Pinnacle West Capital Corp (PNW) 2016 Q2 法說會逐字稿

Greeting and welcome to the Pinnacle West Capital Corp. 2016 second-quarter earnings conference call.

(Operator Instructions)

As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ted Geisler, Director of Investor Relations. Thanks you, sir. You may begin.

Thank you, Christine. I would like to thank everyone for participating in this conference call and webcast to review our second-quarter 2016 earnings, recent developments and operating performance. Our speakers today will be our Chairman and CEO, Don Brandt, and our CFO, Jim Hatfield. Jeff Guldner, APS's Senior Vice President of Public Policy and Mark Schiavoni, APS's Chief Operating Officer, are also here with us.

First, I need to cover a few details with you. The slides that we will be using are available on our Investor Relations website along with our earnings release and related information. Note that the slides contain reconciliations of certain non-GAAP financial information. Today's comments and our slides contain forward-looking statements based on current expectations and the Company assumes no obligation to update these statements. Because actual results may differ materially from expectations, we caution you not to face undue reliance on these statements. Our second-quarter form 10-Q was filed this morning. Please refer to that document for forward-looking statements cautionary language as well as the Risk Factors and MD&A sections, which identify risks and uncertainties that could cause actual results to differ materially from those contained in our disclosures.

A replay of this call will be available shortly on our website for the next 30 days. It will also be available by telephone through August 9. I will now turn the call over to Don.

Thanks, Ted. Thank you all for joining us today. 2016 continues to be in line with our expectations and we remain well positioned to meet our financial commitments this year. Before Jim discusses the details of our second-quarter results, I'll provide a few updates on our recent regulatory and operational developments.

On June 1, APS filed its first rate review in five years. Our proposal moves Arizona forward with continued investments in an advanced energy grid, a cleaner energy mix, and new technologies that will enable our customers to have more choices and control. Today I'll highlight the key request of the filing and their benefits. For your reference, those items as well as key underlying assumptions, are summarized in the appendix to today's presentation.

The rate review provisions contain a number of benefits for our customers, the communities we serve, and our shareholders. The requested regulatory treatment will build upon the constructive regulatory framework established in the 2009 and 2012 settlements. Through this rate review, APS is asking for a change in the way customer rates are designed and an overall 5.74% bill increase, or $166 million annually. APS has asked for an effective date of the new rates of July 1, 2017.

Many of the key provisions in our rate review proposal are focused on constructive regulatory treatment that mitigates regulatory lag. For example, we're seeking post test-year plant additions for the period between the end of the test year and the date new rates take effect. This process has been used to mitigate regulatory lag in our last two rate settlements and in other cases in Arizona. APS is also requesting a deferral order for our investment in the Ocotillo modernization project, which will come into service after the rate case, and a deferral and step increase for the selective catalytic reduction technology equipment now being installed at the Four Corners Power Plant. This type of step increase would be similar to the structure agreed to in our last rate settlement regarding the acquisition by APS of Southern California Edison's interest in the Four Corners Power Plant.

In addition, APS also proposed changes to the rate options it offers to customers, insuring that the price a customer pays more accurately reflects the way that customer uses the electric grid. A three part bill with a demand component in addition to making the basic service charge itself more cost based will reduce intra-class subsidies, better reflect the actual cost of service, and enable the sustainable deployment of new customer technologies. APS already has more than 120,000 residential customers on demand rates today and our proposal expands this rate element to most residential customers. Our proposal also benefits customers by reducing the subsidy currently paid to support the rooftop solar industry by the 96% of residential customers who do not have rooftop solar.

This change would not affect the 45,000 customers who already have rooftop solar or new solar customers who submit a completed inner connection application before July 1, 2017. We want to continue Arizona's solar leadership the right way, with more solar for more customers without driving up the energy bills paid by non-solar customers. The Administrative Law Judge has set a procedural schedule for the rate proceedings. The ACC staff and interveners would begin filing their direct testimony on December 21 and the hearing would commence on March 22, 2017. The Commission staff supports completing the case within 12 months.

