Pinnacle West Capital Corp (PNW) 2017 Q4 法說會逐字稿

Greetings, and welcome to the Pinnacle West Capital Corporation fourth quarter and full year 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, Ms. Layton, you may begin.

Thank you, Doug. I would like to thank everyone for participating in this conference call and webcast to review our fourth quarter and full year 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 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 on 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 2017 Form 10-K 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 will 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 March 2.

I will now turn the call over to Don.

Thanks, Stephanie, and thank you all for joining us today. 2017 was a strong year for our company financially, operationally and in the areas of safety and public policy.

After increasing the dividend in October for the 6th straight year, we completed 2017 with earnings exceeding expectations. Jim will discuss the financial results. My comments will focus on our 2017 highlights in the year ahead. Our fleet continued to perform well in 2017. Palo Verde generating station completed another outstanding year of carbon-free electricity production, generating 32.3 million megawatt hours of energy. It's also notable that the team of Palo Verde completed each of the scheduled 2017 spring and fall refuelings and maintenance outages in 30 days. This is the first time in plant's history when both outages were completed in 30 days. Our generation fleet continues to evolve by integrating additional clean energy and by focusing on meeting our peak demand. The 2017 request for proposal for heating capacity resources concluded with a power purchase agreement for 65 megawatts of solar with 50 megawatts of battery storage. This will be one of the largest battery storage systems in the country.

Although, APS has recognized that it's the national leader in solar energy with more than a gigawatt of solar power on our system, this next step toward battery storage will ensure the sun helps power Arizona homes into the early evening when our customer demand for electricity peaks. The facility is expected to begin serving customers in 2021.

Our investments are focused both on additional clean energy resources and the technology necessary to support these resources.

Our 2017 operations benefited from the robust technology investments that were further strengthening our electric system, increased efficiency of our operations and improved our customers' experience. Among the most significant improvements were the implementation of a new advanced distribution management system, or ADMS, and customer information system. ADMS has increased our ability to control the grid remotely, while the customer information system has increased our ability to respond to customers.

Our continued investment in system improvements has resulted in other tangible customer benefits. In 2017, we achieved top quartile distribution reliability metrics and had the best summer reliability in 5 years despite the hot and demanding weather. APS also remained top decile for safety performance as compared to our pure electric utilities. The transmission and distribution organization had its safest year ever. The safety of our men and women is our top priority. It's indicative not only of our commitment to our people, but it also reflects our commitment to operational excellence. We'll continue to strive for zero, a truly injury-free workplace.

Turning to the regulatory front. A positive and collaborative outcome of our rate review was a milestone accomplishment in 2017. The Arizona Corporations Commission's decision clearly demonstrates Arizona's interest in capitalizing on the changing dynamics of the electric utility industry and meeting the evolving needs of our customers. We will continue this progress in 2018 as our customers transition to the new rates. Although the rate review is complete, there are a number of public policy items to be decided in 2018. A step-increase request for the SCR environmental control project at Four Corners will be filed in April. And the commission's expected to vote on the 2018 demand-side management plan, and yesterday, the commission approved a $119 million bill reduction for customers based on federal corporate tax reductions. The savings from the tax reductions will be passed directly to customers through the tax expense adjustor mechanism, a new adjustor mechanism that was included in our 2017 rate review.

We intend to file a subsequent application with the commission later this year and pass through additional savings from the federal tax reform to our customers.

In addition, discussions continue on ways to economically integrate more clean energy resources statewide without jeopardizing reliability or magnifying the over generation challenges in the middle of the day.

For 2018, our strategic priority is centered around consumer engagement, flexible resources, employees and innovation. Specifically, we plan to deliver consumer-driven programs and services, develop new initiatives that leverage our core capabilities, adopt sustainable programs that support our people and integrate new technologies to enhance performance reliability and the overall experience of our customers. These priorities align with our mission of safely and efficiently delivering energy to meet the changing needs of our customers.

