk about the WRAM decision; we were actually pleased with the decision. And I'll also talk about the sales forecast, how that's done and how that is the source of the problems here.

Second, I'll talk about the cost of capital proceeding; not much new there. And then talk about some small rate changes outside of California that have taken place since the last call. And then talk about, fourth, the progress on our 2012 GRC.

So first, the WRAM decision, whichis really the regulatory news of the quarter for us. As you know, four water companies are all parties in the same proceeding here and April 19th, the Commission issued their decision that did two things.

First, it adopted the all-party settlement on the amortization schedule, so now we're generally collecting those balances (inaudible) over 18 months recovery. That shortens the amortization periods and that's good. But the decision also directs us to address changes to the WRAM mechanism in our 2012 General Rate Case.

My take here is that there's real interest from all parties in minimizing the magnitude of the customer surcharges. No one benefits when large -- when we had these large receivables sitting out here. But the decoupling mechanism of sales and revenue itself is a well-accepted public policy. It's in the Commission's water action plan, which is their public policy document.

Decouplings worked well in electric and gas for decades, and electric and gas have now very small surcharges and they collect those over 12 months. So there's light on the horizon there. Obviously, in water, we've hit some road bumps in the WRAM collection, so this is where I get into the detail about the sales forecast.

And I'll talk about -- I think I'll talk about this for about four or five minutes because the Commission does adopt a sales forecast and that forecast is used to set rates in a General Rate Case. In fact, it's an important part of a General Rate Case.

From the sales forecast, which estimates future customer usage or sales, the Commission sets rates. So the sales forecast really is a major process in the rate case and, in our case, with the WRAM balance, that's the source of the problem. And when I say problem, I mean the large WRAM balances.

So let me use an example. Our 2009 General Rate Case we filed 2009 for rates effective 2011, 2012, and 2013. Now, we filed this in July of 2009, but it used historical sales, customer usage, up to and through 2008. So year 2008 usage and previous usage was before our conservation programs, before the drop in usage we saw the last two or three years.

So that's problem number one, is the sale forecast modeling is based on historical average and the 2009 General Rate Case could not have foreseen the drop in usage, so the forecast is too high, rates were set at the high forecast, customers used less water, and we had this large receivable balance. In fact, when you think about it, the forecast is already two years old by the time the first rates change because it's using 2008 data.

So you've got a five-year forecast you're living with that starts two years out of date as it's being applied, so that's problem one is the forecast itself. The problem two is probably a little more problematic in that once the forecast is adopted, it is inflexible, there's no mechanism to update or change it as we go along here.

So we're forced to apply the high sales forecasts in our years 2011, 2012, 2013 without regard to the actual sales that are going on that we're experiencing through those years, and there's no true-up mechanism until the next General Rate Case, which for us is 2012. To say this another way, there's no mechanism to change the forecast and then change rates to better reflect the reality of what customers are really using.

So we think the 2012 General Rate Case is a good form to iron out these two problems, and there are two problems there, and it's important to fix these two problems because we don't really -- in fact, nobody wants large surcharges to be collected from customers. And we also are incurring, as you know, unanticipated interests and financing costs to carry these balances.

So it's important to find the solutions here that are fair to the Company so we're not carrying large surcharges, fair to the customers so that they pay the cost of service as close as possible to when the use the service, and it's also important to align what we're doing here with the Commission and the state's policy of strong water conservation programs, as they have in the electric and gas business.

We should be able to pursue conservation programs to meet the state usage goals without penalizing the Company. So enough said there.

Next issue is cost to capital; not much new here. As you know, we're still awaiting approval of the settlement of 9.99% adopted ROE. We have budgeted and are planning for the 9.99%. In fact, we are assuming it's going to be retroactive to January 1st.

The only really change here is Commissioner Ferron, who is the assigned commissioner, was just confirmed by the State Senate in March, which is good because now we have five sitting commissioners who are all confirmed, which allows all five some degree of independence, so that's a good thing. So we're just waiting for the decision here from Commissioner Ferron's office.

Third issue is outside California rates, some of these have been adopted since and put in place since our last call. The state of Washington implemented a $1.6 million General Rate Case increase in February of this year. Hawaii, where we serve two islands. Island of Maui, our Kan'anapali system, we put in $1.2 million in new rates in March.

Our Pukalani system on Maui, which is always (inaudible) we're still working through our proposed $1.3 in new revenue there. And on the big island, the Waikoloa systems, which is 50% of our customers for the entire Hawaii subsidiary, we'll file that General Rate Case this month in May, and that will most likely impact 2013 rate, and I'll have those numbers on that rate case in the second quarter call.

