California Water Service Group (CWT) 2012 Q3 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to the California Water Service Group third-quarter 2012 earnings conference call. Today's conference is being recorded.

I would now like to turn the meeting over to Mr. Martin Kropelnicki, President and COO. Please go ahead, sir.

Thank you, Melissa. Good morning, everyone. Thank you for joining us for the California Water Service Group third-quarter 2012 earnings conference call. With me today is Pete Nelson, Chairman and CEO, and Tom Smegal, Vice President and Chief Financial Officer.

And I am Marty Kropelnicki, President and Chief Operating Officer. As a reminder, a replay of today's proceedings will be available from November 7, 2012, through January 6, 2013 at 1-888-203-1112. The replay code is 694-2093.

Before turning it over to Pete for some management updates, we want to take a moment to read our Safe Harbor provisions. 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 stockholders, as well as all interested parties, to carefully read and understand the Company's disclosures on risks and uncertainties found in our Form 10-K, 10-Q and other reports filed from time to time with the Securities and Exchange Commission. And with that, Pete, I will turn it over to you for the update on the management changes.

Okay, thanks, Marty. Good morning, everyone, and welcome to the call. As you heard from Marty in his introduction, we have a lot of new titles here and a new person at the table, so I will walk you all through that. Then I will pass the baton over to Tom for financials, and he will give it back to me for a quick rate update and I will comment on the third-quarter earnings result -- as a result.

First our management changes. My job changed October 1st this year. Prior to then I was Chairman, President and Chief Executive Officer. I moved October 1st to Chairman and CEO. What this means is I will weight more of my time towards Board and governance issues, and at the same time remain CEO of the Company. Also, October 1st, as you saw, Marty was promoted to President and Chief Operating Officer and Tom Smegal appointed Vice President and Chief Financial Officer and Treasurer, replacing Marty in that job.

For those of you who have not met Tom yet, you are going to enjoy working with him, I know, a great guy and very expert in the field and I think you will really enjoy working with him. I will talk a little bit about Tom's background.

He does have two degrees, bachelor degrees from Stanford, one in civil engineering and one in history, and spent two years in graduate studies at the UC Berkeley Energy and Resources Group. And then he joined the utility industry where he worked for 22 years. Lots of work experience in rate-making and utility finance. He actually worked at the California Public Utilities Commission for about seven or eight years, focused on water company revenue requirements. We recruited Tom from the Commission about 15 years ago.

He [filled] several positions here. Most recently, he was Vice President of Regulatory Matters and Corporate Relations. In that job, he was responsible for all of the rate-making functions in all four states, government relations, community relations and communication, so a strong background.

I am looking forward to him being CFO here. I haven't mentioned Dave Healey before. Most of you have met Dave, but I will talk a little about Dave too because he is another more recent appointment. In April, Dave Healey became our Corporate Controller. Dave has also an excellent background, a BS in accounting from the University of San Francisco, a CPA in California, and a Certified Management Accountant.

Dave has eight years of experience in public accounting as a Controller, and two years of public accounting experience as Treasurer, 15 years of utility experience overall. Dave is very strong in utility accounting, accounting systems, process management, internal controls and SEC reporting. He joined Cal Water Service Group about three years ago as the Director of Financial Reporting.

Those are the changes that took place October 1st. As you might suspect, the Board of Directors spends a good amount of time on leadership development and organizational planning, and these changes I just mentioned are all in line with the Board's process.

I am very pleased with the changes and the finance and operating executive team. Marty, Tom and Dave, all excellent, all experienced, not just finance, but in rate-making as well, where they are experts, I would say. A strong team across the board, and I am really happy with the changes.

We are in the search mode for the VP of Rates position and expect to have that filled before the end of the year. That is the changes. I will go to Tom now for the financials.

Thanks, Pete. I am going to go through the income statement and starting with operating revenue, which was $178.1 million for the quarter. That's up 5.2% or $8.9 million. Included in this, sales to new customers added $0.3 million. Rate increases added $4.3 million.

Production offsets added $4.1 million, and usage added $0.2 million. Our production costs for the quarter was $66.5 million. That's up 7.9%, or $4.9 million.

Purchased water was also up 7.9% or $3.8 million to $51.4 million. Purchased power up 5.3% to $0.6 million -- sorry. Up $0.6 million to $11.5 million. Pump taxes were up 17.8% or $0.5 million to $3.6 million.

Our production mix was 133,000 acre feet for the quarter compared to 130,000 acre feet in the prior year. There is no significant change in the mix of purchased and pumped water. Our A&G costs were $23.9 million for the quarter, up 10.5% or $2.3 million.