In summary, we achieved another year of outstanding performance as we focus on delivering on our commitments to the customers who depend on us, the communities we serve, our dedicated employees and the shareholders who trust us with their investment. For 2018, we have clear priorities and alignment amongst the senior leadership to execute collectively on these priorities.

I'll now turn the call over to Jim.

Thank you, Don. And thank you, again, everyone, for joining us today. This morning, we reported our financial results for the fourth quarter and full year 2017.

As you can see on Slide 3 of the materials, we had a solid year. Before I review the details of our 2017 results, let me briefly touch on some of the key factors from the quarter.

For the fourth quarter of 2017, we earned $0.19 per share compared to $0.47 per share for the fourth quarter of 2016. Slide 4 outlines the variances which drove the decrease in our quarterly earnings. Looking at adjusted gross margin, the rate increase, higher sales-related revenue and transmission revenue were all positive contributions.

As we anticipated, higher adjusted operations and maintenance expense in the fourth quarter of 2017 compared to the 2016 decreased earnings, largely due to the higher planned outage costs related to the SCR installation at Four Corners Unit 5.

Now turning your attention to Slide 5, I'll review some highlights of our full year results. We delivered strong results in 2017 that exceeded our guidance range of $4.15 to $4.30, earning $4.35 per share compared to $3.95 per share in 2016. Actual results were higher than projected due in part to effective cost management and higher revenues.

Gross margin was a key driver in 2017 with the key core components. The rate increase that went into effect on August 19, 2017, contributed $0.30. Note, however, that there were related increases in operating expenses that partially offset the benefit of gross margin. Higher sales-related revenue added $0.13 to gross margin in 2017, driven by customer growth and higher average affected prices.

Transmission and LFCR revenues also continued to add incremental growth to our gross margin and combined contributed $0.31 per share.

Looking next at operating expenses. Operations and maintenance expense was up slightly in 2017 compared to 2016 and decreased earnings by $0.03 per share primarily due to higher employee benefit and information technology costs, partially offset by lower Palo Verde operating cost and lower possible generating cost. Higher depreciation and amortization expense was the largest offset for 2017 earnings compared to 2016. The increase was primarily related to plant additions and includes a $61 million annual increase in D&A rates approved in 2016 rate review order. Other taxes were higher in 2017 relative to 2016, reflecting higher property value and the impacts related to the amortization of the property tax deferral as part of the 2017 rate review order.

Lastly, higher interest expense, net of AFUDC, reduced earnings in 2017 compared to 2016. This included higher interest charges due to higher balances, partially offset by higher construction work-in-progress balances contributed to AFUDC. As you know, Arizona's economy continues to be an integral part of our investment thesis. I'll cover some of the trends we are seeing in our local economy. The Metro Phoenix area continues to show job growth among -- above the national average, as seen in the upper panel of Slide 6. Through December, employment in Metro Phoenix increased 4% compared to 1.3% for the entire U.S. This above-average job growth is broad-based and driven largely by tourism, health care, manufacturing, finance and construction. The Metro Phoenix unemployment rate at 3.7% also reflects the strength of the job market. Arizona's political and community leaders continue supporting economic development.

Recently, Nikola Motor Company announced it would move its headquarters and build a new $1 billion manufacturing plant West of Phoenix. This movement is expected to bring 2,000 jobs to the Metro area with construction set to begin this year. This is one example of the ongoing business expansion and related job growth in the Phoenix market. Metro Phoenix also had growth in the residential and real estate market. As you can see on the lower panel of Slide 6, housing construction is expected to continue the upward post-recession trend. Permits for new single-family homes in 2017 were the highest level since 2007. The activity in the market is providing meaningful support to home prices, which have returned to the 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 economy, more generally, to continue to expand at this pace over the next couple of years.

