Nov 3, 2008
Executives
Martin Kropelnicki – VP, CFO and Treasurer Pete Nelson – President and CEO
Analysts
James Lykins – Hilliard Lyons Jonathon Breeder – Wachovia Securities Michael Gresens – Robert W. Baird Heike Doerr – Janney Montgomery Scott Tim Winter – Jesup & Lamont
Operator
Good day, ladies and gentlemen, and thank you for standing by. Welcome to the third quarter 2008 earnings results conference.
At this time, our participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time.
(Operator instructions) As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s conference, Mr.
Martin Kropelnicki, Vice President and Chief Financial Officer of California Water Service Group. Sir, you may begin.
Martin Kropelnicki
Thanks, Devon. Good morning everyone and welcome to the third quarter earnings call for California Water Service Group.
With me today is Pete Nelson, President and CEO. As a reminder, a replay of today's discussion will be available from October 31 to December 29 at 888-266-2081, ID 1285532.
Before looking at the results and discussing results for the quarter, we want to take a brief moment to read our normal forward-looking statements Safe Harbor provisions. 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 shareholders, 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, Form 10-Q, and other reports filed from time to time with the Securities and Exchange Commission.
Having said that, let’s go on and look at the income statement. After the income statement, Pete will give an update on what is happening on the regulatory side and I will come back and talk about the balance sheet.
Revenue for the quarter increased $17.8 million or 15.7% from $113.8 million to $131.7 million. Embedded in that change, we had a rate relief of $18 million resulting from the conclusion of the ’07 General Rate Case, revenue from new customers added $1.1 million, the net RAM MCBA adjustment added $1.2 million and then revenue by existing customers decreased approximately $0.5 million and then with the implementation of the RAM, we have a prospective change in that we pull commission fees out prior to the RAM, we used to include that in revenue and expenses, we pulled that out and that amount was about $1.8 million.
The net effect of all these changes was about $17.9 million change. Going down the line on the production cost, operating expenses for the quarter on the water production costs, water production costs increased 3.1% or $1.4 million to $46.4 million.
Of that amount, purchased water increased 3.3% or $1.1 million to $33.8 million primarily driven to cost increases in purchased water. Purchased power was up 1.3% or $122,000 to $9.3 million due to increased pumping and well production and pump taxes increased $203,000 or 6.5% to $3.3 million.
Under admin and general expenses, the admin and general expenses were up 1.8% or $262,000 to $14.9 million. Other operations increased 10% or $1.17 million to $12.9 million.
Other operations, the breakdown in there, you had increases in water quality cost associated with chemicals, filters, conservation and bad debt. Maintenance expense for the quarter was down approximately 9.7% or down $400,000 to $3.8 million.
Depreciation and amortization increased 10.6% or $900,000 to $9.3 million primarily due to the increases in property plant that we implemented last year. Income taxes for the quarter were up 60.3% or $5 million to $13.5 million primarily due to the new rate relief and higher revenue levels that we achieved in the quarter.
Property taxes and other taxes increased 6.3% to $3.9 million. Net operating income for the quarter increased 52.6% or $9.2 million to $26.8 million.
Going down the line, other income and expense decreased about 153% or $1.2 million to a negative $408,000 primarily due a negative mark-to-market adjustment associated with our non-qualified retirement plans and interest expense was down slightly primarily due to last year we had more cash in the bank at higher interest rates and we also had more capitalized interest this year. Net income for the quarter increased 61% or $8.3 million to $22.1 million and fully diluted earnings per share were $1.06 per share for the quarter compared to $0.67 the previous year.
With that, that’s the income statement, Pete I will turn it over to you.
Pete Nelson
Okay. Thanks, Marty, and good morning everyone.
I will cover rate making because that is the issue this quarter for a couple of reasons and Marty mentioned these. First is we had a major rate case implemented July 1, which is the first day of the quarter, and also to a lesser degree on July 1, we changed the way we recognized revenue and production costs essentially decoupling sales from revenue.
So, we will talk about two proceedings that are in place now and their impacts on our results and then the third proceeding called the cost of capital that is ongoing and we expect to have that wrapped up by the end of this year. All three cases are really part of implementing a good public policy document for water utilities in California.