That is higher labor and benefit expense. Remember in California, our pension costs are covered by a balancing account and therefore do not affect our net income. Our other operations expense was $17.7 million for the quarter, up 0.9% or $0.2 million.

Included in this was conservation expense and increased expense related to water treatment and water quality. And again, for conservation expense in California, that is covered by a balancing account and does not affect net income. Our maintenance cost for the quarter was $4.4 million, a decrease of 5.9% or $0.3 million.

Our depreciation cost for the quarter $13.7 million. That's an increase of 7.8% or $1 million. That is the effect of prior-year plant additions on depreciation.

Our income tax expense for the quarter was $10.8 million. That is a decrease of 26.1% or $3.8 million.

Effective January 1 of this year, the Company must comply with new federal tax regulations relating to repairs and maintenance of tangible property. This requires the Company to deduct a significant amount of costs previously capitalized for book and tax purposes.

We completed our analysis of these amounts for 2011 and prior years in the third quarter, and therefore making these changes now. The Company's federal deduction for repairs and maintenance for that period of 2011 and prior years was $86.7 million, and it is recorded as a $30.4 million deferred tax liability. Federal taxes are normalized in the rate-making process in the states in which we operate.

The Company's state tax deduction for the same years, 2011 and prior years, was $122.2 million, and was recorded as a $7 million reduction to state income tax expense during the third quarter. State income taxes are a flow-through item for rate-making. These changes eliminate the qualified production activity deduction for 2010 and 2011, requiring us to book a $0.8 million federal tax expense during the third quarter.

The net effect of the changes on the state tax side and federal QPAD side is a nonrecurring gain of $6.2 million or about $0.15 a share for the -- recorded in the third quarter. On other income and expenses, we show a gain of $0.6 million, and in the third quarter last year we had a loss of $1.8 million. The difference there is due to an unrealized gain on our benefit plan insurance investments.

During 2012, the Company has reallocated its insurance plan investments to reduce the volatility in this line item and the market to market adjustments. So let's go to net income for the quarter, $29.8 million. That's up 42.2% or $8.9 million from the third-quarter value of 20. -- third-quarter 2011 value of $20.9 million.

Excluding the tax adjustment, we had $23.6 million for the quarter or a 12.6% increase from the prior year. Our earnings per share were $0.71. On a fully diluted basis, that's up 41.8% from $0.50 in the third quarter of 2011. And excluding that tax adjustment we are looking at $0.56 for the quarter or an 11.9% increase from the prior year.

I should mention before I turn it back to Pete that our Form 10-Q is scheduled to be filed later this morning and there is more detail in there, of course. Pete.

Okay. Thanks, Tom. I will do a quick comment on the earnings for the quarter. Third quarter was a good one. As we expected, revenue was up 5% and earnings were up 12% absent the tax adjustment. Happy with the quarter and we're holding the line on expenses across the board, and I think Marty is going to probably mention that when I turn it back to him.

Turning to rates and rate-making, I have two or three items here. The largest one is our 2012 general rate case, which I would say is on schedule. Just as a reminder for those who are not familiar with the process, we must file a general rate case every three years.

We filed one in 2012, which we call our 2012 General Rate Case. We are requesting $93 million in new rates effective January 2014, and then another $17 million in each of the years 2015 and 2016, which are our attrition years.

We are in the part of the process now where the Commission staff evaluates our application. They are asking questions, touring our facilities. We are holding workshops around the state with customers to talk about the rate case.

To date, we responded to 135 data requests from the Commission and held 13 workshop with customers. We are about mid-way through that process now. The next milestone is February of next year, where we will get the Commission staff report. This is basically their position on our application. Then we will go from there.

The process will continue, and we expect a decision from the Commission by year-end for effective January 2014 rates. Another comment on this general rate case and the decoupling mechanism, which we also call the revenue adjustment mechanism and the modified cost balancing account, is decoupled sales from revenue.

Some of you may have heard some rumblings, and I will call them misinformed rumblings, that the mechanism as put in place is not working as it was planned because we have developed this large receivable over the last two years, mainly due to customers not using the water anybody thought they would. In fact, using a lot less water than anyone thought they would.

But, in fact, the mechanism is working exactly as it was planned. The problem that has led to the large receivable is the sales forecast that the Commission adopted in that last rate case, and from which rates are set. In a perfect world, the sales forecast would match actual sales, and there would be no receivable or payable from customers.

But the rate-making world is never perfect. And so there is -- I see two problems with the sales forecast adopted in the last rate case. One is, I mentioned it was obviously way too high. Customers used less water, they conserved. And the second problem is the mechanism is inflexible.

