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California Water Service Group (NYSE:CWT)

Q1 2013 Earnings Call

May 2, 2013 11:00 AM ET

Executives

Thomas Smegal – VP, CFO and Treasurer

Paul Townsley – VP, Regulatory Matters and Corporate Relations

Martin Kropelnicki – President and COO

Analysts

Jonathan Reeder – Wells Fargo

Heike Doerr – Robert W. Baird

Operator

Good morning, ladies and gentlemen. Welcome to the California Water Service Group’s First Quarter 2013 Earnings Results Conference Call. As a reminder, today’s call is being recorded. I would now like to turn the meeting over to Mr. Thomas F. Smegal, Vice President, Chief Financial Officer and Treasurer. Please go ahead sir.

Thomas Smegal

Thank you, Dianna. Welcome everyone to the first quarter 2013 earnings call for California Water Service Group. With me today is Martin Kropelnicki, President and Chief Operating Officer; and Paul Townsley, who is our Vice President of Regulatory Matters and Corporate Relations. Pete Nelson could not be here with us today. He is traveling and he sends his regards to everyone.

A replay of today’s proceedings will be available beginning today May 2, 2013 through June 30, 2013 at 1-888-203-1112 or 719-457-0820 and the replay pass code is 3539432. Before looking at this quarter’s results, we would like to take a few minutes to cover forward-looking statements.

During the course of the 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 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 I will point out at this point that we are intending to file our 10-Q as soon as possible after this call.

Now, let’s look at this quarter’s forward-looking statements. So I have the income statement quarterly results to go through. On the revenue side, as you’ve seen in the press release last night, we recorded a $111.4 million of revenue for the quarter, that’s down 4.5% or $5.3 million. There is two big factors in this. The first is $8.9 million decrease due to in 2012 our recognition of revenue that has been deferred from 2011, due to the timing of recovery for RAM and MCBA balances.

And as you’ll recall that was an issue that got resolved substantially by the Public Utilities Commission in March and April of 2012, and that’s why we get reverse that deferral in early 2012. That is an event that has not occurred again in 2013. The second big factor is that we had a decrease of $3 million in our accrued unbilled water sales that is a lower accrual in 2013 and 2012. The accrued unbilled revenue represents an estimate of the water which has been delivered during the period but is not yet been billed to our customers by the end of the period.

This is a not a component of the RAM mechanism which operates on a cash basis reflecting customer billings. The unbilled revenue is particularly variable in the first and third quarters, depending upon the weather conditions in California and our customer usage in reaction to those weather conditions. And I will say that the unbilled revenue accrual does not have a significant impact on our annual revenue in past year. So this is essentially a timing of when the water sales are billed and used.

Our other activities on revenue in the quarter, rate increases added $2.5 million. The effect of our balancing accounts for pensions and conservation programs added $900,000 to revenue. Those are direct offsets to increased costs for those programs. The RAM and other items added $4.5 million to revenue.

For production cost in the quarter, they were $41.7 million, that’s up 7% or $2.7 million from last year. The primary drivers increased purchase water expenses due to rate changes, and changes in mix in certain of our districts. These costs are booked to the modified cost balancing accounts.

As a percent of the total production, our purchased water remained constant at 52% while the local surface water increased from 3% to 5% and well direction declined from 45% to 43% from the same period last year. Our A&G expenses were $25.3 million for the quarter, that’s up 9.8% or $2.3 million, and Marty will talk a little bit about this later on, but we have higher labor and benefits expense, particularly health care for retirees and for active employees, we’ll talk about that, and uninsured loss expense due to property damage from several large main breaks.

Our other operations costs for the quarter $15.6 million, that’s down 34.3% or $8.2 million. And this is related also to the deferral of revenue and this is the expense related to the deferral of revenue from 2012 – affected the other operations costs in 2012. So it was a higher number in 2012 due to that adding of the deferral from 2011, this is a more normal amount for us in 2013. We do see increased conservation expense driving the amount of other operations expense.