It has been in place almost three years and those of you who have been following us know that the California Water action plan which speaks to streamlining the regulatory process and strengthening conservation programs among other things and you will see those themes kind of woven through here. So, to the first proceeding, the 2007 General Rate Case, this one covered eight of our 24 rate making districts and headquarters or corporate costs.
This decision, as you saw, added $47 million of annual revenue to the company starting July 1. Now that $47 million breaks down to two pieces, first is the $33 million which reflects in those eight General Rate Case districts and it also reflects those eight allocations of headquarters or corporate costs.
But then the second piece is probably more significant because it is a change and that is $14 million which will be reflected in rates of the other 16 districts for the headquarters or corporate costs allocation. This is a change which allows the corporate or headquarters’ cost for example healthcare, pensions, benefit costs things like that to be reflected in all 24 rate making districts without delay, which to me and I think when you think about it seems only fair because it makes sense because there is agreement that these corporate costs, these headquarters costs are reasonable and prudently incurred and as such they should be reflected in rates without any delay.
I will call the 2007 General Rate Case, to put it in perspective, our transition rate case because we are going from the past, which was our 2006, 2005, 2004 General Rate Cases from an old method where we would file 8 of our 24 districts each year, each on a three-year cycle for general rates and then we file our corporate or headquarters rate case every three years. But that rate case for corporate or headquarters cost will be phased in reflected in rates only as subsequent districts came into their general rate cases.
What this created is a lag in rates reflecting corporate costs and when you do the math that could be up to seven years to have corporate cost increases fully reflected in rates throughout the system. So that is the past.
The present I will say is the 2007 General Rate Case 8 of 24 districts plus headquarters cost reflected in all 24, and we are transitioning to the future which is our 2009 General Rate Case, this is going to be one Rate Case for the entire company and we are preparing that now. The dates on the 2009 General Rate Case are the proposed application will be filed May 1, 2009, the official filings July 1, 2009 and if all stays unscheduled new rates would be in effect January 1, 2011 for the entire state plus all the headquarters costs.
So, just in summary 2009 that rate case for us completes the Water Action Plan’s objective to streamline the General Rate Case process. The second proceeding I mentioned is the conservation proceeding and this is important because it changed the way revenue is reported as Marty mentioned.
We have now decoupled sales from revenue and this is also effective July 1, so it covers the entire third quarter. There are three significant changes that come out of the conservation proceeding for us and the first is the water revenue adjusted mechanism acronym of RAM.
This mechanism as you probably know decouples sales from revenue. For the third quarter, revenue was less than that adopted in rate cases so the RAM effect was $3.5 million of under collected revenue and I emphasize under collected.
The second mechanism is called the modified cost balancing account which is really a companion to the RAM for water production. This essentially balances out the differences of water production costs that we actually incurred from the production costs adopted in rate cases.
Now for the third quarter the water production was lower than that in adopted rate cases to the tune of $2.3 million. I will call that over collected expense that goes up to the rate payer.
Now to get the net effect you have got to consider both mechanisms, so you have got the RAM $3.5 million under collected and then the modified cost balancing account $2.3 million over collected. So the net is $1.2 million in an under collected position and that is how you get the $1.2 million added to revenue for the quarter as a result of the decoupling mechanisms.
So, I think you can see that by far the change in the financial results in the quarter is due to the 2007 General Rate Case and not so much the decoupling mechanisms. Another important outcome of the conservation proceeding was the installed tiered rates or conservation rates or increasing block rates throughout the state during the quarter.
These three rate mechanisms, the RAM, the modified cost balancing account, and the tiered rates all are designed to remove the disincentives for water utilities in the state to promote conservation and to encourage customers to be efficient with their water use. So, now July 1 this year, we are in a good position to really gear up our conservation water efficiency programs which we see as good public policy and we are in the middle of doing that right now.
It also looks to be good timing because we are in the middle of a dry year here in California. The third proceeding I mentioned is the cost to capital where the authorized return on equity is set for us.