We could not change the forecast in between general rate cases even though everyone knew it was way off and not accurate at all. There is just no mechanism to adjust the sales forecast and adjust rates based on reality at the time.

To help solve that problem in this rate case, we have asked for the ability to, I will say, true up at least to some degree, the sales forecast every year, and then adjust rates each year either up or down to better match the actual sales of customers. To me this makes a lot of sense. I think all parties are going to benefit.

The customer would pay a more accurate rate based on usage. And we would not end up with a large receivable or payable back to customers, which really skews the message to customers on usage. I am looking forward to this rate case and coming up with a solution for that problem on the sales forecast.

A couple other rate issues. Our 2013 attrition filing for California, we will file that in November. We are still running the numbers on the attrition. And the two cases -- the other two cases that are outstanding for us are both in Hawaii. One is our Pukalani wastewater case on Maui.

That is a $1.3 million revenue request. We are in discussions with Commission staff on that. We did file our Waikoloa rate cases on the Big Island, which is our larger systems.

We are requesting $6.3 million in new rates. Expect a decision on that case late next year. So that is it for rates. I will turn this over to Marty for balancing account.

Great. Thanks, Pete. I will give everyone a quick update on the balance sheet, and then start talking about a couple things that we are focusing on for 2013. First of all, net utility plant is up 6.6% or $100 million to $1.4 billion. During the nine months ended September 30 the Company had plant expenditures of $99.6 million, just shy of $100 million.

Primarily financed by the cash flow from operations, which was a positive $99.4 million. Feel real good about the Company expenditures going into to CapEx through the third quarter. Also feel good with the fact that we have been financing that primarily from cash flow from operations.

In addition, in October, the Company filed advice letter projects to be included in rates of $13 million. We anticipate that will be in rates, hopefully, January 1st of 2013. That brings the total advice letter projects from the 2009 general rate case to about $22 million with $51 million remaining to complete over the next year, year-and-a-half. So moving forward, to getting the advice letter projects put into rates.

In addition, on the liquidity side, during the quarter the Company paid down $30 million of debt on the short-term line of credit. That was all focused on California. That was the California line of credit that has been used to finance some capital activities for the quarter.

The liquidity in terms of the California operations remain very strong, for group as well as for the Company. We have approximately $340 million availability on our unsecured lines of credit and plenty of liquidity. As Pete mentioned, the WRAM, a couple of things to point out on the WRAM that I think are relevant that had an effect on liquidity for the quarter.

As you may recall, in April we had the Commission's decision that allowed allow faster amortization of the WRAM receivable and allowed the Company to start collecting the net receivable balance from the WRAM MCBA. It is noteworthy this is the first time since they implemented the WRAM that the WRAM actually shrunk from Q2 to Q3. If you look at the WRAM balance at the end of Q2, it was $53.7 million. That has dropped $1.7 million to $52 million.

That is the effect of getting the receivable at long-term portion starting to turn and getting the shorter amortization that the Commission approved. That was further helped by consumption levels that are up. We have been running at about 92% of our adopted consumption numbers, which is about 12% higher from where we were last year.

One other note I would make on the liquidity side is last week S&P did their rating of all the electric, gas, and water utilities they rate in terms of strongest to weakest. California Water Service Group and North America came out at number 11. We are one of the only utilities that has a 1 rating on liquidity. Again, plenty of liquidity and positioned well going into Q4.

What is on the horizon for 2013? As Pete mentioned, it is the third year of the rate case cycle for us, which always makes it the leanest year of the rate case cycle for California, which is the biggest part of our operations. We are very focused on continuing our efforts to control spending in discretionary areas, especially in legal, outside services, travel, et cetera. We have made some good progress on that year-to-date.

I have mentioned this in previous calls. This is the second year of a software application we have put in called Hyperion, which is our budget software. In addition, for 2013, we have put in place a financial planning analysis team that has been diligently working with our district managers, as well as our department heads, to better understand their budgets, track costs, et cetera. We have gotten a lot of really good bandwidth on that.

And at the end of the day, when you boil down all the inputs and outputs to earnings, there was about a $0.02 pickup for better cost management that I am very, very happy with -- with the operations. And that is really important as we go into 2013. Some of the challenges that we will face in 2013, one is just basic inflation, especially on the medical side.

Medical inflation has been running about 12%, and we are starting to see that creep into our numbers, which means we will have a little bit of regulatory lag as we go into the rate case settlement and 2014 when we start getting rate relief.