In addition to the APS rate review filing, the Arizona Corporation Commission is managing a very full schedule. On June 13, hearings concluded in the value and cost of solar generic docket. Final legal briefs are due on August 5 and we expect a recommended opinion and order later this year. While the initial round of testimony has recently been filed in the Tucson Electric rate case, hearings are now complete in the UniSource electric case and a recommended opinion and order was recently issued recommending a 9.6% non-fuel rate increase.

Turning to operational developments, we concluded planned outages at the Palo Verde nuclear generating station and both units at the Four Corners generating plant. Jim will discuss the financial impact, but the extended duration of the Four Corners planned outages was a head wind in the second-quarter results compared to the second quarter of 2015. Palo Verde, which is Americas largest carbon-free energy source, had a solid first half of the year, including successfully completing the unit one planned refueling outage in 35 days.

On a related note, APS recently announced changes to its senior leadership team at Palo Verde. Bob Bement, who has been instrumental in Palo Verde's success, has been promoted to Executive Vice President, Nuclear. Bob will continue reporting to Randy Edington, Executive Vice President and Chief Nuclear Officer, until October 31 when Bob will then take over as Chief Nuclear Officer while Randy transitions to Executive Vice President and advisor to me.

Jack Cadogan, currently Vice President, Nuclear Engineering, has been named to replace Bob as Senior Vice President, Site Operations and completing the leadership team at Palo Verde, Chuck Kharrl has been named Vice President, Site Operations and General Plant Manager and Mike McLaughlin has been named Vice President, Operations Support. In addition, Bruce Rash is joining Palo Verde from Exelon Corporation in the position as Vice President of Nuclear Engineering. These changes insure Palo Verde will continue to have the strongest nuclear leadership team in the industry.

Looking to our capital investment program, we continue making good progress on both the Ocotillo modernization project and the installation of selective catalytic reduction technology at Four Corners. Our 40-megawatt utility scale solar plant, Red Rock, is more than 50% complete and on schedule for completion later this year. APS recently issued an all-source request for proposals seeking 400 to 600 megawatts of capacity resources to help meet customer peak energy needs. We're now evaluating the proposals with an expected decision later this year. Last May, APS announced plans to participate in the energy imbalance market. We're currently performing parallel operations and expect to go live on October 1. Participation in this five-minute energy market is expected to offer economic savings to our customers and improve the integration of renewable resources.

Let me conclude by saying we're excited about the opportunities ahead for our customers, our employees, and our shareholders. In April, APS celebrated 130 years of providing its customers with reliable electricity at an affordable cost. One month later, we filed a historic rate review which builds on the foundation established in previous rate reviews. The investments and proposals discussed in this filing provide a clear and compelling vision for the future. In many respects, this case serves as a transition from the challenges of the present to the opportunities of the future. Meanwhile, we are delivering on our commitments and continue to be well positioned for the balance of the year. Now I'll turn the call over to Jim.

Thank you, Don, and thank you again, everyone, for joining us on the call. This morning, we reported our financial results for the second quarter of 2016, which were in line with our expectations. As summarized on slide 3 of the materials, for the second quarter of 2016, we earned $1.08 per share compared to $1.10 per share in the second quarter 2015. Slide 4 outlines the variances in our quarterly, ongoing earnings per share, the key drivers being higher gross margin, which is primarily offset by higher operations and maintenance expenses.

Looking at gross margin, there were several factors that contributed to the $0.21 increase, including favorable weather. June's weather was the hottest on record and when paired with the mild conditions in the second quarter of last year, the net effect of weather variations increased earnings by $0.09 per share. Higher sales in the second quarter of this year compared to the second quarter in 2015 addled $0.04 to gross margin. In total, weather normalized retail kilowatt hour sales were flat compared to last year but the sales trends by customer class were mixed, ended up yielding a positive gross margin effect.

