Nov 7, 2012
Executives
Martin Kropelnicki - President and COO Pete Nelson - President and CEO Dave Healey - Corporate Controller Tom Smegal - Vice President and CFO
Analysts
Michael Roomberg - Ladenburg Thalmann Dave Parker - Robert W. Baird
Operator
Good morning, ladies and gentlemen. Welcome to the California Water Service Group Third Quarter 2012 Earnings Results Conference Call.
Today’s conference is being recorded. I would now like to turn the meeting over to Mr.
Martin Kropelnicki, President and COO. Please go ahead, sir.
Martin Kropelnicki
Thank you, Melissa. Good morning, everyone.
Thank you for joining us for the California Water Service Group third quarter 2012 earnings conference call. With me today is Pete Nelson, Chairman and CEO; and Tom Smegal, Vice President and Chief Financial Officer, and I’m Marty Kropelnicki, President and Chief Operating Officer.
As a reminder, a replay of today’s proceedings will be available from November 7, 2012 through January 6, 2013 at 1888-203-1112. Replay code is 6942093.
Before turning over to Pete for some management updates, we want to take a moment to read our Safe Harbor provisions. In particular, during the course of this conference call, the company may make certain forward-looking statements.
Because these statements deal with future events, they are subject to various risks and uncertainties and actual results could differ materially from the company’s current expectations. Because of this, the company strongly advises all current stockholders, as well as all interested parties to carefully read and understand the company’s disclosures on risk and uncertainties found in our Form 10-K, 10-Q and other reports filed from time to time with the Securities and Exchange Commission.
And with that, Pete I will turn it over to you for the update on the management changes.
Pete Nelson
Okay. Thanks Marty.
Good morning everyone, and welcome to the call. As you’ve heard from Marty and his introduction, we have a lot of new titles here and a new person at the table, so I’ll walk you all through that.
Then I’ll pass the baton over to Tom for financials and he’ll give it back to me for quick rate update and I’ll comment on the third quarter earnings as a result. So first our management changes.
My job changed October 1st this year, prior to then I was Chairman, President and Chief Executive Officer, and I moved October 1st to Chairman and CEO. What this means is I’ll weigh more of my time towards Board and governance issues and at the same time remain CEO of the company.
Also October 1st as you saw, Marty was promoted to President and Chief Operating Officer and Tom Smegal appointed Vice President, Chief Financial Officer and Treasurer replacing Marty in that job. For those who have not met Tom yet, you’re going to enjoy working with him, I know a great guy and very expert in the field and I think you will really enjoy working with him.
I’ll talk a little bit about Tom’s background. He does have two degrees, bachelor degrees from Stanford, one in Civil Engineering and one in History and spent two years in graduate studies at the UC Berkeley Energy and Resources Group, and then he joined the utility industry where he worked for 22 years, lots of work experience at rate making the utility finance.
He actually worked at the California Public Utilities Commission for about seven or eight years focused on water company revenue requirements and we recruited Tom from the Commission about 15 years ago. He’s held several positions here.
Most recently he was Vice President of Regulatory Management and Corporate Relations. In that job, he was responsible for all the rate making functions in all four states, government relations, community relations and communications.
So strong background, looking forward to him being CFO here. I haven’t mentioned Dave Healey before.
Most of you have met Dave but I’ll talk a little bit about Dave too because he is another more recent appointment. In April, Dave Healey became our Corporate Controller.
Dave has also an excellent background on B.S. in Accounting from the University of San Francisco, a CPA in California and a certified management accountant.
Dave has eight years of experience in public accounting as a controller and two years of public accounting experience as a treasurer, 15 years of utility experience overall. Dave is very strong in utility accounting, accounting systems, process management, internal controls and SEC reporting and he joined Cal Water about three years ago as a Director of Financial Reporting.
So those are the changes that took place October 1st as you might suspect the Board of Directors spends a good amount of time on leadership development and organizational planning and these changes I just mentioned are all inline with the Boards process. I’m very pleased with the changes in the finance and operating executive team.
