Pinnacle West Capital Corp (PNW) 2017 Q3 法說會逐字稿

Greetings, and welcome to the Pinnacle West Capital Corporation 2017 Third Quarter Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Stefanie Layton, Director of Investor Relations. Thank you. You may begin.

Thank you, Christine. I would like to thank everyone for participating in this conference call and webcast to review our third quarter 2017 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' Executive Vice President of Public Policy; and Mark Schiavoni, APS' Chief Operating Officer, are also here with us. First, I need to cover a few details with you. The slides 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 place undue reliance on these statements. Our third 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 November 10. I will now turn the call over to Don.

Thanks, Stefanie, and thank you all for joining us today. This year continues to be in line with our expectations and keeps us on pace with our full year guidance. Although we experienced milder weather compared to normal during September, our positive customer growth, ample investment opportunities and disciplined cost management continue to support our ability to meet financial commitments. Just last month, our board also approved a 6.1% dividend increase, demonstrating the confidence our board and our management team have in our ability to maintain sustainable growth. Before Jim discusses the details of our third quarter results, I'll provide several updates on recent regulatory and operational developments. Our rate review concluded on August 15 (inaudible) on a corporation commission voting to approve our settlement agreement without material modifications, including a 10% return on equity; and a $94.6 million base rate increase, which results in an overall 3.3% customer bill increase. New rates went into effect on August 19. The successful rate review outcome continues to demonstrate Arizona's constructive regulatory environment. On September 1, we filed our proposed 2018 demand side management, or DSM, plan with the corporation commission. The 2018 DSM plan shifts focus to better align with our changing resource needs. The plan moves away from incentives, where savings no longer align with system needs. It also introduces new programs to shift customer usage to the middle of the day, when solar resources are abundant and energy is less expensive. For example, the 2018 DSM plan includes a pilot proposal to electrify school buses and provide charging infrastructure. We believe electrifying vehicle fleets is a win-win solution, utilizing excess power generated by solar during the middle of the day while effectively reducing carbon emissions in a cost-efficient manner. To further address excess mid-day power, the 2018 DSM plan also includes an innovative reverse demand response pilot, allowing customers to take advantage of negative pricing events. Further recognizing the growing market for electric vehicles, for 2018, DSM plan includes a managed EV charging pilot program for electric fleets, workplaces and multi-family housing locations. And charging stations would be utility-controlled and available to provide demand response and load-shifting capabilities. The shift in energy efficiency towards a strategic focus on managing peak demand allows customers to save money by encouraging usage during periods when energy is less expensive. From an operational perspective, this shift helps address our overgeneration challenges in the middle of the day. In addition, it plays a key role in providing environmental benefits by allowing us to more fully utilize 0 or low-carbon resources.

Turning to our operations. Our employees once again did an excellent job, maintaining the generation fleet and electric grid this summer. The Palo Verde generating station performed well, with all 3 units operating at a combined capacity factor of 99.4%. Also, Unit 1 at Palo Verde ended its planned refueling outage on October 7. In September, Four Corners began a 95-day planned outage on Unit 5. During the outage, we will tie in with selective catalytic reduction equipment referred to as SCRs. A second 95-day planned outage will result -- will occur in early 2018 to repeat the process for Four Corners Unit #4. The SCR being installed at Four Corners will reduce nitrogen oxide emissions by more than 80%. APS customers have benefited from savings of $30 million in the company's first year in the Western regional energy imbalance market. Our EIM participation has allowed us to garner efficiencies by decreasing production costs, lowering the cost of integrating renewable resources and taking advantage of negatively priced power from other states. The summer of 2017 also rewrote APS energy records, an all-time peak usage record and new technology defined the season. On the technology front, we experienced our first summer with the newly-implemented advanced distribution management system, or ADMS. And ADMS provides grid operators increased visibility of our system and the ability to remotely control greater portions of a distribution grid across the state. And this ability played an important role in APS' response to monsoon storms over the course of the summer. And with our operating system and other grid-enhancing technology, APS is positioned to meet the evolving needs and expectations of our customers. Our capital investment program continues to be robust and is focused on flexible generation, new grid technology and advancing core utility operations. We are progressing on the installation of 5 new fast-start, flexible generating units at the Ocotillo power plant. Also, in lieu of rebuilding about 20 miles of poles and wires in rural Arizona, we will be installing a battery storage system to meet the area's growing demand for electricity. Construction on our new 8-megawatt hour battery storage project will begin in early November and is expected to be operational early next year. We also installed 2 battery storage units in the West Valley in December 2016, as part of the Solar Partner Program, and we're exploring additional storage opportunities. These innovative projects are indicative of the type of grid we envision for customers: smart, multifunctional and a platform for additional customer-cited technology. Looking forward, our long-term strategic plan positions us well to capitalize on new investment opportunities. Our fundamentals and our expectation for growth remain unchanged. And the recent dividend increase reinforces the boards' and management's confidence in our ability to execute and deliver value to our shareholders. I'll now turn the call over to Jim.