More specifically, sales to higher margin residential customers increased 1.8% in the second quarter, but this growth was partially offset by a 1.5% reduction in sales to lower margin business customers. Collectively, the adjustment mechanisms continue to add incremental growth to our gross margin as designed, contributing $0.04 per share. A final comment on gross margin, in April, APS completed the sale of a 50% ownership stake in an existing 230 KB transmission line which resulted in a $0.03 contribution to gross margin.

Now turning to operating expenses, as I mentioned earlier, higher O&M was a primary offset to ongoing earnings per share in the second quarter. Included in guidance, and in line with our expectations, the major planned outages at Four Corners Units 4 & 5 that concluded in the second quarter were a headwind to quarter activity compared to 2015. Another key factor that contributed to an increase in O&M in the second quarter of this year relative to last year was higher employee benefit costs, including stock compensation costs.

Higher D&A also increased earnings by $0.02 in the second quarter. This variance includes higher expenses resulting from additional plant and service which were partially offset by lower depreciation related to the extension of the Palo Verde sale leaseback. The gross margin and D&A variances exclude operating revenues and expenses related to Palo Verde Unit 2 decommissioning recovered through a systems benefit charge. The drivers I discuss exclude these items as there was no net impact on second-quarter results.

As the Arizona economy continues to be an integral part of our business story, I'll highlight next the trends we are seeing in our local economy and in particular, the Metro Phoenix area. Job growth in the second quarter in the 2,000 Metro Phoenix area remained at about double the national average, continuing a trend we had seen for nearly five years. As seen in the upper panel of slide 5, Metro Phoenix added jobs at a 3.4% year-over-year rate. This job growth is broad based with construction, business services, financial services, and healthcare showing strong sectoral strength, adding jobs at a clip above 4% year-over-year.

Job growth continues to have a positive effect on the Metro Phoenix's areas commercial and residential real estate markets. Absorption of vacant commercial space remains steady in the second quarter with combined 2 million square foot of office and retail space occupied by new tenants. Vacancy rates in both markets have fallen to levels last seen in 2008 and almost 3 million square feet of new office and retail space was under construction at the end of the quarter. We expect a continuation of business expansion and related job growth in the Phoenix market, which will in turn support continued commercial development.

The residential real estate market reflects those trends as well. As you can see in the lower panel of slide 5, housing construction is on pace to have its best year since 2007, driven primarily by the single-family market and overall, the amount of vacant housing in Phoenix is solidly back to pre-recession levels. Record low apartment vacancies and absorption of available single-family homes is providing meaningful support to home prices, which have returned to levels last seen at early 2008.

We believe that solid job growth, low mortgage rates, and the opening up of credit to the wave of households who suffer from foreclosures during the recession to allow the Metro Phoenix housing market and the economy more generally to expand at a healthy pace over the next couple of years. Reflecting steady improvement in an economic conditions, APS's retail customer base grew 1.4% compared with the second quarter of last year. We expect that this growth rate will continue to gradually accelerate in response to economic growth trends I just discussed. Importantly, the long-term fundamentals supporting future population, job growth, and economic developments in Arizona appear to be in place.

In closing I will review our earnings guidance and financial outlook. We continue to expect Pinnacle West's consolidated ongoing earnings for 2016 will be in the range of $3.90 to $4.10 per share. You will find a complete list of factors and assumptions underlying our guidance included on slide 6, which remain unchanged. In terms of our recent financing, on May 6, APS issued $350 million of 3.75% senior unsecured notes. The proceeds from the sale were used to redeem and cancel certain pollution-control bonds and to repay commercial paper and replenish cash temporarily used to fund capital expenditures. Additionally, on August 1, APS repaid at maturity $250 million of 6.25% senior unsecured notes. We anticipate issuing up to $350 million of additional long-term debt this year.

Overall, our balance sheet and liquidity continue to remain very strong. At the end of the quarter, Pinnacle West had no short-term borrowings and APS had $64 million of commercial paper outstanding. Finally, our rate based growth outlook remains 6% to 7% through 2018 and our forecast does not include the need for additional equity.