If this proceeding stays unscheduled because it is in process right now, we should have a decision late in the fourth quarter for implementation in July 1, 2009, call our current adopted return on equity is 10.2%, in this proceeding we asked for 12.57% the staff position from the partner Ratepayer Advocates is recommending 9.0%. So, where the final decision ends up is really anybody’s guess.
That’s the rate making part. We did mention in the press release our acquisition of West Hawaii Utilities, so I’ll mention that.
This is water and wastewater systems on the Big Island serving Waikoloa Resort and Waikoloa Village. It’s a good fit with our earlier acquisition earlier this year of the Island Utility Services which was a contract operator with contracts on the Kohala Coast of the Big Island and for us the Waikoloa’s systems looks like our anchored tenant on the Big Island and we expect to establish our office and headquarters in the Waikoloa service territory.
So now I think I will turn this back to Marty to go for the balance sheet.
Martin Kropelnicki
Thanks, Pete. Just a couple of highlights from the balance sheet we wanted to share with everyone today consistent with how we have talked about in the past.
Net utility plant was up approximately 12% from $991 million at the end of Q3 last year to $1.1 billion this year, again we continued on the quest to get all of our projects done on schedule and on time. Company-funded CapEx through the capital expenditures through Q3 were approximately $75 million.
Of that amount approximately $70 million was Cal Water, the California Utility and about $5 million came from our affiliates. Work in progress for the quarter ended up 40% higher or $35 million higher to $112 million and so we will try to close that as much of that as we can here in the fourth quarter.
A couple of things on the balance sheet, as Pete talked about our Waikoloa acquisition; we do have approximately $4.6 million of goodwill that you will see on our books associated with the Waikoloa acquisition. Overall we continue to believe that the company is well capitalized and well funded despite the credit prices and everything that we have been seeing and the company has taken a very conservative approach to our money management starting as early as last year when the commercial paper market started having some problems and so we continued to believe that we are well capitalized to weather the storm up to and including the $40 million temporary line increase we got in September from our bank.
So, with that Devon, we will open up for questions from the callers please.
Operator
Thank you. (Operator instructions) Our first question comes from the line of James Lykins of Hilliard Lyons.
James Lykins – Hilliard Lyons
Good morning everyone.
Martin Kropelnicki
Hi Jim, how are you doing?
James Lykins – Hilliard Lyons
Good thanks and congrats on a great quarter. First of all I wonder if you could just with the credit crunch give us a feel for what any impact could be and also because if there have been any or there could be any changes in your dividend policy?
Martin Kropelnicki
The company has had a long history of dividends and increasing that dividend, at this point we don’t foresee any changes. We are very proud of our heritage.
I think the most important thing I could share with you is that we started preparing to be in a defensive huddle with the credit crisis in August of last year, early August when the commercial paper market started to have some problems. So, we feel the company was ahead of the curve in terms of implementing some procedures and changes and processes to be ready for the downturn.
So, at this point, I don’t see anything that frankly is going to affect us. Obviously the longer term issue is one’s ability to go out to the market and to raise capital, whether it is debt or equity.
S&P reaffirmed our A+ rating in September which we think is good and appropriate, A+ stable. Obviously you see the financial results, California Water was very aggressive with the water action plan that was published by the CPUC.
So, we think we are in good shape. It is hard to (inaudible) a crystal ball, who knows what is going to happen.
They came out this morning that there was a contraction in GDP in the third quarter but I think from our standpoint for the things that we can’t control within the company, we think we are well positioned.
James Lykins – Hilliard Lyons
What about on the acquisition side, has the credit crunch maybe given you some additional opportunities to make some acquisitions it might have been possible before?
Martin Kropelnicki
On the acquisition side, we still have our same principles. We would like to buy acquisitions that are accretive.
Certainly, in a down economy sellers’ expectations might come down a little bit that could potentially help us. But as you know Jim, in a regulated entity you can only pay so much and still make money on it and we are watching that.
I will tell you we have not seen a flurry of new deals come through our offices but we are always out there looking.
James Lykins – Hilliard Lyons
Okay. Can you tell us if you are still looking at about $90 million for CapEx for the year, I am also wondering if you can give us the 2009 CapEx estimate yet too?