Marty, Tom and Dave all excellent, all experienced not just in finance but in rate making as well where they are experts I would say. Strong team across the board and I’m really happy with the changes.
We are in the search mode for the VP of Rates position and expect to had that filled before the end of the year. So that’s the changes and now I’ll go to Tom now for the financials.
Tom Smegal
Thanks Pete, I’m going to go through the income statement and starting with operating revenue which was $178.1 million for the quarter, that’s up 5.2% or $8.9 million included in this sales to new customers added $0.3 million rate increases added a $4.3 million production offsets added $4.1 million and usage added $0.2 million. Our production cost for the quarter was $66.5 million, that’s up 7.9% or $4.9 million.
Our purchased water was also up 7.9% or $3.8 million to $51.4 million. Purchased power up 5.3% to 0.6, sorry up $0.6 million to $11.5 million.
Pump taxes were up 17.8% or $0.5 million to $3.6 million. Our production mix was 133,000 acre feet for the quarter compared to 130,000 acre feet in the prior year.
There is no significant change in the mix of purchased and pump water. Our A&G costs were $23.9 million for the quarter up 10.5% or $2.3 million, that’s higher labor and benefit expense and remember in California our pension costs are covered by a balancing account and therefore do not affect our net income.
Our other operations expense was $17.7 million for the quarter up 0.9% or $0.2 million. Now included in this was conservation expense and increased expense related to water treatment and water quality and again for conservation expense in California that is covered by a balancing account and does not affect net income.
Our maintenance cost for the quarter was $4.4 million, a decrease of 5.9% or $0.3 million. Our depreciation cost for the quarter was $13.7 million, that’s an increase of 7.8% or $1 million and that is the effect of prior year planned additions on depreciation.
Our income tax expense for the quarter was $10.8 million, that’s a decrease of 26.1% or $3.8 million. Effective January 1 of this year the company must comply with new Federal tax regulations relating to repairs and maintenance of tangible property.
This requires the company to deduct a significant amount of cost previously capitalized for book and tax purposes. We completed our analysis of these amounts for 2011 in prior year’s in the third quarter and therefore making these changes now the company’s Federal deduction for repairs and maintenance for that period of 2011 in prior years was $86.7 million and is recorded as $30.4 million deferred tax liability.
Federal taxes are normalized in the rate making process in the states in which we operate. The company’s state tax deduction for the same year 2011 and prior years was $122.2 million and was recorded as a $7 million reduction to state income tax expense during the third quarter and state income taxes are a flow through item for rate making.
These changes eliminate the qualified production activity deduction for 2010 and 2011 requiring us to book a $0.8 million federal tax expense during the third quarter. So the net effect of the changes on the state tax side and the federal Q pad side is a non-recurring gain of $6.2 million or about $0.15 a share for recorded in the third quarter.
On other income and expenses we show a gain of $0.6 million and the third quarter last year we had a loss of $1.8 million and the difference there is due to an unrealized gain on our benefit plan insurance investments during 2012 the company has reallocated its insurance plan investment to reduce the volatility in this line item and the mark-to-market adjustments and so lets go to net income. For the quarter $29.8 million that’s up 42.2% or $8.9 million from the third quarter ‘11 value of $20.9 million and excluding the tax adjustment we had $23.6 million for the quarter or 12.6% increase from the prior year.
Earnings per share were $0.71 on a fully diluted basis that’s up 41.8% from $0.50 in the third quarter of 2011 and excluding that tax adjustment we are looking at $0.56 for the quarter or 11.9% increase from the prior year and I should mention before I turn it back to Pete that our Form 10-K is scheduled to filed later this morning and there is more detail on there of course. Pete?
Pete Nelson
Okay. Thanks Tom.
I will do a quick comment on the earnings for the quarter. Our third quarter was a good one as we expected revenue was up 5% and earnings were up 12% absent to tax adjustments.
So happy with the quarter and we’re holding the line on expenses across the Board and I think Marty is going to probably mention that when I turn it back to him. Turning to rates and rate making I’ve got two or three items there.
The largest one is our 2012 General Rate Case which I would say is on schedule. Just as a reminder for those who are not familiar with the process.