Reflecting this steady improvement in economic conditions, APS' retail customer base grew 1.8% in 2017, which is also the highest growth rate since 2007. 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 the economic development in Arizona appear to be in place. Switching topics to our financing activities, on November 30, Pinnacle West issued $300 million of 3-year, 2.25% senior unsecured notes. The net proceeds were used to repay Pinnacle West $125 million term loans and for general corporate purposes. In 2018, we expect to issue up to $600 million of long-term debt at APS. Overall, liquidity remains strong. At the end of the fourth quarter, Pinnacle West had $95 million in short-term debt outstanding, and APS had no short-term borrowings outstanding.

A quick note on pension. The funded status of our pension remains healthy at 95% as of year-end 2017. This is largely due to the continued success of our liability-driven investment strategy.

Turning to our earning guidance and financial outlook. As shown on Slide 7, we expect Pinnacle West consolidated earnings for 2018 will now be in the range of $4.35 per share to $4.55 per share, up $0.10 from $4.25 to $4.45 per share. This increase in guidance is supported by continuation of our cost management and favorable cost trends coupled with a solid gross margin forecast. Our earnings outlook also incorporates the financial impacts from tax reform, including the tax expense adjustor mechanism, which was approved in last year's rate review in the lower effective tax rate.

This rate increase, our adjustor mechanism and sales growth remain important gross margin drivers, which we expect will be partially offset by higher fossil plant outage costs and higher other operating expense related to more plant in-service, including higher D&A and property taxes.

As a reminder, we have higher fossil plant outage costs in the first half of 2018, including the 9 and 5-day SCR installation of Four Corners Unit 4 and planned outages at our gas plants such as Redhawk. As updated -- an updated list of the key factors and assumptions underlying our revised 2018 outlook is included in the appendix to our slides. Also included in today's materials, you will see that we have extended our capital expenditures in our rate base forecast through 2020. We increased our capital expenditures forecast for 2019 to $1.15 billion, and we anticipate APS' spend to be around $1.2 billion in 2020. With this capital spending level, we expect our rate base to continue to grow at an average annual rate of 6% to 7%, although annual individual years may vary.

Before closing, I'll take a few minutes to walk through the impacts of the tax reform. Though the various effects our mix, on balance, we view the impacts of the Tax Cuts and Jobs Act as favorable. Most notably, the preservation of interest and property tax deductions for the regulated utility. The reform package will also relieve some rate pressures. The corporate tax rate reduction to 21%, beginning in 2018, results in $1.1 billion of excess deferred tax and regulatory liability of $1.5 billion after the required revenue grows up for APS. Under the new tax provision, a majority of these excess deferred taxes are subject to IRS normalization provisions.

During 2018, we will be working with our federal and state regulators to determine the period over which to return these excess deferred tax to customers. We do not expect material earnings impact from the tax reform package, especially given PNW's minimal parent-level debt. From a rate base perspective, our preliminary estimates show incremental rate base increasing approximately $150 million per year in 2018 and 2019 as a result of both the lower tax rate and the legislative changes related to tax depreciation.

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 Greg Gordon with Evercore.

So looking at the drivers for the financial outlook for 2018, it appears that the only meaningful change in the near term is that AFUDC is higher by -- and that explains the -- all thing equal, the move up in the range. Is that correct? And if so, can you just give us a brief explanation as to why?

Yes, so that's one driver and it's really driven by the fact that we expect more construction work in progress in 2018 over 2017. But I think what's also being masked is that electric gross margins were -- the big downward estimate was due to tax reform, but also, we show higher retail revenue in there as well. We finished the year at 1.9% customer growth, 1.8% for the year. So we're seeing continued improvement in that economy. And although we did not change the O&M range, we expect to have a lower O&M in 2018.

Okay. So within the ranges for electric gross margin and O&M, even though you didn't change them, all things equal seen, you're sort of better inside those ranges than you were before?

That's right, we'd see continuation of effective cost controls.

And that gross margin improvement, that's due to the changes in the rate design that are allowing you to -- you have historically given us sort of a spread between what you would expect to be gross revenue or gross customer growth and sort of net revenue growth? If I'm understanding right, the given rate design, you've seen some improvement in that?