Martin Kropelnicki
We are currently in our budgeting process now. I don’t have the exact number for ’09 because the engineers have not given it to me yet.
We usually go through a pretty rigorous process of looking at how much we have in rates versus how much we can actually get done. What can I tell you and this is in our cost to capital is from 2008 through 2012 we estimate $577 million.
So I would anticipate next year’s number being between $100 million and $115 million just kind of ball-parking it right now. In terms of what we can accomplish this year, as we have talked about in the past, capital projects can be very lumpy, there is permanent issues, there is getting sign off issues, getting the supply in the steel and the concrete, getting it done and getting it put into production, our Web balance right now at $112 million is very high.
Obviously the team wants to get as much of that into the ground before January 1. Our target, our internal target was $90 million to $100 million.
I think we will hit that we might even slightly exceed that for the year. All the projects that we do we have recovery on.
James Lykins – Hilliard Lyons
Okay. One last question then I will let someone else ask one, can you just tell us what that $40 million of notes payable was that showed up on the balance sheet?
Martin Kropelnicki
$40 million of notes payable, I would have to look that up Jim. Part of what happened here with the RAM and actually this is a good thing to talk about, the RAM itself, we have to do the RAM accounting at the district level so for every district we have a RAM and we have a modified cost balancing account, we have to close it out.
So, our close we lost about five days this quarter so we are moving relatively fast on that. I will look that up and I will get back to you on that.
James Lykins – Hilliard Lyons
Okay. Thanks Marty.
Martin Kropelnicki
Okay. Thanks Jim.
Operator
Thank you. Our next question comes from Jonathon Breeder of Wachovia Securities.
Jonathon Breeder – Wachovia Securities
Good morning, great quarter, it kind of caught me a little off-guard wasn’t expecting it to be that good but clearly the GRC is having its impacts. One question I have is other than the step increases you have coming from the 2006 and 2007 GRCs, is there going to be any other California Rate Release prior to that consolidated filing becoming effective in 2011?
Pete Nelson
Jonathan, this is Pete. We do have attrition rates coming into effect July ’09 and then again July 2010.
First of the year, sometimes our wholesale providers change their cost but that is rolled into the modified cost balance sheet accounts, you would not see that necessarily in revenue. But that’s it, from here on to the General Rate Case in 2011 raise is sufficient for the General Rate Case it has already been decided.
Jonathon Breeder – Wachovia Securities
You had mentioned before that there is the potential for I think it was like one of the general office filing that is just a stand-alone in 2009 that is not going to happen.
Pete Nelson
No, now we are going to file the entire system, 24 districts plus General Office July 1 next year.
Jonathon Breeder – Wachovia Securities
Right. The 10.2% ROE, do you guys pretty much have that in place in all of your districts (inaudible) some idea like 10.16%?
Pete Nelson
For a very, very few number of customers it is a little lower than that, I would say overall definitely it is 10.2%.
Jonathon Breeder – Wachovia Securities
Okay and now did I mishear you Pete, did you say that the cost of capital, the new ROE was going to go into effect July 1 not January 1?
Pete Nelson
Cost of Capital is January, if it is still on schedule, January 1, 2009 will be the new return on equity adopted numbers.
Jonathon Breeder – Wachovia Securities
Okay. Now, can you talk a little bit about maybe Q4 last year, you guys reported $0.39, what was like the weather impact conservation during that period?
Martin Kropelnicki
If you pull the press release from Q4, we break out where the changes in revenue come from, we don’t have it here in front of us. What is going to be difficult comparing last year to this year is you have premium mechanisms in place and we have that perspective change we broke out the PUCPs and we are accounting for those differently and we will do that again on the Q4 call.
Conservation last year we were spending some money but it was not as significant as we are spending now.
Jonathon Breeder – Wachovia Securities
Lastly, Marty can you give, I kind of missed it that breakout out you gave of the other revenues, the $1.2 million, I understand the majority is the RAM and the MCBA but –
Martin Kropelnicki
Yes, actually you are talking about the third item I gave which is the – that’s the net RAM MCBA adjustment. So, we under collected on the revenue side.