Thank you, Don. And thank you again, everyone, for joining us on the call. Today, I'll discuss the details for our third quarter financial results, provide an update on Arizona economy and review our financial outlook, including introducing 2018 guidance. This morning, we reported our financial results for the third quarter of 2017 which were in line with expectations. As summarized on Slide 3 of the materials, for the third quarter of 2017, we earned $2.46 per share compared to $2.35 per share in the third quarter of 2016. Slide 4 outlines the vacancies that drove -- the variances that drove the changes in our quarterly ongoing earnings per share. I'll highlight a few of the key drivers. Gross margin was up $0.22 per share in the third quarter this year compared to last year supported by several factors: the rate increase approved by the commission in ADS' rate case proceeding, which became effective August 19, improved gross margins by $0.13 per share; higher sales in the third quarter of 2017 compared to the third quarter of 2016 increased earnings by $0.02 per share, driven by customer growth, partly offset by the effects of energy efficiency and distributed generation; the net effect of weather variations added $0.02 per share. Cooling degree days were higher in the third quarter this year compared to last year, although weather on both the 2016 and 2017 third quarters were less favorable than the 10-year averages. Higher operations and maintenance expense decreased earnings by $0.02 per share in the third quarter of 2017 primarily due to an increase in employee benefit costs. We also had a higher planned outage cost related to the beginning stages of the SCR installation at Four Corners Unit 5. Depreciation and amortization expenses were higher in the third quarter of 2017 compared to the third quarter of 2016, impacting earnings by $0.07 per share. The increase was primarily driven -- related to plant additions and the $61 million annual increase in D&A rates accrued in the rate case. Looking next to Arizona's economy, which continues to be an integral part of our investment thesis. I'll cover some of the trends we are seeing on the local economy and in particular, the Metro Phoenix area. Metro Phoenix area continues to show job growth above the national average. Through August, employment in Metro Phoenix increased 2% compared to 1.5% for the entire U.S. The above-average job growth is broad based and driven largely by tourism, health care, manufacturing, finance and construction. The Metro Phoenix unemployment rate of 4.3% also reflects the strength of the job market. This sort of job growth continued to have a positive effect on the Metro Phoenix area commercial and residential real estate markets. As seen on the upper panel of Slide 5, vacancy rates in commercial markets continue to fall and are at the levels last seen in 2008 or earlier. Additionally, about 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. Metro Phoenix has also had growth in the residential real estate market. As you can see in the lower panel of Slide 5, housing construction is expected to continue the upward post-recession trend. In 2017, housing permits are expected to increase by about 2,000 compared to 2016, driven by single-family permits. In fact, permits from the single-family homes in the third quarter were the highest levels seen since 2006. One factor driving this increase is that Maricopa County was the fastest-growing county in the U.S. in 2016. The activity in the market is providing meaningful support to home prices, which have returned to levels last seen in early 2008. We believe that solid job growth and low mortgage rates should allow the Metro Phoenix housing market and the county more generally to continue to expand at this pace over the next couple of years. Reflecting a steady improvement in the economic conditions, APS' retail customer base grew 1.9% in the third quarter. We expect that this growth rate will continue to gradually accelerate in response to the economic growth trends I just discussed. Importantly, the long-term fundamentals supporting future population job growth and economic development in Arizona appear to be in place. Finally, I will review our financing activity, earnings guidance and financial outlook. On September 11, APS issued $300 million of 10-year 2.95% senior unsecured notes. The proceeds were use to finance -- refinance commercial paper borrowings and replenish cash temporarily used to fund capital expenditures. Overall, our balance sheet and liquidity remain strong. At the end of the quarter, Pinnacle West and APS had approximately $100 million and $32 million of short-term debt outstanding, respectively. As Don discussed, in October, the Board of Directors increased the indicated annual dividend by $0.16 per share or approximately 6% to $2.78 per share effective with the December payments. Turning to guidance. We continue to expect Pinnacle West's consolidated ongoing earnings for 2017 will be in the range of $4.15 to $4.30 per share. Key drivers for the remainder of the year include impact from our rate case and higher O&Ms as we complete the plant outage at Four Corners. The extended planned outage at Four Corners is why earnings in the fourth quarter of this year are expected to be lower than the fourth quarter of 2016. We are also introducing 2018 ongoing guidance of $4.25 to $4.45 per share, which includes an increase in our weather-normalized sales forecast to 0.5% to 1.5%. The rate increase, our adjustment mechanisms and sales growth will be important gross margin drivers, with -- we expect will be partially offset by higher fossil plant outage cost and higher other operating expenses related to more plant in service, including higher D&A and property tax. We have also increased our 2018 capital expenditure growth cap by approximately $40 million, mainly from reliability-related projects. We have higher fossil plant outage cost in 2018, including the 95-day SCR installation at Four Corners Unit 4. We also have planned outages at gas plants, including Redhawk. Maintenance at our gas plant is based on [run hours] and starts. Our participation in the Energy Imbalance Market, increasing levels of solar generation and low gas prices, combined, have resulted in more starts at many of our plants. We added -- we'll continue to plan to operate our business for long-term success, and we continuously strive to manage costs in a sustainable manner. In 2018, the larger than normal number of planned outages will provide the necessary maintenance to continue operating our diversified fleet with the high level of reliability our customers expect. We also believe that thoughtful and well-executed preventive maintenance can limit more costly emergent work in the future. You will find a complete list of factors and assumptions underlining our 2017 and 2018 guidance in the appendix to today's slides. Our rate base growth outlook remains at 6% to 7% through 2019, and we still expect to achieve an annualized consolidated earn -- return on average common equity of more than 9.5% over the same time horizon. The combination of modest customer growth supported by robust economic development activity, extensive capital investments opportunities and renewable resources, technology and grid modernizations, together with a constructive and forward-thinking regulatory commission, we believe we are well positioned to continue our track record of success. This concludes our prepared remarks. I'll now turn the call back over to the operator for questions.

