California Water Service Group Q4 2008 Earnings Call Transcript

| About: California Water (CWT)

California Water Service Group (NYSE:CWT)

Q4 2008 Earnings Call

February 26, 2009 11:00 am ET


Martin Kropelnicki – Vice President, Chief Financial Officer and Treasurer

Pete Nelson – President and Chief Executive Officer


James Lykins – Hilliard Lyons

Tim Winter – Jesup & Lamont

David Parker – Robert W. Baird & Co.

Heike Doerr – Janney Montgomery Scott


Welcome to your year end and fourth quarter 2008 earnings results conference call. (Operator Instructions) I would now like to introduce your host for today’s conference call, Mr. Marty Kropelnicki. You may begin, sir.

Martin Kropelnicki

Welcome to our year end and fourth quarter earnings conference call for California Water Service Group. With me today is Pete Nelson, President and CEO of the company. I’d like to remind everyone that a replay of today's call is available starting at the end of the day and available until approximately April 27th and the replay is at 888-266-2081 ID 1322231.

Before looking at the results for the year end and the quarter, I’d like to take a brief moment to talk about forward-looking statements. 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.

Now let’s take a look at our year end results. I’ll be starting off for the full year and then we’ll talk about the quarter. For the 12-month period ended December 31st, revenue was $410.3 million up $43.2 million or 12% from $367 million in 2007. The change in revenue is attributable to a couple of main things.

First and foremost, the company had a $42 million of rate relief. We had $4 million in sales to new customers and the net affect of the RAM and the MCBA so the water rate adjustment mechanism and the modified cost balancing account was a positive $2 million that equals $48 million. That $48 million was partially offset by sales to existing customers, which declined $2.2 million and approximately $2.6 million in other declines that we saw. So the net affect is the $43.2 million.

Water production costs for the year were as follows, purchased water for the year was up 4.7% or $4.9 million to $112 million. Purchased power was up 8.2% or $2 million to $26 million, and pump taxes were up 9% or $739,000 to $8.9 million. Maintenance for the year was $19 million up $600,000 or 3% from 2007.

Depreciation was $37.4 million up $3.8 million or 11% over the same period last year, and income taxes were up $6.6 million or 37% over 2007. Property and other taxes increased approximately $1.2 million or 8.5% to $14.8 million, and net operating income was $57.5 million up 30% or $13.3 million for 2007.

In other income and expense, other income expense decreased 111% or $4.6 million primarily due to one, no property sales in the fourth quarter as compared to the fourth quarter of 2007, and that was approximately $0.08 a share. And a $3.8 million mark-to-market adjustment associated with long-term investments held by the company that approximate 11%, so it was a negative $0.11 per share adjustment. Net income for the year was $39.8 million up $8.6 million or 28% over the same period last year.

We’ll now look to the fourth quarter. Fourth quarter revenue was up $14.2 million or 17% to $100.1 million. Included in revenue, the increases were as follows, we had $13.8 million in rate increases, $2.3 million of sales to new customers, and a net RAM MCBA adjustment was $900,000. This is partially offset by $1.6 million in decreased sales to existing customers and $1.2 million in other decreases.

Operating expenses for the fourth quarter was $88.7 million up 17% or $12.8 million over the fourth quarter of the previous year. Purchased water cost increased 7.2% or $1.8 million to $26.4 million, while purchased power increased 32.4% or $1.5 million to $6.2 million. Pump taxes for the fourth quarter went up 25.6% or $366,000 to $1.8 million.

Other production costs, which include pension healthcare, chemicals, filters and customer accounts receivable increased 22% or $5.4 million to $30.6 million. Maintenance expense for the quarter increased 40% or $1.7 million to $6.1 million, while depreciation increased 14% or $1.2 million to $9.6 million.

Taxes other than income increased 18% or $600,000 to $37 million, which includes property taxes, and fourth quarter other net income, was down $2.1 million primarily due to no property sales in the fourth quarter and a mark-to-market adjustment within the fourth quarter of approximately $0.05 a share. Fourth quarter net income was $7.3 million or $0.35 per share.

With that, I will turn it over to Pete Nelson to comment on a regulatory update and then I’ll come back and talk about the balance sheet.