In addition, the water cost-to-capital adjustment mechanism, which is the mechanism used to adjust ROEs based on changes to the Moody's AA Utility Bond Index, it looks at the change over a 12-month period. The marked period is from 10/01/2011 to 9/30/2012 and you take the weighted average of that change. That index was down 112 basis points.

And so, when that change is over 100 basis points, we have to record 50% of it. We have filed with the Commission to reduce our ROE by about 56 basis points for 2013. What this means when you work through the weighted average of the cap structure, it will lower our authorized rate of return from 8.25% to 7.94%.

Now this is already on top of the reduction that we had on the cost-to-capital decision that came out in April of this year. There is about a $0.06 loss there for 2013, due to change in the utility bond index that we have to track and follow. And just as a reminder, everyone, that is a two-way account. If we get to a point where interest rates start to rise you do the same mark period and adjust up when you have adjustments moving up greater than 100 basis points.

As we go to 2013, budget management is going to be key. And we are going to continue doing what we are doing, and diligently wringing out all of those costs that we can find on the operating lines. The GRC, even though Tom's title has changed and my title has changed, Pete's title has changed, as everyone knows, the general rate case is an all-hands effort. And both Tom and I will continue to work diligently with the new VP of Rates to bring the general rate case to fruition, and hopefully position us strong going to 2014.

No issues on liquidity or the balance sheet. We are going to continue doing what we are doing and hopefully drive that rate case home early sometime next year. With that, Melissa, we will open it up for questions and answers, please.

(Operator Instructions). We have a question from Michael Roomberg from Ladenburg Thalmann.

Hi. Good morning, guys.

Hey, Michael. How are you?

I'm well, thank you. Thank you. I just want to start off with the general rate case, perhaps for Pete or Tom. The two requests you have made for medical cost balancing account and chrom-6, the costs associated with chrom-6 remediation, can you talk a little bit about how your conversations may -- have progressed so far on those two issues in particular?

This is Tom. I will take the first crack at that. I think we have had some data requests on those issues, but we won't hear the opinion of the Commission staff until February.

They are pretty taciturn. They don't like to tell you what they are going to say until they say it. I would look for that early next year.

Okay. Okay. And then just, I guess kind of a modeling type question. What was the exact number of the after-tax gain from the market-to-market in the quarter?

It was, for the quarter, it was about $600,000. But if you go back to last year it was a negative $2.9 million. Remember, Q3 of last year there were a lot of issues happening. And the VIX Index shot up almost to 30 on the last day of the quarter in Q3. So that's where we had to do the market-to-market. You went from a loss of $2.9 million to a gain of $600,000.

Got you. So if I ex that out, essentially your nonregular ops were essentially break-even in the quarter? Is that the right way of looking at it?

Yes, I think that is right. If you look at net operating income it was up slightly, but a lot of the gains that we picked up on are fixing things that are down on the other income and expense line.

Got you. Got you. Okay. Thank you, guys.

(Operator Instructions). At this time we are no further questions in the queue. I would like to give everybody one final chance. (Operator Instructions). We do have a question from Dave Parker from Robert W. Baird. And sir your line is open.

I'm sorry. Good morning, everyone. A question for you and thanks for the color year-to-date to date. We're well aware 2013 will be a tough year with the third year of the rate case cycle.

Just so that we can plan as we do our earnings forecast, can we -- give us a view on -- directionally the under-recovered balances on the WRAM are declining. And I assume that helps us in a year-over-year basis maybe to pick up a few pennies here or there. I don't recall what the mark-to-market in the first and second quarter were as far as a positive or negative for us for earnings.

I assume with the rebalancing of the portfolio that may be less of a mover going forward. Those kinds of items, can -- is it -- can you help us with that a little bit as we sort of look at what 2013 may or may not be?

Sure, as we mentioned, we tried to rebalance the insurance plan investments for the Surf and so for the first quarter, that was a positive $1.7 million. The second quarter was a negative $0.1 million. We are trying to reduce the volatility in that account compared to some big swings that we had in 2011.

One thing to note, Dave, when you look at the Surf for last year and what happened in Q3, losing that $2.9 million in unrealized loss that basically eroded any gains we had from earnings from operation. It was offset by the loss -- unrealized loss on the Surf.

That is why the swing is important right now. The goal on the Surf, by the way, is not to be aggressive in the market, again, those basically are used to fund our nonqualified retirement plans.

As we were rebalancing the Surf, we are very focused on data reduction, removing the volatility, which would ultimately help stabilize the earnings. As you may recall, the last couple years we have had a lot of volatility associated with the market-to-market in these plans.