New Mexico did receive a rate increase this year, but it's small in comparison to the others. So the fourth issue and last is our 2012 General Rate Case. It's our next major General Rate Case. We filed our first paperwork May 1st, which starts the process.

We do our full filing before July 1st, and so you'll have much more information about that rate case on our next call. These will be for new rates starting 2014, 18-month processing time, and so we'll give you those numbers when we have them.

So summarizing for us, 2012 is a attrition year. We're very focused on cost management and operating efficiently. We have good efficiency ratios. We watch them all the time, but it's still a tight budget year and we are managing it to be just that tight.

So I think now I'll go back to Marty for the balance sheet and to take questions.

Great. Thanks, Pete. And just to remind everyone that the 10-Q will be filed this morning. We're waiting to get confirmation from the SEC that it's been received and more information about the events for the quarter will be in detail in the 10-Q.

Looking at the balance sheet for the quarter, the new utility and plant increased $100 million, or 7.1%, to $1.4 billion as of March 31st. We're happy to see that continued growth in the net utility plant. Company-funded CapEx for the first quarter was a healthy $29 million. That's usually a little bit more than what we do in the first quarter, but with the mild winter, we've taken advantage of that to get more capital on the ground. Again, our target for the year is approximately $125 million of capital for the year.

Cash flow from operations was $23 million and with the recent WRAM decision, we expect to see a 20% to 25% increase in cash flow as those balances start to amortize here in the second quarter. And as Pete said, Q1 really is one of our softest quarters.

For the utility in California, there was no draws on the line of credit for the quarter. We did draw $3 million on the line for our subsidiary operations to fund plant expenditures in Hawaii.

So overall, Q1's always pretty tight from a cash flow perspective, but we did get through the quarter without drawing a line for the major California utility, just a minor amount for the Hawaii utility. And looking at liquidity, we did end the quarter with $16 million of cash and have $350 million availability on our line of credit. So overall, we think liquidity is looking good.

So, Jessica, with that, we will open it up for questions, please.

Thank you. (Operator Instructions). And we'll go first to Ryan Connors with Janney Montgomery Scott.

Good morning.

Good morning, Ryan.

I'm interested in your comments on the PUC and their idea of using sort of the GRC process to make adjustments to the WRAM mechanics. Obviously, whatever is decided there, I assume will set precedent for your peer companies. So are the ideas you laid out in terms of what the issues are and how they can be rectified, are those, to your knowledge, in line with the general industry thinking on the part of your peers, at least where they would be supportive of that approach, or are there other takes out there on what the issues are?

I think you've nailed it. I think our peers would definitely agree with what I said about what the problems are, and that's kind of a precursor to our rate case. You can kind of see where we're going there. And we knew way back when we first talked about decoupling years and years ago that the sales forecast was going to be important and that mechanism just has not changed to keep up with the WRAM accounting and the WRAM mechanism, so it's time to fix it.

Okay.

And, Ryan, one thing I would add on that, if you look at the broader utility base in California, the electric and gas industries, they true-up their forecast every year and so we've had this built-in lag in the process. You fix the sales forecast, you fix that lag, you fix that WRAM receivable growth, so the case law within the state of California is pretty clear.

Okay. And just in terms of timing, can you just walk us through how that will play out? So you apply for that in the rate case andI assume that -- how do you envision that playing out in terms of is there going to be some kind of public comment period or will that just be kind of a closed black box and we'll get a finding along with the rate case decision?

Not sure how that plays out in the rate case. This is kind of a new directive for us to take this into the rate case. Timing is going to be 2014 for rates and we will be applying the amortization period you saw from this decision until then.

Okay. Last question, related issue, but I mean it seems to me from the outside watching in that one of the issues also has just been -- the reason why the forecast has been an issue is that the steepness of the decline curve in per capita usage has been more pronounced than people had envisioned it would be. And so is there anything as you look at your data on customer usage, is there anything to suggest that that decline curve might be getting a little bit less steep and, therefore,that that issue would take care of itself even without corrective action to the WRAM?Or do you think that that per capita usage will continue to sort of plummet at the rate that it has?

Don't know. Don't know, but you did see the perfect storm here of a high forecast based on old data, quick turnaround in customer usage driven by the drought partially and also by our conservation program. So you've got three or four things that came together to really make the difference. It was kind of a perfect storm, actually.