On the maintenance side, our costs were $4.1 million for the quarter, that’s a decrease of 28.3% or $1.7 million, and it shows decreased costs for main and service repairs in the quarter. Our depreciation was up to $14.6 million, an increase of 4.9% or about $600,000 and that is generally related to prior year additions of plants that are now being depreciated.

Our income taxes showed a $700,000 benefit for the quarter, and this is a difference of $1.6 million from the prior year and related to obviously our decrease in pre-tax income. Net other income for the quarter was $700,000, income net of expenses. In the same period last year we had a gain of $1.2 million. The change is primarily due to a lower unrealized gain on our benefit plan insurance investments.

So our net income, we had a loss of $1.1 million for the quarter compared to gain of $1.1 million in the same period last year with the major factors that I talked about on the revenue side. The earnings per share reflect a loss of $0.03 per share on a fully diluted basis and that compares to a gain of $0.03 per share in the prior year.

And now I’m going to turn it over to Paul Townsley to give us an update on the California Regulatory Situation and our General Rate Case in California.

Paul Townsley

Thank you, Tom. As management previously reported in last July, in July of 2012, the company filed a General Rate Case application with the California Public Utilities Commission. This particular application covers a three-year rate cycle for the years 2014, 2015 and 2016. And in the application that we filed, we requested new revenue of $93 million in 2014, $17 million in 2015 and $17 million in 2016.

The two major drivers of this particular rate case are first of all, capital investments. We in our rate case, we have requested $480 million of new capital investments in our 25 districts over a three-year cycle, and also declining use by our customers and the declining use has methods, we need to reallocate that fixed costs of running our utility over fewer units sold. This is about $28 million of the $93 million of new revenue in 2014.

Earlier this year on March 1, the Department of Ratepayer Advocates, which is a division of the PUC that represents ratepayers filed its report on our rate case. As might be expected, they recommended a lower revenue increase than we have requested. And just this week, we filed our rebuttal testimony to both the Department of Ratepayer Advocates report as well as other interveners. Our rebuttal testimony included about 900 pages of rebuttal testimony and about 1,700 pages of its exhibits. And we are really rebutting a lot of the positions made by the Ratepayer Advocates in our rebuttal.

Settlement meetings with the Department of – the Division of Ratepayer Advocates and other interveners, is scheduled to start next week. And evidentially hearings are scheduled to start on June 4. And we are on track with the original schedule that we envision when we filed the application last July.

Also as part of the rate case process, the Public Utilities Commission hosts public hearings in many of our districts. And in this particular case, they hosted – they scheduled 16 hearings in a number of our districts and about half of them have been completed to-date. And the purpose of the public hearings, are really to give the communities and our customers an opportunity to provide input into the rate case process.

In some of our smaller districts, our small remote districts, we’ve had good size customer turnouts because in these small districts, we’ve been asking for a larger rate increases. But these larger rate increases are really an artifact of the CPUC’s model that district specific costs need to be borne by district specific customers and in those cases, smaller customer bases.

In our large districts, we’ve had relatively low customer turnout. And as an example on Tuesday of this week, I was at Bakersfield for a public hearing. We serve about 67,000 customers in Bakersfield and we had eight Bakersfield customers speak at the hearing, so quite a small turnout.

Overall, I would say our rate case process is running well and we are on schedule for a CPUC decision later this year with new rates going into effect in January of 2014. That’s all I have.

Thomas Smegal

Okay, thanks Paul. I’m just going to touch on a couple of things from the balance sheet. First of all, our net utility plant, at the end of the quarter it was $1.469 billion, that’s up 4.9% from the 2012 value of $1.401 billion. And our cash at the end of the quarter, position we had a $127.5 million in cash that was related primarily to the proceeds received. We received $105.8 million in net proceeds from the sale of 5,750,000 shares of common stock on March 26. And at the – in the beginning of April, we paid down those borrowings on our lines of credit.