Pete Nelson

I will touch on three areas today. One is, I’ll do a quick rate case review and I think I’ll organize that in past, present and future rate cases. Then I’ll talk about the acquisitions we were able to make last year 2008, and then I’ll just spend a little time on the water supply situation in California because I’m asked about that every day.

So, first rate cases, past rate cases. Last year we had two major rate cases that were passed, one was our 2007 general rate case, which was approved July 1st and that granted us $33 million in new revenue for 8 of our 24 operating districts and $14 million in corporate or headquarters costs, which was reflected in all 24 of our rate making districts beginning in July last year.

The second proceeding was what we call a conservation proceeding and this was also approved July 1st. And this one directed us to implement the decoupling mechanisms or the water revenue adjustment mechanism and the modified cost balancing account that Marty referred to. This case also directed us to implement tiered rates in California.

So the impact of this decision was two-fold, one was to remove the disincentives to us to promote conservation and water efficiency, and secondly, to mitigate the impact of varying sales or customer usage on revenue. We think all of these cases in 2008 last year that were decided were very constructive. They are all consistent with the California Water Action Plan, which we see as good public policy.

So to present rate cases or rate case, there’s one proceeding that’s ongoing, and that’s what’s called the cost of capital proceeding. And what this proceeding does is it sets the allowed return on equity for three of the California water companies, Cal Water, Golden State and California American.

We are currently at a 10.2 return on equity allowed and we requested a 12.57 in this rate case and this case should be setting the return on equity allowed for the years 2009, 2010 and 2011. There was a proposed decision issued in December last year, which is a 45-page document and it recommends a 10.2% return on equity allowed for all three companies, which would be no change for us.

This proposed decision, and I’ll understate the case, we are less than enthusiastic about it. We filed comments in January and our comments ran some 37 pages, which we can get you a copy of if you like and like to read that. But we took issue with several areas in the proposed decisions, including the allowed return on equities, and the risks that are faced by the water utilities, especially when compared to the California energy company’s risks and their allowed returns.

This case is still in process. The commission can either put this proposed decision on the agenda and vote it out, or another commissioner could propose an alternate decision called an alternate proposed decision or an APD. This could be opposed by any one of four commissioners. It could not be opposed by the assigned commissioner, which is Commissioner John Vaughn.

Obviously, the route we prefer is the alternative proposed decision. The commission also added a Phase II to the cost to capital, and this Phase II is looking at the affect of the current state of the economy in the U.S. and does that economic condition right now have any impact on our cost to capital and allowed returns.

And it’s also looking at for the years 2010 and 2011, should there be some mechanism in place to adjust the allowed return on equities the way they do for the energy companies in California. So the entire case is still in process. I definitely will stay tuned there and you should all stay tuned. It’s an important case and we’ll see how it goes.

The future, we have one rate case we’ll be filing this year, a major rate case, which is our 2009 general rate case. The official filing date is July 1st for rates effective January 1, 2011 so this is an 18-month processing. This will be the first time we will have filed the entire company all 24 rate making districts and the headquarters or the corporate costs at one time. Then this transitions us to a three-year rate case cycle, which will begin January 1, 2011, which also is called for in the water action plans.

Second issue is acquisitions. In 2008, most of our activity in acquisitions was in Hawaii on two islands. On Maui, we acquired an 800 customer wastewater system that is called Pukalani, and on the Big Island, principally on the Kona Coast, we made several acquisitions. We acquired what I’ll call the Waikoloa systems, which is both water and wastewater serving Waikoloa Resort and Waikoloa Village. There’s about 2,000 customers there.

We also purchased a Kukio system, which is adjacent to Waikoloa, serves about 250 customers. And then we also purchased an operating contract company called Island Utility Services, which as a number of operating contracts up an down the Kona Coast. Our investment in Hawaii through acquisitions last year was in the neighborhood of about $30 million and this establishes us with these acquisitions with a sizeable footprint in operations on the Big Island.

Also back in California on a much smaller scale, we agreed to purchase two publicly owned systems on the San Francisco peninsula here. Both are adjacent to our operating district that we call Bear Gulch. But this is about 500 customers, pretty routine, pretty small potatoes compared to the Hawaii acquisitions.

The last item is water supply in California and what the potential looks like for possible rationing this year. The short answer is we don’t know yet. The supply situation in California really varies region by region, Northern California, the Valleys, Southern California, the Bay Area. Each region deals with supply pretty much on their own, although there are some restrictions that are new in the last two years for how much water can be moved from north to south. It’s a pretty complicated issue.