So, we came in below our adopted number but then with demand being lower, our production cost lower that has to get given back. So, the net amount was $1.2 million.
Jonathon Breeder – Wachovia Securities
I think you said existing customers were down $0.5 million?
Martin Kropelnicki
Right.
Jonathon Breeder – Wachovia Securities
Okay, thank you guys.
Martin Kropelnicki
Thanks Jonathan.
Operator
Thank you. Our next question comes from Michael Gresens from Robert W.
Baird.
Michael Gresens – Robert W. Baird
Good morning and congratulations.
Martin Kropelnicki
Good morning Michael.
Michael Gresens – Robert W. Baird
Wondering about the seasonality of the tiered rates and how that affected not only the third quarter but seasonality of revenue over the rest of the year?
Martin Kropelnicki
Good question. Let’s back up a little bit and talk about methodology, the way we established our RAM.
As you know we have a bell shaped curve and we used three years of our historical data to study that. So, under the RAM the adopted revenues will follow a similar type curve.
So, clearly in Q3, which is our peak demand period, peak demand quarter we had more revenue coming from our tier three than what we have had in the past. In terms of quantifying that frankly the RAM is new to us, we are still working to understand that I don’t think I have an answer for you other than we did have a fairly good size amount of revenue coming from our tier three customers.
So people who bumped into the third tier based on consumption.
Michael Gresens – Robert W. Baird
Okay. Could you remind me what the attrition increases are scheduled for 2009 on the three 2007 GRC cases?
Martin Kropelnicki
Yes, I will have to look those up Jonathan and again I would call your attention to what is in the Q and what would be in the K because we are trying to get disclosure around that.
Michael Gresens – Robert W. Baird
Okay thank you.
Operator
(Operator instructions) Our next question comes from, excuse me if I pronounce this wrong, Heike Doerr of Janney Montgomery Scott.
Heike Doerr – Janney Montgomery Scott
It’s pretty close. Good morning gentlemen, congratulations on a strong quarter.
Martin Kropelnicki
You know Heike, it could be worse if you had Kropelnicki.
Heike Doerr – Janney Montgomery Scott
But that is your last name Marty. I wanted to go back to the line of questioning that Jonathan had started, can you tell us how we should expect to hear from you each quarter what the RAM impact was, will you do it similar to what you did this time around?
Martin Kropelnicki
Can you repeat the question please?
Heike Doerr – Janney Montgomery Scott
Will you tell us each quarter what the net effect was and what part of that was on the revenue side and what part of that came in on the modified cost balancing account side?
Martin Kropelnicki
Potentially – I mean, part of it again is it is new for us and we are working through with our public accountants Deloitte in terms of what our appropriate disclosures need to be. Obviously we have, as a water company, I think we are one of the first in the nation or in the country to have a RAM MCBA but we are looking at what the electric and gas have done in their disclosures to try to manage it.
From our perspective, from a management perspective, we want to give as much transparency as possible to the analysts and the people on the streets so they understand it.
Heike Doerr – Janney Montgomery Scott
Okay, that’s helpful, we appreciate it. This decrease of about $0.5 million of revenue from existing customers, does that translate into you not really seeing much of a conservation impact in this quarter?
Martin Kropelnicki
You know Heike it is hard to tell what usage is reflected by conservation or weather. It is impossible to tell.
All we know is customers use less water than they did last year.
Heike Doerr – Janney Montgomery Scott
But $0.5 million is not really much of a difference, right, in the grand scheme of things?
Martin Kropelnicki
It’s not. So, obviously in general, we don’t see a huge move to people conserving water but I expect that to change as we get our programs in place and geared up and if the state goes through another dry winter I expect real focus on conservation.
Heike Doerr – Janney Montgomery Scott
Okay. Marty, could we have a little bit more detail, perhaps I am not familiar with this, the commission fees, what is that, can you refresh our memories?
Martin Kropelnicki
Sure, we collect fees on behalf of the commission to fund the Public Utilities Commission and so it is really not revenue and it is kind of a mixed bag, about half the utilities do it one way and about half do it the other way. In the past it has been in revenue and it has been in expense.