(Operator Instructions) Our first question comes from the line of Ali Agha with SunTrust.

Jim, as you pointed out, in 2018, you will have higher than normal outages, and so the O&M expense gets lumpy and is higher. As you look forward, maybe the next couple of years, can you remind us again when we should see that kind of lumpiness in the O&M expense? I mean, you mean '19, '20 perhaps return to normalized levels? Or how should we think about that?

Well, I would say that since we haven't gone beyond 2018 is our fossils -- overall spend has always been lumpy. And you can see on Slide 14, in the appendix, sort of the historical pattern. This was an unusual year with the higher (inaudible) or the SCRs and the scope of the work to make that happen, along with gas plants, which are just, as I said, based on starts and hours. So I will just say it's lumpy, but this year is unusually high.

As of next year?

Excuse me?

As for the next year as well.

Yes, of course.

And then second question. In the slide deck, you laid out at least an aspiration of the plan for the dividend growth to continue at 6% beyond the current level. Should we use that as a good proxy of how you're thinking about EPS growth longer term as well?

Well, I would just state it this way since we don't give earnings growth is, our rate base growth is 6% to 7%. The board and the management team feels very comfortable of what we'd see through the next rate cycle. So you can imply anything you want from that.

Okay. Last question. Year-to-date, weather-normalized sales growth has been essentially flat, I think, up like 0.1%. Is that in line with what you were thinking for this year? And any read-through on how you're expecting longer term? I know you wanted -- you are expecting it to go higher, but how would you rate sort of the year-to-date trends?

I would say that year-to-date of 0.1%, we saw a somewhat of a slow down in usages that came [probably in October. Probably some impact in there, higher than the rate case.] We had a weak fourth quarter of 2016, so I think sales are right in line with what we were forecasting throughout the year.

Our next question comes from the line of Greg Gordon with Evercore.