This concludes our prepared remarks. I'll now turn the call back over to the operator for questions.

(Operator Instructions)

Thank you. Our first question comes from the line of Greg Gordon with Evercore.

Hey, hello, guys.

Hey, Greg.

If we look at the schedule for the rate case, I have a two part question. One is traditionally when do we get in the window where we can start to potentially settle certain items in the case or potentially get a global settlement, although that's a little bit harder obviously? Two, what can we glean from the rate cases that have been going on in the southern part of the state in terms of issues that have been settled or resolved that might be precedential for your case?

Hey, Greg, it's Jeff Guldner. On the schedule and settlement, typically you would start looking at that after direct testimony has been filed by other parties and so that's probably the time you'd first start to get really engaged in settlement discussions with folks like staff. Obviously, you'll be engaged in discussions along the way. We do and are doing right now technical conferences to help folks understand the filing itself and so we'll continue that through the testimony piece.

On the other issues, obviously rate design has been a pretty major topic in most of the cases and while it's certainly helpful in seeing what some of those issues are, one of the things I'd be cautious of is all of the utilities in the state are coming from a slightly different position. You've probably seen the UNS order. The recommended order is out of the UNS case and it's proposing a move to TOU rates. We had also suggested in our testimony in that case that they move more towards the demand rates which is similar to our proposal, but they aren't in the same position as we are and so one way that we're viewing that case now is that, that's a good step in overall rate modernization because they're moving customers out of TOU. We're in a better position with half our customers on TOU, and about 11% of the customers on demand rates, residential demand rates today. That's helpful in seeing what some of the issues and discussions are but the cases are all going to be different as they ultimately move forward.

Okay. Remind me when you said the date for direct testimony filing is?

Direct testimony on the (inaudible) piece is December 21 and then the rate design piece would be January 27 of 2017.

Okay, great. Thanks, guys.

Our next question comes from the line of Julien Dumoulin-Smith with UBS.

Hey, good morning.

Morning.

I just wanted to ask, how has the election strategy evolved of late, just broad brush in light of everything going on? Perhaps comparing this cycle versus the last, if you will.

Well most significant difference is there's three slots that are potentially open at the Commission and Julien, you know that alternates every other year or two versus three. We have five republican candidates and two democratic candidates running in the primaries at the end of this month.

Has your strategy in terms of your approach changed at all?

They're running their campaigns.

Got it. Okay, great. Separately, can you elaborate a little bit on demand charges, especially versus fixed charges? Any commentary with respect to the ALJ that came out recently in the UniSource case and how does that differ from your own case, if you can comment?

Sure, Julien. It's Jeff. One of the ways to think of the difference between demand rates and fixed charges is with the demand rate, the customer can still control that. One of the challenges if folks are talking about moving to higher fixed charges that don't vary with demand, there's essentially nothing a customer can do to manage that, and so what we've seen with our residential customers who are on a demand rate and particularly with customers who have transitioned from a more traditional or a time-of-use rate to a demand rate is that they actually can do things both behaviorally and with technology that can manage demand. There's a lot of value in moving to something that sends a better price signal that can actually incent some technology or some behavioral adaptation from customers that help us manage peak demand and with all of the solar we see in the Southwest, that's the major transition that we've got to start looking at.

When you look at the other utilities, we have done more, I think we have more customers on residential demand rates than anyone in the US so we're in a better position to understand the dynamics of those rates, how the rate design matters, and make those changes. I think there's a recognition of that from the folks who are involved in the hearings here but overall in the Southwest, rate modernization is something that has to happen. What you're seeing in UNS is a transition out of time of use. We've done the time-of-use rate for over 30 years and so we're at a slightly different place, our metering technology is more advanced and so you have to be careful in looking at other cases for direct precedent but they are certainly instructive in what some of the issues are.

How do you think about customer sort of education on demand charges that were raised?