So, net at zero to the company what we did with the RAM because we have all these new components in revenue, we completely pulled that out. So, it is not in revenue, it is not in expense, we just collect that money and we give it to the commission.
Heike Doerr – Janney Montgomery Scott
Okay and as a final question, do you anticipate any pension funding needs that may have changed in the last couple of months given the market swings?
Martin Kropelnicki
How did you know I liked the story (inaudible), yes the board asked the same question yesterday, our pension expense for this year is nailed, it is done. The way it works from an actuarial perspective is at the end of the year, you do evaluation and you look at your PBO, your projected benefit obligation and you compare that to the net value of the all the assets held in the plan, to the extent there is a 10% differential between the two, and I think for this year for most companies including Cal Water that will be the case, then that delta, that amount of under funding will get amortized in over the next 15 years and at the end of every year you do this valuation study part of FAS 87 and part of FAS 106.
So, I think that will be a common theme going into next year I will tell you as part of the ’07 General Rate Case we did recover all our pension costs. So, I think that certainly has to be watched as to be determined.
Getting back to the point I made earlier when Jim asked the question, Cal Water, we were keenly watching that commercial paper market and what was happening, our contribution to the pension plan last year we put in the money market it was not fully invested and the contributions we made this year we left in the money market. So, while our plan is down, we are not down as far as the Dow and the S&P are.
We are only down about 20%, I think the market has been down about 30%, 33%.
Heike Doerr – Janney Montgomery Scott
Great. That’s helpful, thanks for your time.
Martin Kropelnicki
Sure. Just one quick follow-up I had for Jim Lykins who asked the question of $40 million, we have $40 million outstanding on our line of credit right now.
That’s what that is.
Operator
Thank you. (Operator instructions) Our next question comes from Tim Winter of Jesup & Lamont.
Tim Winter – Jesup & Lamont
Congratulations guys, it is nice to see finally flowing to the bottom line. I was wondering if you were able to calculate what the earned ROE was for the trailing 12 months for the California properties and secondly how they are going to apply the cost of capital, the new allowed returns to the existing rate structure?
Martin Kropelnicki
The answer to the first question is no, we have not calculated it yet on the trailing 12, we typically do that calculation at year end since we are on a 12-31 year end basis. In terms of how they will apply it, I think they will be consistent with how they have done it in the past which is we will look at how we performed and any change in ROE will take effect on hopefully January 1 or when it is adopted.
Tim Winter – Jesup & Lamont
So, will they adjust rates with using the starting point, your most recent allowed ROEs or your earned ROEs as the starting point?
Martin Kropelnicki
It would be our allowed, allowed ROEs.
Tim Winter – Jesup & Lamont
Okay and that would probably be effective January 1.
Martin Kropelnicki
That’s the goal that the judges is driving for in the commission but again it is a regulatory process and that is subject to changes based on their schedule, we don’t really control that. All the testimony is in, all the final briefs have been filed, it has been reviewed by the commission now and now we are waiting for a draft decision which is scheduled to come out some time at the end of November.
Tim Winter – Jesup & Lamont
Okay and that draft decision is coming from the commission itself or from ALJ, who is that coming from?
Martin Kropelnicki
It technically comes from the ALJ.
Tim Winter – Jesup & Lamont
Okay, thank you.
Martin Kropelnicki
All right. Thanks Tim.
Operator
Thank you. (Operator instructions) I am showing no further questions at this time, sir.
Martin Kropelnicki
Right, thanks Devon. That’s kind of the update from now.
Obviously we have a bunch of new mechanisms, we will know more and probably about these once we get used to working with them. We are pretty tight with our data this quarter because it is all new.
But we appreciate everyone’s great support. We look forward to talking about these mechanisms at the end of the year, and more importantly, I think we look forward to promoting efficiency within the State of California and pushing the water action plan as far as we can get it.
So, everybody have a great day and thank you. Thanks a lot folks.
Operator
Thank you, ladies and gentlemen. Thank you for your participation in today’s conference.
This concludes the program, you may all disconnect. Thank you and have a nice day.