Going back to your question about the proceeding and how we'll work through the WRAM there. There will be, I'm sure, parties commenting and the department -- or rate pay advocates will be in the middle of this, so thiswill be fully aired and I think if we stick to the public policy as the basis for the decision, we'll be fine.

Okay. Thanks for your time this morning.

Thanks, Ryan. And I think it's important to underscore that untilthe 2014 rates come into play and we do have the WRAM decision that came out, that was going to cover 2012 and 2013. So the issue that we experienced looking backward should be somewhat minimized the because there's no threshold triggered now for filing for WRAM balances.

And we'll go next to Heike Doerr with Robert W. Baird.

Good morning.

Good morning, Heike.

I want to follow-up a little bit on Ryan's questions about this WRAM; I'msure it will be a popular topic on your call today. I'm trying to understand or to reconcile why your forecasts are more off than the other companies? If you look through the ALJ document, the other companies don't have the same level of surcharges that they're asking to recoup from customers. Why would you your forecasts be off more so than the others?

You know, a couple things, Heike, on that. I can't speak for anyone else's balance sheet, but the real question is how big is that WRAM receivable on the books? And, obviously, for us, the WRAM receivable was around $50 million and that was material, which is why we've had a lot of disclosure on that.

The other thing to keep in mind is that we were the first kind of company to come out of the chute with decoupling and, therefore, our forecast, as Pete talked about, was based on 2008 and prior data. And, as Pete mentioned, that the perfect storm, that really it was it. So you had older data that you used in your forecast,you had the inability given the regulatory process to true-up that mechanism, and then you had a pretty steep decline in consumption, approximately 16% on average, for our customers.

And so from my perspective or our CFO perspective, when I look at it, that receivable turning and how fast that receivable we can collect that cash. And so for us, the receivable is essentially flat from year end to Q1 and it will start to see that receivable come down a little bit because we're collecting that cash. But I think the real question is how big is the receivable on everyone else's balance sheet?

Okay. And we're still at the proposed decision phase, right? We're still pending a commission approval?

Of the WRAM decision?

Of the WRAM decision.

That's decided. It's done.

It's decided. So was there a cap put -- a percentage cap put on this surcharge? I know that that was part of the proposed decision.

Yeah, there was a couple things. There's after -- there's a 10% cap going out after 2014, but what the decision really did, it's really going to speed up the amortization because it took away a trigger. There was a 2.5% threshold trigger there.

So if you have a large district, you had balance to be $2 million or $3 million before we could collect it, and if it didn't trigger, then we were carrying on the books, and that's where the accounting literature and PUC policies kind of crashed into each other. And so the decision that's been adopted, and by the way for everyone, if you look at page seven and eight on the Q when if comes out, we give you a full reconciliation. All the components are referenced that are changing here.

It's allowing us to collect that cash. And almost in all of our cases, all those WRAM balances we were not able to collect, we're able to collect, with the exception of two very, very small districts, that we'll able to collect in the next 24 months or less.

Okay. Final question on this topic. I believe the proposed decision also asks that Cal Water specifically break out the surcharge as its own line item because that's something that you hadn't been doing previously. Will we see increased operating expenses in the second quarter as you meet that requirement?

No. It's really -- one of the things we've prided ourselves on is we've really focused on our IT platformand we have a very robust billing system, so we have to go in and make some tweaks to the system but it's not significant.

Okay. And my final question, let's switch gears. The mark-to-market gain in the first quarter, can you refresh our memory as to what the mark-to-market allocation was in the first quarter of last year and how it looked this year?

Yeah, the first quarter of last year it was about a $500,000 positive, the first quarter this year it's a $1.7 million positive, so you're delta is about $1.2 million.

Great. That's helpful, thanks.

Thanks, Heike.

(Operator Instructions). And we'll go next to Jonathan Reeder with Wells Fargo.

Hey, Marty, just going off of Heike's last questions there. The $1.7 million and the $500,000, is that pre-tax or is that after tax?

You know, that is -- it's down in other income and expense, which is net.

Okay, so those are net numbers?

Yeah. So it's not flowing through the utility lines. It's down in other income and expense, and when you look on the income statement, it's in the other income and expense net line.

Okay. And then going back to the whole usage numbers, if -- say the rules don't change, if you're not successful in getting that change, what would I guess the period be for usage in the 2012 filing? Is it just -- I guess my understanding was it was like a three-year rolling historical?

Yeah, you know, the team accumulates data over a 10 to 20 year period and then they do their analysis off of it. So it's ten years for 2011. But we're in the process -- obviously, part of the rate design here is recommending mechanisms to fix the sales forecast, andit's a little premature for us to go into details about that.