From a precipitation standpoint, I’d say we’re much better off today than we were a month ago because it’s been raining pretty steadily the last few weeks. In fact, it’s looking more like a normal weather year from a rainfall point of view. But nonetheless, we’re preparing for the possibility of mandatory rationing any place in the state.

My guess is if it did happen it would occur region by region that would be a local decision, and of course, any rationing scheme we would implement would be approved by the California Public Utilities Commission.

So we’ll just have to wait and see and see how the rainfall looks this late winter and spring. Obviously, it’s good timing to have the decoupling or the water revenue adjustment mechanism and the modified cost balancing account. It’s a good time to have those two mechanisms in place, which really allows us to promote conservation and water efficiency.

So, now we’ll go to the balance sheet and I’ll turn this back to Marty.

Martin Kropelnicki

A couple heights in the balance sheet we want to talk about. First and foremost, company funded CapEx or capital expenditures for the year, which is investments made in property plant equipment that are used in serving customers was approximately $97 million that was up 29.3% or $22 million from our 2007 budget.

Our five-year compound annual growth rate on our CapEx budget is about 12.4%. We ended the year with work in progress balances of $81 million that’s up 84% or $37 million from where we were in 2007. Net utility plant for the year, we ended the year with $1.1 billion in net utility plant that’s up just about $100 million from where we were in 2007. And our five-year compound annual growth rate for net utility plant is approximately 8%.

We ended the year with approximately $40 million outstanding on our line of credit and our cash flow from operations for the year was approximately $93 million positive. So we thought that was a good year from a cash flow perspective for the company.

Looking ahead into 2009, we anticipate our capital spending for the year to be between $100 and $120 million. A couple things that make it difficult to forecast that is just the determining process and when you actually finish a plant getting final signoff. So we have a $20 million range there between $100 and $120 million.

The company’s balance sheet finished the year strong. We’re very happy with the cash flow. We’re very happy with the receivables. We have seen a modest increase in our bad debt expense but our bad debt expense for the year was approximately one-half of 1%, and that’s up slightly from about one-third of 1% the previous year. So we’ve seen a little bit of increase there but we think all things considered equal that’s actually not too bad.

So we figure the balance sheet is in good shape going into 2009 and we are keenly focused on getting that CapEx budget in the ground for 2009.

So with that, operator why don’t we open up for questions, please.

Question-and-Answer Session


(Operator Instructions) Your first question comes from James Lykins – Hilliard Lyons.

James Lykins – Hilliard Lyons

First of all, I was wondering if you could talk about with the increase in expenses, I’m just wondering if the decoupling and the modified cost balancing accounts are working as advertised, first of all?

Martin Kropelnicki

I’ll take that one. I think if you think about our business you can break it down kind of into three lines. You have revenue, you really have cost to goods sold, which would cover your production cost, and then you have your other expense items.

The RAM really is going to take care of your revenue line and the differences in adopted revenue versus your actual sales. The modified cost balancing account is really going to cover the cost on your production line. So then you do have to drop down to where you’re other expenses are.

I think for the year, what I think was interesting in doing my analysis, if you look at where the changes came from in the revenue, that the difference between, when we talked about the increase in revenue at $43.2 million the net RAM MCBA adjustment was $2 million, which was just about equal to the decline in sales to existing customers and that would tell me that we’re tracking about right.

The big increase that you saw in the expense lines and operating expenses really had to do with increased pension costs, healthcare costs, and the change that we saw in the bad debts going from the one-third of a point to a half a point in bad debt expense, as well as increased water production costs.

James Lykins – Hilliard Lyons

Okay. And with some of these costs, I know you stated in you press release, like water mains, reservoirs, pumping, and also the health and welfare. Do you think some of these are more one-time in nature or are we looking at more of a run rate at these levels going forward?

Martin Kropelnicki

I think it depends on what happens. Obviously, medical costs, I think generally speaking, are deflating a little bit fright now across the U.S. So that works to our advantage. Obviously, with the market results, as you’ve seen in some of our non-qualified plants, we’ve had negative mark-to-market adjustments. Those are things that have to get factored actuarially into our plan expenses for next year.