We must file a General Rate Case every three years. We filed one in 2012 which we call our 2012 General Rate Case.
We are requesting $93 million in new rates effective January 2014 and then another $17 million in each of the years 2015 and 2016 which are our attrition years. We’re in the part of the process now where the commission staff evaluates our application.
They’re asking questions, touring our facilities. We’re holding workshops around the state with customers to talk about the rate case and to-date we responded to 135 data request from the commission and held 13 workshops with customers.
We’re about mid-way through that process now. The next milestone is February next year where we will get the commission staff report and this is based on their position on our application.
And we will go from there the process will continue and we expected a decision from the commission by yearend for effective January 2014 rates. Another comment on the General Rate Case and the de-coupling mechanism which we also call the revenue adjustment mechanism and the modified cost balancing account is de-coupled sales from revenue.
Some of you may have heard some rumblings and I’ll call them misinformed rumblings that the mechanism as put in place is not working as it was planned because we’ve developed this large receivable over the last two years mainly due to customers not using the water anybody thought they would in fact using a lot less water than anyone thought they would. But in fact the mechanism is working exactly as it was planned and the problem that’s led to the large receivable is a sales forecast that the commission adopted in that last rate case and from which rates are set.
In a perfect world the sales forecast would match actual sales and there would be no receivable or payable from customers. But the rate making world is never perfect and so there’s I see two problems with the sales forecast adopted in the last rate case.
One is I mentioned it was obviously way too high, customers use less water, they conserved. And the second problem is their mechanism is inflexible.
We could not change the forecast in between general rate cases even though everyone knew it was way-off and not accurate at all, there is just no mechanism to adjust the sales forecast and adjust rates based on reality at the time. So to help solve that problem in this rate case we’ve asked for the ability to also true up at least to some degree the sales forecast every year and then adjust rates each year either up or down to better match the actual sales of customers.
And to me this makes a lot of sense I think all partners are going to benefit the customer will pay a more accurate rate based on usage and we would not end up with large receivable or payable back to customer’s which really skews the message to customer’s on usage. So I’m looking forward to this rate case and I’m coming up with a solution for that problem on the sales forecast.
A couple other rate issues our 2013 attrition filing for California. We will file that in November.
We’re still running the numbers on the attrition and the two cases, the other two cases that are outstanding for us are both in Hawaii, one is our Pukalani waste water case on Maui that’s a $1.3 million revenue request. We’re in discussions with the commission staff on that and then we did file our Waikoloa rate cases on the big island which is our larger systems.
We’re requesting $6.3 million in new rates, expected decision on that case late next year. So that’s it for rates, and I will turn this back to over to Marty for balancing accounts.
Marty Kropelnicki
Great. Thanks, Pete.
I’m going to give everyone a quick update on the balance sheet and then start talking about a couple of things that we’re focusing on for 2013. First of all net utility plant is up 6.6% or $100 million or $1.4 billion during the nine months ended 9/30 the company had plant expenditures of $99.6 million so just shy of $100 million, primarily financed by the cash flow from operations, which was a positive $99.4 million.
So we feel real good about the company expenditures going into CapEx through the third quarter also feel good with the fact that we’ve been financing that primarily from cash flow from operations. In addition, in October the company filed advice letter projects to be included in rates of $13 million and we anticipate that will be in rates hopefully January 1, 2013 and that brings the total advice letter projects from the 2009 General Rate Case to about $22 million with $51 million remaining to complete over the next year and year and half.
So moving forward getting the advice letter projects put into rates. In addition on the liquidity side during the quarter the company paid down $30 million of debt on the short-term line of credit.
That was all focused on California. That was the Californian line of credit.
That was been used to financing for capital activities for the quarter. The liquidity in terms of the California operation has remained very strong.
For group as well as for the company, we have approximately $340 million availability on our unsecured lines of credit and plenty of liquidity. As Pete mentioned, the RAM, a couple of things to point out on the RAM that I think are relevant that had an effect on liquidity for the quarter.