Very important. Again, what you want to do is make sure that customers understand the simple aspects. We have proposed in our case and are working on a pretty aggressive customer education program but then also what are the tools that we can provide to customers? Some of them are very simple from just understanding the time frames and there's things we can do in rate design that help soften the impact of the rate, make it different from a commercial demand rate but we also want to make sure that customers know the other things that they can do to take control of the rate.

Got it. All right, thank you.

Our next question comes from the line of Ali Agha with SunTrust.

Thank you. First question, when you look at the first-half results, Jim, you mentioned you're on track but weather has been better, the costs obviously you had budgeted but overall, would you say that through the first half the results are right on plan and budget as you would have envisioned the year?

Like I said in my remarks, Ali, we're meeting our expectations based on where we thought we would be in the year. The O&M is mostly fossil maintenance and it was front-end load and we know that so there's no surprise sitting here where we are today.

Okay, and then secondly, the budget is still for customer growth of 1.5% to 2.5% for the year. We're only at about 1.4% and also I know the second quarter is a shorter quarter but weather normalized as you said were flat. It was up over 1% in first quarter. Are those trends again pretty much as expected or does that give you a better or clear picture on how the full year may be shaping up based on how first half has shaped up so far?

Yes, we plan for gradually improving throughout the year and if you look at 2015, the first half we were 1.2% customer growth 2015, second half 1.3% and now we're at 1.4% and we thought that would be that gradual acceleration through time, so I think we're right on track.

Also for the usage as well, in terms of weather normalized rates?

Yes, we're at 0.6% year-to-date. Our plan this year is 0 1% so we're safely within that sort of range we expected.

Okay. Lastly, Jim as you mentioned, your latest rate based growth numbers call for 6% to 7% CAGR. They've actually gone up after you filed the rate case (inaudible) numbers. Can you remind me again why that doesn't accelerate the earnings growth profile as well because the rate base has gone up?

Because we don't have perfect regulations so we continue to have some regulatory lag as well as financing costs for every construction program will erode that earnings slightly. As we've always said, rate-based growth is a sort of top end and dividend growth is the bottom end of where we would expect earnings to come in, if we were going to project earnings, which we don't.

Understood. What is the plan for dividend growth?

The Board will look at it again in October. We've accelerated from [four] when we begin dividend growth again to [five] in 2014 and so we'll have to see where we are all things considered in October.

Got it. Thank you.

Our next question comes from the line of Michael Weinstein with Credit Suisse.

Hi, guys. With updates due for the preliminary IRP on October 1, which is the same day that you begin energy and balance market operations, to what extent do you expect any incremental renewable opportunities at the utility that aren't already reflected in the preliminary IRP?

Yes, I wouldn't not connect EIM and the IRP. I think obviously as we look at additional renewals will be based on specific needs at a specific time.

I mean, it's just that one of the justifications, I think, for joining the EIM was to benefit or to give more opportunities for renewables. I'm just wondering to what extent was your decision to join the EIM driven by that?

EIM was really a customer benefit proposition that will allow integration of renewables more but that will provide customer savings, which was our motivation.

Roger. Okay, thank you.

Our next question comes from the line of Michael Lapides with Goldman Sachs.

Hey, guys, congrats on a good quarter and good first half of the year. Question on O&M a little bit. Can you bridge us, Jim? O&M is up and if I include the energy efficiency and DSM charges, roughly about $60 million on a year-to-date basis. Last year in the second half of the year, I think O&M was right around $440 million, $445 million. Are you expecting O&M to be down year-over-year in the second half of 2016, more flattish? I'm just trying to get a feel directionally for where you think this is just given the kind of the sizeable uptake in first half of the year due to the outages.

If you look at the middle of the range from 2015 to 2016 it's about $63 million of which $50 million of that is related to the outages, so that would imply that the comparisons moving forward will be fairly comparable.

Got it. Okay. Should we assume 2017 has a sizeable roll off? How much of this O&M that you're incurring in 2016 is kind of recurring longer term versus will kind of fall off when we get to next year?