So I think it depends really on what happens. Can the stock market go any lower could that increase our expense to our pension plan? Potentially, but it’s hard to see it going any lower than the current level if you compare it to historical lows and what the falloff has been.

So I think those are the things you really got to watch for our business, so what’s going to happen with healthcare and what’s going to happen with pension expense, and then really what happens with other production costs.

James Lykins – Hilliard Lyons

One last one, you gave a really good detailed explanation of everything that’s going on in California right now, but can you just give us an update on anything happening that we might look for in 2009 on the regulatory front in the other states.

Pete Nelson

Jim, I’ll take that one. The other states are obviously New Mexico, Hawaii and Washington. We do plan to file rate cases in all three of those states in 2009 for all the customers in all those states. Of course, they’re small potatoes compared to California, but we’ll be asking for rate relief all over.

James Lykins – Hilliard Lyons

Can you give us any idea of when and the amounts for any of those right now or is it too premature?

Pete Nelson

It’s too premature. I haven’t put the cases together yet.


Your next question comes from Tim Winter – Jesup & Lamont.

Tim Winter – Jesup & Lamont

I was wondering if you could talk a little bit more about the $0.11 item for the year and the $0.05 for the quarter what that was?

Martin Kropelnicki

That pertains to long-term investments held by the company, which basically are corporate owned life insurance policies that are used to fund part of our Surf program. The other portion we have a non-qualified deferred compensation plan, so the cash surrender values of the life insurance policies go up and down because they’re basically invested in mutual funds and we have to record the gain or loss.

Tim Winter – Jesup & Lamont

I was wondering if you could talk a little bit about what kind of economic impact you’re seeing on residential, commercial, industrial sales, if there is any impact on industrial sales.

Pete Nelson

It’s hard to tell what causes customers to use less water. It could be conservation. It could be weather. It could be the economy. But we’re not seeing a huge drop in usage at all from our customer base. It’s just not happening. I think Marty gave you the numbers on the drop in customer usage for the quarter. It’s just not that significant.


Your next question comes from David Parker – Robert W. Baird & Co.

David Parker – Robert W. Baird & Co.

Maybe, Marty, and I got a question for you too, Pete. But like you went through with the RAM mechanism, can you talk a little bit about the impact for increased cost, particularly that are recovered through balancing accounts like your water acquisition cost.

Martin Kropelnicki

Keep in mind we changed July 1st. We used to have the ICBAs and under the ICBAs incremental cost balancing accounts, the company expensed any change in cost and it flowed through the income statement, and we would then put it into an off balance sheet balancing account that would grow and accrue interest and we would have to file for rate relief from the commission. So it’s essentially off the books.

As of July 1st, with the MCBA those costs are booked on a monthly basis and they actually flow through the income statement. So if you look in the press release on the balance sheet, if you look at current assets under receivables under other, there’s a $2 million receivable that’s been booked there, which is the net affect of the MCBA and the RAM.

And so the differences as we have changes in these production costs that are different than are adopted that these amounts actually get books on the balance sheet and they’re accounted for.

David Parker – Robert W. Baird & Co.

As of July with that change and the way that you, either recognize pluses or minuses to quarterly earnings what’s the change there too, Marty?

Martin Kropelnicki

The change there basically it’s being booked so you’re net affect for the two mechanisms the net would be the $2 million that I referenced, which would be approximately $0.06 a share.

David Parker – Robert W. Baird & Co.

That’s what I was trying to get to because you had a fair amount of increase, which it should have been collected through the mechanisms, is that correct?

Martin Kropelnicki


David Parker – Robert W. Baird & Co.

Then for you, Pete, is there additional color the cost of capital debate, I guess, seems to have dragged on a little bit longer than my expectations. Can you give us any color there, Pete, and is the California current budget crisis playing any impact or role there?

Pete Nelson

No. Dave, I don’t see the California budget crisis having any role here. The commission has done a good job of isolating this issue just for water utilities and it’s still in process. What’s going to happen next, I can’t predict. I think we made a very good case for the problems we have with the proposed decision.

In fact, I think the records very good from the proceedings about the reasons why we think allowed ROE should be higher than they are currently. But it’s in the commissioner’s lap at the moment to either vote out this proposed decision or propose an alternate so we’re waiting to see what happens there.


Your next question comes from Heike Doerr – Janney Montgomery Scott.