As you may recall on April, we had the commission’s decision that allowed faster amortization of the RAM receivable and allowed the company to start collecting their net receivable balance from the RAM MCBA. It’s noteworthy that this is the first time since the implement of the RAM that the RAM actually shrunk from Q2 to Q3.
So if you look at the RAM balance at the end of Q2 was $53.7 million, that’s dropped $1.7 million to $52 million, so that’s the effect of getting the receivable at long-term portion starting to turn and get the shorter amortization that the commission approved. That was further held by consumption levels that are up.
We’ve been running at about 92% of our adopted consumption numbers which is about 12% higher from where we were last year. One other note I would make on the liquidity side is last week S&P did their rating of the, of all the electric gas and water utilities that they rate in terms of strongest to weakest Cal Water in North America came out at number 11 and we are one of the only utilities that has a one rating on liquidity.
So again, plenty of liquidity and positioned well going into Q4. So what’s on the horizon for 2013?
As Pete mentioned, it’s the third year of the rate case cycle for us which always makes the leanest year of the rate case cycle for California which is the biggest part of our operations. We’re very focused on continuing our efforts to control spending in discretionary areas specially in legal, outside services, travel et cetera.
We’ve made some good progress on that year-to-date. I had mentioned this in previous calls, this is the second year of a software application we put on call Hyperion, which is our budget software.
In addition for 2013, we put in place a financial planning and analysis team that has been diligently working with our district managers as well as our department heads to better understand their budgets, track cost ex cetera and so we’ve got a lot of really good bandwidth on that. And at the end of the day when you boil down all the inputs and outputs to earnings there was about a $0.02 pick up there from better cost management and I’m very, very happy with the operations.
And that’s really important as we go into 2013, some of the challenges that we’ll face in ‘13, one is basic inflation specially in the medical side. Medical inflation has been running about 12% and we’re starting to see that creep into our numbers which means we’ll have a little bit of regulatory lag as we go into the rate case settlement and ‘14 when we start getting a rate relief.
In addition the water cost of capital adjustment mechanism which is the mechanism used to adjust ROEs based on changes, so that Moody’s AA Utility Bond Index, it looks at the change over 12 month period the marked periods from 10/01 to 9/30 and you take the weighted average of that change, that index was down about 112 basis points and so when that change is over 100 basis points we have to record 50% of it. So we’ve filed with the commission to reduce our ROE by about 56 basis points for 2013, what this means when you work through their weighted average or the CAT structure, it will lower our authorized rate of return from 8.25 to 7.94.
Now this is already on top of the reduction that we had on the cost of capital decision that came out in April of this year. There is about $0.06 loss there for 2013 due to the change in the utility bond index that we have to track and follow.
And just as a reminder everyone that’s a two way account. So as if we get to a point where interest rates start to rise due to same marked period and adjust that when you have adjustments moving up greater than 100 basis points.
So as we go into 2013 budget management it’s going to be key and we’re going to continue doing what we’re doing and diligently wringing out all those costs that we can find on the operating lines. The GRC even though Tom’s title has changed, my title has changed, Pete’s title has changed as everyone knows the general, the general rate cases are all hands effort and both Tom and I will continue to work diligently with the new leap year rates to bring the general rate case to fruition.
And hopefully position us strong going into 2014. So no excuse on the liquidity or the balance sheet we’re going to continue doing what we are doing and hopefully drive that rate case home early some time next year.
And with that Melissa we will open it up for questions and answers, please.
Operator
(Operator Instructions) And we have a question from Michael Roomberg from Ladenburg Thalmann.
Michael Roomberg - Ladenburg Thalmann
Hi, good morning guys.
Pete Nelson
Hi, Michael how are you?
Marty Kropelnicki
Good morning Michael.
Michael Roomberg - Ladenburg Thalmann
I’m well, thank you, thank you. I just wanted to start up with the general rate case perhaps for Pete or Tom.
The, the two request you’ve made for medical cost balancing account and RISCOM 6, the cost associated with RISCOM 6 remediation, can you talk a little bit about how your conversations may have progressed so far on those two issues in particular?
Tom Smegal
This is Tom. I’ll take the first crack at that.