I mean, Ali asked -- frankly, asked the key questions that I was focused on, but I'm looking through the slides here. I don't see any update on what rooftop solar penetration or rooftop solar sales have done since the rate case was resolved and the rate design has changed. Can you give us a sense of how the market has changed from what...

Yes. So the exact number will be in our EEI slide deck, which will be filed today later today but -- and we're just finalizing the number. But you did see it fall off of what we expected with the pull forward in 2018 to the grandfathering, but that number will be in the slide that we'll file later today.

Okay. Great. And I know, Don, you talked about ample investment opportunities or -- just around the economic growth and modernization of the -- your infrastructure. Your current '17 and '19 CapEx plan is reasonably significantly backward-dated. It goes from $1.3 billion to $1 billion per year. At what juncture should we expect or what milestones should we look for, for you to identify customer-friendly sort of customer necessary investments that might bring those numbers up?

Well, good question, Greg. We continue to look for those opportunities, and I think it's going to be largely driven by the kind of growth we're seeing from some of the things that Jim touched on. But in addition to that, Maricopa County, where Phoenix is at, is the #1 population growth center in the United States. We saw employment in Metro Phoenix increase 2% compared 1.5% for the nation. And realtor.com projects Phoenix to be the #1 housing market in 2017. We had, on the larger customer side, like Intel, which isn't a customer, but they announced a new fab facility in the Metro area, which the housing component of that in the service sector, we believe it will (inaudible) into our service territory. And you just get into a car and drive around [apartments] trying to block without a multi-family project going up, and downtown Phoenix is really taken off. So it's pretty bullish on our customer expectations over the next 2 to 5 years. I think that will grow a lot of -- drive a lot of our CapEx spending.

And Greg, we'll have an update -- we'll file our updated CapEx, including 2020 in our 10-K in February, so that will give you also a outlook in the future.

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

I wanted to follow up a couple of questions real quickly, a little bit to the last one that Greg asked. You talked about future investments, given the acceleration here. Can you talk about smart grid and reinvesting into the grid from that perspective beyond kind of the near term and beyond 2019? Clearly, it seems like that's a trend in the industry and you all probably see that to a larger extent, perhaps, than others given the customer growth.

We have smart meters across our system, so they're fully deployed. Don mentioned the ADMS, which is really the grid technology that allows us to get visibility into the grid and control. And I would say, our annual spend today on things like integrated [bullbar] are probably $40 million to $50 million. And that's really evolving at this point. So ample opportunity to continue to support the 2-way grid.

Got it. Actually -- and then, separately, obviously, more of an IRP-related question, but how do you think about the timeline to retirement of some of the units here? I mean, can we see some of the accelerations out there just given the age of unit cost structure, et cetera? I mean could that be a mitigant for some of the future O&M growth or the current O&M growth you're facing here?

So Navajo is closing in 2019. The way it stands today, we did an RFP last year for power beyond 2020. We have 1 in store right now as well. So I think unless you're talking about successful sort of safety type, I wouldn't have put anything in near term.

Got it. Fair enough. Excellent. And then out of the RFP, any commentary in terms of your ability to own something? I mean, obviously we saw last year's results turn out to be contracted gas. How are you thinking about that for yourselves under any number of potential outcomes, including build, own, transfer, acquire, own the rate base? Any number of scenarios?

So the RFP's in process now. We're nearing the final stages at this point. We did not include in there a build, own, transfer or a sales build at this point. This is really for power blocks of the day, is really what we're looking for.

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

Just 2 follow-ups of Julien's question. So would we see perhaps a replacement from Navajo being sought in next year's RFP? Is that the kind of timing that we would be thinking about?

So we went out -- last year's RFP was for 2020 and beyond. So we'll get through this RFP and see what our needs are at this point.

All right. And at some point, do you anticipate trying to take advantage of some of the exceptions to this self-build moratorium such as renewable ownership and that kind of thing and maybe that would show up in the CapEx forecast at some point?

Yes. We don't really need anything at the moment, but we'll evaluate ongoing, whether we need supplement or not.

Is there any -- I mean, I know it's -- you haven't put out the new presentation for EI(inaudible) but what do you think are the expansion possibilities for battery storage at this point beyond the current programs? Is that something that could take off and accelerate?