The only thing I would draw everyone's attention to is look at the electric and gas industry and how the mechanisms work and, obviously, we're studying that and that will be part of our blueprint as we try to make corrective measures to our sales forecasting process.

Right, but under current form if it's based -- I mean is it based on just the actual historical data or can you make a forecast as of 2012? Do you know what I'm saying?

It's a very complicated formula, and as I understand it, for the 2012 rate case, it will be through 2011 usage. Looking back ten years of usage, and whether normalized back 30 years. Try to figure that one out. That's why I didn't get into that much detail on the sales forecast. It's a very complicated calculation that really doesn't work when usage is going up and down.

I was going to say, is it skewed at least towards the most recent data given, the high degree of conservation and the drop in usage so that at least that forecast would be much more accurate than the 2008 forecast?

I wouldn't say much more because now it's using two years of better data, two or three years of better data, but still averaged against seven years before that. So it's not going to change the line that much.

Okay, so it's not heavily weighted towards the most recent years? You're saying it's kind of just an equal average type over the ten years?

It's an arithmetic average.

And I think part of the take the best analyst in the world, give him ten years of historical data and hell him to predict out five years, which is essentially what we lived through in the last three years, and good luck.

If you read Malkiel's book, A Random Walk on Wall Street, he talks about the monkey stock pickers versus the expert stock pickers and statistically they come out about the same. As Pete said, the perfect storm, I think that's had a good analogy with the sales forecast and the trick is you have to have the ability to true it up at some point in the process.

I'll take that last comment as not being an insult, Marty.

It's one of the number one best-selling finance textbooks for 30 years.

I'm very familiar with it. I'm just saying because that's essentially our job. All right, last question. If we strip out the deferred WRAM net costs from the operating expenses, which obviously kind of skewed those percentages as little bit, it still seems like the underlying expenses are trending pretty high in Q1. What do you kind of expect the trend to be as the year progresses and kind of for the full year?

Keep in mind Q1, we always have the least amount of gross margin available because that adopted consumption curve, the revenue is just strictly based on that consumption curve, so Q1 is always our lowest quarter and yet our fixed costs go up we know effective January 1st.

So, as Pete said, we really budget for break even to just slight profitability in Q1 and we're really happy with that. We're happy we didn't have to draw a lot on the line. For example, you'll see a 75% increase in gross margin dollars between Q1 and the top of Q2, so that will give you an idea of what the delta looks like quarter-over-quarter.

Right, but on those, I guess, those operating expense lines for the full year, are we still going to see a lot of double digit year-over-year increases kind of like the Q1?

No, I think you'll see them level out. I think you feel it more because we're a high fixed cost provider and there's not a lot of margin there to cover it but as your margin goes up and your revenue goes up, it will shrink as a percent.

The big thing to really watch for us, and it's really no different, I think, than any other company in America right now is healthcare costs. Production costs are covered by the modified cost balancing account,revenue is covered by the WRAM,pension is covered by a pension balancing account.

We have a balancing account, memorandum account for conservation, so you really are left with just the A&G costs and other operations. So in A&G costs, labor, we're fairly good at managing that cost and we have a large union population where a percent of our employees are union within California, but that's fairly predictable. It's really kind of the healthcare costs, and then as you big changes in demand, you have the cost of other operations which is really your chemicals and filters.

It was interesting to note that we did see a fairly big uptick in water produced and consumed this quarter over last quarter. If that continues, obviously, that will be some more costs in other operations. But Q1, it's just always the softest quarter, and I think as we move into later parts in the year, medical is really the thing you want to watch.

Okay. Thanks for the additional clarity.

One of the things I would note is as we're preparing the General Rate Case, we've had our actuary study, kind of our plan versus the broader markets and other plans and we would show that we're about 15% cheaper than going to -- we're self-insured going to a fully insured plan. And so if our costs are going up by 8%, the general market trend is going up 12% to 15%.

(Operator Instructions). And it does appear that there are no further questions at this time. Mr. Kropelnicki, I would like to turn the conference back to you for any additional or closing remarks.

Thanks, Jessica. Everyone, thanks for calling in today. Again, there was a lot of stuff that talked about. The 10-Q will be coming out this morning for the information on the WRAM, look to page seven and page eight, that will give you the information and the reconciliation of the changes in WRAM balances.

As Pete said, we're keenly focused on our General Rate Case for California and continuing our capital program while tightly managing our A&G costs. So thank you for being with us here today and give us call if you have any questions. Have a good day. Thanks.

That does concluded today's conference. We appreciate your participation.