We have overhaul schedules based on OEM run rates and how we use them and they are lumpy, but we aren't really ready to talk about 2017 at this point.

Got it. Okay, thanks, Jim much appreciated.

Our next question comes from the line of Charles Fishman with Morningstar.

Thank you. Don, I only have one question left. This transmission line sale, was that just too good of a deal to pass up or should we read something more into that as a strategy shift?

No, so this was a transmission line we had 50/50 partnership in and there had been discussions in prior years about the partner wanting at some point potentially to own that line and so they approached us about a potential transaction that was favorable to us and so we did that and consistent with commissions, we did 50% of proceeds over book value went back to customers and shareholders (technical difficulty) 50%.

Okay, so don't read anything into it?

Don't read anything into that, no.

Got it. Thank you, that's all I had.

Our next question comes from the line of Paul Ridzon with KeyBanc Capital Markets.

Good morning.

Hey, Paul.

Could you just kind of give a 10,000-foot view of kind of the high points of what came out of the value of solar discussion and how you expect that to interplay with your pending case?

This is Jeff. The briefing is still ongoing so you've got replied briefs that are actually coming in on Friday and what will happen then is then the ALJ, the Administrative Law Judge, will put a recommend order out. The Commission will hear that, that open meeting. Right now the only rate case that's teed up concurrently with that is the UNS case. One the questions will be, then, whatever comes out of the value in the cost of solar docket, remember that docket was focused on two things, first how do you look at the cost of service associated with solar, the cost of solar, and then what are the ways you value the export energy. That then has to be integrated into the rate cases and the first case that is going to be up with that is UNS, and again, our timing is a little better because we're later in the process. So more to come on the value of solar yet.

When is the ALJ rep due?

It not. There's no due date, but the briefs go in August so typically you're going to see that in a month or so after the briefing at least.

Thank you very much.

Our next question comes from the line of Paul Patterson with Glenrock Associates.

Good morning.

Hi, Paul.

There's a workshop later this week on reducing peak demand costs and you were just talking about TOU and what you guys have done and what have you and I'm just wondering, could you elaborate a little bit on what's sort of driving this workshop and the look that the Commission is having on it?

Paul, this is Jeff again. One of the challenges that we're seeing out here on the wholesale market is that we've got a lot of solar and when that solar production is on, particularly in the spring and the fall, what it is doing is creating negative prices in the middle of the day and shifting the peak out later in the day and so it means there's a very heavy focus on that peak demand part of the day and less on kind of overall energy consumption. Folks are trying to figure out in both rate design and the use of technology and how we design the system, so things like the Ocotillo modernization project, how we deal with peak demand, it's increasingly the challenge in running the system. That workshop is, I think, a positive sign that says we're looking at how all these things play in what role technology has, what role rate design will have, and so it's a constructive conversation.

Okay, good. On the value of solar, I've seen some of the briefs and there's been some sort of issue regarding the models and what have you. I'm just wondering whether or not there's a potential for a settlement with some of the parties, perhaps, among some of the parties with respect to the distributed generation value proceeding or if we should just expect that to be kind of fully litigated.

I would expect to see it be litigated, given where you are in the proceeding right now.

Sure, okay. Thanks so much.

Our next question comes from the line of Stephen Fleishman with Wolfe Research.

Yes, hi, thanks. Just quickly, the Bloomberg grabbed a story from your 10-Q about the subpoenas you got for the 2014 election. I just wanted to clarify that, that is related to the politicians involved and such and clarify that the subpoenas are not related to anything they are investigating at the Company?

Steve, just to reiterate, in June the Company received two subpoenas issued in connection with investigation by the US Attorney's office pertaining to the 2014 statewide election races in Arizona. At the time we said we would cooperate fully and that's still the case. We're not able to comment further on the investigation while it's ongoing.

Okay. All right, thank you.

It appears we have no further questions at this time. I would now like to turn the floor back over to Management for closing comments.

Thanks, Christine. Thank you all for joining us today. This concludes our call.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.