Oh, I think we'll continue to deploy more battery storage as we move forward. I think we're taking a measured pace and make sure we're not in front of the cost growth. As Don's said, we're putting in a couple of batteries in the rural area to -- in lieu of upgrading the circuit. And I think there will continue to be opportunities where we can (inaudible) capital near-term in battery storage. But we're just getting started in battery storage at this point.

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

If I just look at your guidance for 2017 and your guidance for 2018 and take midpoint to midpoint, implies about -- I mean, just back of the envelope, 3% EPS growth. Your rate base growth guidance is about 2x of that or double that. I'm just curious, can you help me understand, do you think 3% is kind of a normal EPS growth? Or are there abnormal themes that are happening in 2018 that make the EPS growth rate below average?

Well, obviously, we don't think 3% is normal or the board would not have rate the dividend at 6%. '18, as it sits today, is a test year. There's a lot of capital that's not recovered in there. You have the drain of the -- you have a deferral, but you're not earning on it. So no, I think it's just an unusual year. And if you look back historically, we've grown from 10% to 1.5% EPS, and I wish this stuff was linear. It'd makes it a lot easier but it's -- unfortunately, it's not linear. We'll always have cycles through the rate cycle.

And I want to make sure I understand when I think about the rate case cycle. Will you be filing just to add Four Corners and Ocotillo in rates as follow-up bolt-on kind of mini-cases? Or are you still planning to have a full blown GRC filing in '19 with '18 as the test year and '20 as the implementation time frame?

So the way it sits today, remember, we have the step increase in Four Corners which should be 1/1/19. We currently have '18 as a test year, which should be -- Ocotillo will be done in May of '19, and then it will be the rest of the capital with an '18 test year as it sits today.

But the case will be, if you're using '18 as a test year, it's not just the capital, it's the capital, it's the O&M, it's kind of all in?

Everything. It's not a one-issue rate case, it would be a full rate case.

Got it. And when would that case get -- kind of trying to think about the timing of it, when would that get implemented, probably sometime in '20?

So we cannot file before June 1, 2019. So if you think about the last cycle, we filed June 1. Rates would go into effect July 1 '20, as it's currently contemplated.

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

Just one quick one. Dividend growth guidance was 5% as recently as after the August rate case decision. Now it's 6%. Can you provide a little color, what was the board -- what drove the board to increase it to the 1%? payout ratio? And how do they look at it?

They look at it not with payout ratio per se, although we look at payout ratio as quite a metric in everything. They just look at the -- our long-term future and see that we have a good plan in place with growth. We started the dividend increases in '12 at 4%. We raised it to 5% in 2015. So it's part of them annually looking at a sustainable dividend growth.

Our next question comes from the line of Shar Pourreza with Guggenheim.

My questions were answered.

Our next question is a follow-up from Greg Gordon with Evercore.

So I just wanted to be clear, and this goes back to the first question that was asked. And then as it ties into the 3% year-over-year growth at the midpoint and guidance. That's also clearly a function of the fact that you're -- the timing of the maintenance, sort of $0.11 higher year-over-year, right, I mean going back to 2018?

That would be one piece of it, Greg.

Yes. I mean, I understand the other pieces you articulated but just that alone, if you look at Slide 14, you're looking at, over the last 1, 2, 3, 6 years, you're at an all-time high on planned outage spending. So by this is the right way to think about it without trying to tie you into a specific guidance format that you're not comfortable with, looking at sort of a long-term average and thinking about that as what a run rate should be in any given year?

I haven't calculated. But certainly, your $0.11 in 2018 over '17 is part of that up and down that happens on a year-to-year basis.

Right. But even '17 was -- '16 and '17 were higher than the prior 3 years by a significant margin. I guess, what I'm trying to do is maybe at EEI, you can decide to give people what you're thinking, what average estimated cost would be through the cycle so we could get a better sense of what it will look like out through time.

Yes. I'll tell you, overall, O&M and obviously, this goes up and down. Cents per kWh, O&M expense as a cent per kWh whether normalized retail sales have been flat since 2010 at $0.275 of kWH. So we'll work hard that -- to keep O&M certainly over the timeframe based on kWh growth.

We have reached the end of the question-and-answer session. I will now turn the floor back over to management for closing comments.

Thank you for being on the call. We'll see you next week in Orlando.

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.