Heike Doerr – Janney Montgomery Scott

Pete, first question for you, can you go into a little bit more detail on this mechanism that would adjust the allowed ROE in 2010 and 2011.

Pete Nelson

Well, there’s no mechanism adopted yet. In fact, I haven’t done much homework on the electric and gas industries mechanism, but I’ll speculate, which I hate to do but I will. If there’s a major change in the cost of capital, be it bonds, interest rates or something, the commission is considering bring some kind of a mechanism to adjust allowed ROEs up or down to kind of follow that.

How that’s going to play out, we don’t know yet. But maybe the best model you can look at is what the energy companies have in state here because that’s the only model that the commission has to look at.

Heike Doerr – Janney Montgomery Scott

Part of the water action plan had been implementing an infrastructure mechanism we call it a disc in many states. We haven’t heard any of you really talk about that. Is that something that’s still in the works?

Pete Nelson

Well, we did propose kind of a version of the disc mechanism on our 2007 general rate case. We call it the infrastructure investment mechanism or something, I can’t remember the acronym. We haven’t filed our ’09 rate case yet we’re not exactly sure what we will propose there in this area.

Our rate cases in California do look out three years and looks to capital cost going out for the years in this case 2011, 2012, 20123. So in a sense you’ve got a little bit of a disc mechanism already in the general rate case plan. It’s not high on our priority list, not as high as cost of capital is right now.

Heike Doerr – Janney Montgomery Scott

Marty, if you could humor us with perhaps a little utility pension accounting lesson. I see that the amount that you’re pension and post-retirement benefit liability has gone up you put a similar amount into regulatory assets. How should we be thinking about that as we think of how it flows through the income statement and/or a future cash contribution?

Martin Kropelnicki

First of all, we’ll file our 10-K either Friday or Monday and in the back of the 10-K in the footnotes you can look up actuarial assumptions for any publicly traded company in their 10-K they have to put the assumptions they use for their plan in the funding status of the plan.

So for any of us that have pension plans I always recommend going there and the footnotes kind of confusing but in essence what you’ve got to look at is the year end valuation. You look at the difference in the net asset values within the plan compared to the projected benefit obligation. And to the extent that that Delta is greater than 25%, then you pick up increased amortization costs and the funding for the following year.

So obviously with the stock market results being so bad and most pension plans being invested in the stock market, you’re going to expect to see some increased funding happening in 2009. For us, we anticipate that our funding is going to be about $22 million, which is just about the amount that we have in rates. So despite the market looking bad, the good news is in our ’07 general rate case our actual forecast appeared to be pretty accurate.

Heike Doerr – Janney Montgomery Scott

That wasn’t so scary.

Martin Kropelnicki

It’s not. Again, you read the footnote and it is a little scary. The thing to focus on is really, what’s the difference between the net asset value of the plan versus the projected benefit obligation, and I believe it’s the five-year amortization of that Delta.

Heike Doerr – Janney Montgomery Scott

Just a final housekeeping question, as we look at year-over-year depreciation, you were in the low double digits from 2007 to 2008. Should we be expecting a similar depreciation as CapEx continues in ’09?

Martin Kropelnicki

Yes. But maybe a little bit lower. There are a couple things going on there. As Pete mentioned, we did acquire reduced contracts from IUS and those contracts have a shorter life than a typical utility asset so, therefore, we picking up more amortization expense from those contracts. That’s issue number one.

Issue number two, and you’ll see this on our balance sheet, we now have goodwill associated with one of the acquisitions. As part of the FASB rules, we have to study that goodwill and get an actuarial evaluation from an independent third party evaluation firm. And there could be some allocation of intangibles from the goodwill of that acquisition.

So I think give or take a full point is probably where we’ll end up, but we have to do that valuation study first to see where we come out.


(Operator Instructions) There are no further questions at this time.

Martin Kropelnicki

Just in closing, we want to thank everyone for what was a very good year for Cal Water. We appreciate everyone’s support and their interest in the RAM MCBA that we implemented through the year, and obviously for us all eyes are on 2009.

We are keenly focused on our 2009 general rate case for the entire California Company, and then we’ll be working on the rate case for our subsidiary companies in the other states. So, again, thank you for your support in 2008 and we look forward to working with everyone in 2009. Thank you.


Ladies and gentleman, this does conclude today’s presentation. You may now disconnect.

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