I think it's due to higher sales. We expect 1.5 -- 1% to 1.5% in 2018, and we are seeing higher realized prices in the last half of '17.

Okay. And then there's been some debate amongst investors on how to think about, structurally, how your earnings power grows through time, especially when it gets to sort of 2020, now you've given us rate base numbers, which help. But I just -- to be clear, when you give your guidance, we should assume that you're still targeting a return on parent equity of 9.5% or better. And that should be consistent through 2020, and that we shouldn't be sort of obsessing about the equity layer in the utility business or the rate base number, the notional equity value, but more models here get your capital structure and model to whether or not we believe that given these drivers, you can earn 9.5% or better on parent equity.

Correct. Gregg, nothing has changed in our investment pieces.

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

So a couple of quick questions. First, on the CapEx update, obviously, constructive here. Can you elaborate a little bit on what the precise revenue pieces are? I know good monetization has been something that has garnered some amount of attention. How fully baked are the numbers that you're presenting here relative to the potential in the medium-term here? As well as any potential incremental solar opportunity that may have emerged out of the RFP, et cetera, just whether in the future, whether you acquire them or otherwise? Just want to be clear about that.

So the big driver is really on the distribution side, and that's really driven by modernization of the grid, reliability, and then, really growth. We have 21 substations, new substations planned over the next 3 years. So that's a sign of the -- comparing for future growth as well. So those are the big drivers.

Got it, but it's relatively fully reflected in the numbers as it stands?

Yes, we continue to talk to customers, like the city of Phoenix with a microgrid at the airport, things of that nature. But none of that is in here because we do not have specific projects. So incrementally, maybe a little upside, but I think it reflects our best thinking as of now.

Great, excellent. And then just turning back to the earned ROEs. Looking beyond 2018 here, obviously you're doing well thus far. Can you comment a little bit on 2019 onwards earned ROE expectations? Should we expect further pressure as you kind of wean away from the latest rate case? Or how do you think about that given the latest efforts for cost management that you've already taken?

I think the last question, Don answered the question was, we continue to take -- we'll earn somewhere between 9.5% and 9.9% based on revenue cost controls. We have the Four Corners step increase in 2019. And so nothing's changed in that regard.

Right, but even specifically, '18 and '19, do you think your ability to consistently earn the ROE at the same level is a fair statement at this point?

Yes.

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

Jim, first, coming back to -- you said one of the big drivers for both '18 guidance going up and the fourth quarter coming in stronger than given the original expectations. On the revenue side, things came out better, cost as well. But I just wanted to reconcile that with -- you reported negative 1.8% weather-normalized retail sales numbers for the fourth quarter, even though customer growth as you pointed was strong. So how do we reconcile strong customer growth but negative retail sales but higher-than-expected actual revenues? Can you just link those?

It's just the realized price was based on when customers use their electricity.

Okay, but the usage, shouldn't that be caught in the weather-normalized retail sales growth number?

No. Sales are the number of units sold, the revenue is really the impacted prices realized per unit.

Okay, so time of usage in other words.

Yes, yes.

Okay, okay. And then secondly, on the tax reform front, as you think about your financing plans over this '18 through '20 cycle, call it, any changes at all that tax reform has triggered that would change any of your medium, longer-term financing plans?

Not at this time. I mean, we're an A-. We have a very pristine balance sheet, strong [asset corporate] debt and so we're not looking or planning on equity at this time.

Okay, and the period we are looking at is this '18 through '20 sort of period?

Yes.

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

I only had one question. Slide 11, third bullet point down on the left, FERC guidance on rate reduction for transmission customers expected in '18, would that be prospective? Or would you have -- can they go backwards on that at all?

It would not -- they would not be retrospective, they would be '18 forward.

There are no further questions in the queue. I'd like to hand the call back over to management for closing comments.

Thank you for joining us today. This concludes our call.

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