I think we’ve had some data request on those issues but we won’t hear the opinion of commission staff until February. They are pretty pass it on, they don’t like to tell you what they are going to say until they say it.
So I would look for that early next year.
Michael Roomberg - Ladenburg Thalmann
Okay, okay. And then just I guess a modeling type question, what was the exact number of the after tax gain from the mark-to-market in the quarter?
Pete Nelson
It was for the quarter it was about 600,000 but if you go back to last year it was negative $2.9 million, remember Q3 of last year there are lot of issues happening and the VIX index shot up almost to 30 on the last day of the quarter in Q3, that so we had to do the mark-to-market. So we went from a loss of $2.9 million to a gain of $600,000.
Michael Roomberg - Ladenburg Thalmann
Got you. Okay so if I ex that out essentially your non-reg ops were essentially breakeven in the quarter, is that right way of looking at it?
Pete Nelson
Yeah. I think that’s right.
If you look at net operating income it was up slightly but lot of the gains that we picked up on are fixing things that are down on the other income and expense line.
Michael Roomberg - Ladenburg Thalmann
Got you, got you, okay thank you guys.
Operator
(Operator Instructions) And we do have a question from Dave Parker from Robert W. Baird.
And sir, your line is open.
Dave Parker - Robert W. Baird
I’m sorry. Good morning, everyone.
Pete Nelson
Hello Dave.
Marty Kropelnicki
Morning, Dave.
Dave Parker - Robert W. Baird
Yeah. A question for you and thanks for the color year-to-date and well aware 2013 will be a tough year with the third year the rate case cycle.
Just so we can plan as we do our earnings forecast, can you give us a view on directionally the under recovered balances from the RAM are declining and I assume that helps us in a year-over-year basis maybe pick up a little, a few pennies here or there. I don’t recall what the mark-to-market in the first and second quarter were as far as a positive or negative for us for earnings and I assume what’s the rebalancing of the portfolio that may be less of a mover going forward.
I mean those items, is it, can you help us with that a little bit as we look at what 2013 may be or may not be?
Tom Smegal
Sure. As we mentioned, we tried to rebalance that the insurance plan investments for the SERP and so for the first quarter that was positive $1.7 million, the second quarter it was negative $0.1 million.
So, we’re trying to reduce the volatility in that account compared to some big swings that we had in 2011.
Marty Kropelnicki
Yeah. One thing to note, Dave, when you look at the SERP last year and what happened in Q3, that losing that $2.9 million in unrealized loss that basically eroded any gains we had from earnings from operation.
It was offset by the loss, the unrealized loss on the SERP. So that’s why the swing is important right now.
The goal on the SERP by the way is not to be aggressive in the market again those basically are used to fund our non-qualified retirement plans and so as we rebalance and so we are very focused on data reduction removing the volatility which would ultimately help stabilize their names as you may recall the last couple of years we’ve got a lot of volatility associated with the, with the mark-to-market in these plans. In terms of the WRAM remember the WRAM is all cash flow the WRAMs booked on a monthly basis.
So as we’re accelerating picking up more cash which is what was on the quarter it doesn’t effect earnings because that booked every month the WRAM and MCBA. So that’s been booked as cost change within the quarter.
So the only thing that’s really going to effect is cash flow that’s always nice about seeing the cash flow start to pickup which enabled us to pay down our short-term debt and fund almost 100% of the CapEx program year-to-date.
Dave Healey
And Dave let me add one thing on that issue is that this is the first quarter where we’re starting to fully recover on the amortizations that are under the new amortization policy the commission and so we’ve seen that faster amortization as well as the higher sales bringing us a closer to that turning point we really hope that we’re getting to that turning point where that WRAM balance starts to decrease.
Marty Kropelnicki
Yeah I think and when you look at ‘13 where the potential changes will be in earnings is if that receivables stabilizes and doesn’t grow which is what’s happening now, it’s actually shrinking a little bit it reduces our financing cost. And financing cost associated with the WRAM the commission gives us basically the money market rate, 90 day commercial money market rate, our commercial paper rate.