In terms of the WRAM, remember the WRAM is all cash flow. The WRAM is booked on a monthly basis. As we are accelerating, picking up more cash, which is what we saw in the quarter, it doesn't affect earnings, because that is booked every month, the WRAM and the MCBA. That is being booked as cost change within the quarter.

The only thing it is going to affect is cash flow. And that is what was nice about seeing the cash flow start to pick up, which enables us to pay down our short-term debt and fund almost 100% of the CapEx program year-to-date.

Dave, let me add one thing on that issue.

This is the first quarter where we are starting to fully recover on the amortizations that are under the new amortization policy, the Commission. We have seen that faster amortization as well as the higher sales bringing us closer to that turning point. We really hope we are getting to that turning point where that WRAM balance starts to decrease.

I think --- and when you look at 2013, where the potential changes will be in earnings if that receivable stabilizes, and doesn't grow, which is what is happening now -- it's actually shrinking a little bit -- it reduces our financing costs.

The financing costs associated with the WRAM, the Commission gives us basically the money market rate, 90 day commercial money market rate, our commercial paper rate. But there is a long-term component that adds a long-term receivable. That has been financed with a long-term bond at 5.5%.

Getting that receivable stabilized and shrinking is actually a good thing, because it reduces our financing cost in the long run.

Year-to-date, what do you guess that has cost us in earnings per share, do you think?

You have got $50 million of it at 5.5%. You know, $2.7 million, $2.8 million on an annual basis. It takes 75% of that.

Right. And so that wouldn't be eliminated next year. That could be a way we pick up some margin.

Yes. And I think, the other thing, Dave, I want to underscore the cost management. Michael asked this question.

It is a little complicated when you look at the net operating that come out in the press release because it's up $6 million. But that contains a tax piece of it. But ultimately when you look at the input-output of earnings, you had $0.56 a share versus $0.50 a share excluding the tax piece of it.

Your cost to capital reduction for the quarter was about $0.02. That was going from the 10.2% to the 9.9%. So that is a negative. You pick up about a penny on the WRAM deferral, that is a positive. Then you have the unrealized gain on the retirement plans, which is a positive $0.05.

That is $0.04. We picked up about $0.02 through better cost management. Part of that is really down in the nonregulated side, looking at our contracts that are making money or losing money and restructuring those. A big part of that is above the line, making sure we get every dollar of capital in the capital bucket and tightly manage the expense side of the business.

That is a big move. This is where you just don't know what kind of wiggle room do you have as you are looking at 2013 and as you tighten your belt. $0.02 times $0.04 a quarter, is $0.08 to $0.10 a realistic way you can look to tighten your belt? Or is it -- and I know you run a pretty lean ship now as it is anyway.

I guess on the other side, you have increasing health care expenses and [those obviously for] the headwinds, so what is your sense? I know I am asking you what is 2013 going to look like, and you're probably not done with your budgets, from a budget perspective, but how much discretion do you have there?

That is a good question. I would say that there is not a lot of discretion. I think we are in the process of calculating the step increases for 2013.

Once we know those, those will be filed with the Commission. That becomes public data. You will be able to see that. That is really the big variable we have got to plug in first.

I think we could -- you can accurately predict that health care is going to go up between 12% and 15% next year. You know, that is for the offsetting cost reduction internally really taking down the travel, taking down the outside services to try to offset some of that lag that we see in that third year.

I think the piece that is missing, Dave, and the thing to watch is when we file our application with the Commission for the step increases, because that will give us the inflationary increases that we will get in 2013.

As a comment from an investor perspective, I appreciate the mechanism to adjust ROEs up and down with the market. The one thing that seems to be missing is when you guys are a far cry from earning your authorized ROE that it takes $0.06 out of earnings that seems a little crazy given the other headwinds you've got.

I don't know if that is something to fix for the next rate case or not, but that is painful I think.

I hope the Commission is listening to this call.

Give me a call if you have a question. Thank you, Commissioners.

Thank you. Thanks very much. I appreciate it.

(Operator Instructions) No one else has queued up for any questions at this time. I will turn it back over to our speakers for any additional or closing remarks.

Thanks, Melissa. This is Marty, everyone. Thanks for listening today. As I mentioned, watch for the step increase filing. We will probably have that on file here probably in the next 30 days or so. That will show what the inflationary increases are that we will get in California for 2013.

As a reminder, our Form 10-Q is scheduled to be filed later on this morning before lunch Pacific Coast time.

Thank you for listening. If you have any questions, feel free to give us a call and if not we will talk to everybody during our year-end conference call. Thank you.

That does conclude our conference for today. Thank you for your participation.