But there is a long-term component of that, it’s a long-term receivable that’s been financed with the long-term bond at 5.5%. So getting that receivable stabilized and shrinking is actually a good thing because it reduces our financing cost in the long run.
Dave Parker - Robert W. Baird
Right. And year-to-date what do you guess Marty that’s cost us on earnings per share do you think?
Martin Kropelnicki
You got 50 million of it that’s 5.5% so $2.7 million, $2.8 million on annual basis take three portion of that.
Dave Parker - Robert W. Baird
Right. And so well that won’t, obviously won’t be eliminated next year that that could be away we pick up some margin?
Tom Smegal
Yeah. And I think the other thing, Dave, I want to underscore the cost management.
And Michael asked this question, it’s a little complicated when you look at the net operating income on the press release because it’s up $6 million so that contains the tax piece of it. But ultimately when you look at the input output of earnings right, you had $0.56 a share versus $0.50 a share excluding the tax piece of it.
Your cost to capital reduction for the quarter was about $0.02 that was going from the 10.2 to the 9.9 so that’s a negative. When you pick up about a penny on the RAM deferral that’s a positive, and then you have the unrealized gain on the retirement plans which is a positive 5, that’s $0.04.
So we still picked up about $0.02 through better cost management. Part of that is really down in the non-regulated side looking at our contracts that are making money or losing money and restructuring those and a big part of that is above the line making sure that we get every dollar of capital in the capital bucket and tightly manage the expense side of the business.
Dave Parker - Robert W. Baird
Yeah. That’s a big move and this is where you just don’t know what work room do you have as you’re looking at 2013 and as you’re taking you belt this $0.02 times four quarter is $0.08 to $0.10 are realistic where you can look to tighten your belt or is it I know you’re running a pretty lean ship now as it is anyway.
So, what’s then I guess on the other side, you’ve got increasing healthcare expenses and also that obviously comprised of headwinds. So what’s the, what’s you sense, I know I’m asking about what’s 2013 going to look like and you probably not done with your budgets from a budget perspective, but how much discretion do you have there?
Tom Smegal
That’s a good question. Again, I would say there is not a lot of discretion.
I think we’re in the process of calculating the step increases for 2013. And once we know those, those will be filed with the commissions that becomes public data, you’ll be able to see that.
That’s really the big variable we got to plug in first. I think we could – you can accurately predict that healthcare is going go above between 12% and 15% next year and that’s where the offset and cost reductions internally relate taking down the travel, taking down the outside services to try to offset some of that lag that we see in that third year.
So, I think the piece that’s missing Dave and I think to watch for us is when we file our application with the commission for the step increases because that will give us the inflationary increase that we’ll get in 2013.
Dave Parker - Robert W. Baird
Got you. And as a comment from an investor perspective, I appreciate the mechanism to adjust ROEs up and down with the market.
But the one thing that seems to be missing is when you guys are far cry from earning your authorized ROE that take $0.06 out of earnings. That seems a little crazy given the other headwinds you’ve got.
So, I don’t know if that’s something that get fixed for the next rate case or not, but that’s a little painful I think.
Pete Nelson
Hopefully, the commission is listening to this call.
Dave Parker - Robert W. Baird
Yeah. Please.
Yeah. Give me a call if you have a question, thank you.
Thanks very much. I appreciate it.
Pete Nelson
Thanks Dave.
Marty Kropelnicki
Thanks, Dave.
Operator
(Operator Instructions) And no one else is queued up for any questions at this time. I’ll turn it back over to our speakers for any additional or closing remarks.
Marty Kropelnicki
Great. Thanks Melissa, this is Marty everyone.
Thanks for listening in today, as I mentioned watch for the step increase filing we’ll probably have that on file probably in the next 30 days or so that will show what the inflationary increases are that we will get in California for 2013. And as a reminder our Form 10-Q is scheduled to be filed later on this morning sometime before lunch Pacific Coast time.
So thank you for listening. If you have any questions, feel free to give us a call and if not we’ll talk to everybody during our year end conference call.
Thank you.
Operator
That does conclude our conference for today. Thank you for your participation.