We had a line of credit outstanding at the end of the quarter of $93.3 million. We’ve substantially paid down those lines of credit in April. And one of the things to add on the balance sheet is we did get a reaffirmation from S&P of our exceptional liquidity rating. We are rated A+ negative with an excellent business profile in the intermediate financial profile from S&P. The exceptional liquidity is one or two companies that they rate that have that value, that’s the highest that can be achieved.

And so with that, I’d like to turn it over to Marty and have some comments on the quarter.

Martin Kropelnicki

Great. Thanks, Tom. I’m going to cover four key areas. One, give some color as to the quarter and what was happening within the quarter. Two, talk about the results of our successful equity offering that we completed a couple of weeks ago and give some details around that. Three, talk about the rare occasion or rare occurrence excuse me, from March 11 when we gave guidance, why we gave guidance and reaffirm that guidance for 2013. And lastly, wrap up talking about our next steps in what we’re focusing on for the next quarter and also the rest of the year.

First, let me go to Q1 and the Q1 results. And just as a backdrop, I think there is two important things to remember when we analyze the quarter. First and foremost, the first quarter is always the slowest quarter for Cal Water. And in California where we have decoupling, we have adopted revenues and we have adopted production costs. When you net those two out, you get what’s called adopted gross margin. We get the least amount of adopted gross margin in the first quarter. It’s the lowest quarter of the year from adopted gross margin standpoint. And typically as a result, internally we don’t budget to do a whole lot from earnings perspective during the quarter.

Secondly, as Tom mentioned when you go back to the Q1 of 2012, it’s really important to factor in the results of the deferred RAM revenue that took place at 12/31/2011. As you may recall we had a delayed decision from the CPUC on the amortization of the RAM balances and as a result we had to defer certain amount of revenue and certain amount of costs depending on the collectability within a defined period of time.

But a different way when you look at 2012, if you back out the deferred RAM revenue and the deferred RAM costs, we would have broke even in Q1 of last year, we won’t have made money, we would have broke even. And that’s usually typical as the first quarter given where we are with the gross margins and being the second year and now the third year of the General Rate Case. There will also be some more information on the Q that you can reference to help put that picture together.

So with that as a backdrop, what happened during the quarter. As Tom mentioned, health care costs are just up. Cal Water is not different than any other company out there in corporate America that we’re dealing with higher health care costs. Now typically we’ve seen a less than health care costs usually in the fourth quarter. The fourth quarter of this year we did not see that, we saw it in the first quarter of this year.

Payments to health care providers and reimbursements increased $1.5 million to $3.8 million. It’s driven by really two things. One, we have increased costs associated with the HMOs that 25% of our employees elect to participate in. And we have an increase in the larger claims associated with our self-insured PPO plans which represents 75% of our employees. With 2013 being the third year of the General Rate Case, we believe and we estimate that health care costs will run $3 million to $5 million above and beyond what we’re currently getting recovery on in rates.

And while the company’s current medical plans have experienced much lower increases in costs in medical inflation, by the time we get to the third year of the rate case cycle, that regulatory lines starts to sit in, and despite having step increases or inflationary increases, they are not enough to offset the cost increases that we’re seeing in health care costs.

Second to that in just as followed as Tom mentioned, we got a number of main leaks that took place in the first quarter. We operate 6,000 plus miles of main, so main leaks are a common occurrence in our business. What’s not a real common occurrence are big main leaks. And during the quarter, we had four large main leaks. We had three in Southern California, one in Northern California.

In total, the company incurred over $800,000 in costs associated with the repairs of these four leaks. That compares about $200,000 in the first quarter of 2001. While the company does maintain adequate insurance coverage for such events, our self insurance retention level is $500,000 and none of these four events on a per occurrence basis rose about $500,000.

We had one in East L.A. that approached $400,000 but none that went to our rate we have happened to our insurance coverage, meaning that the company incurred those costs in repairing the leaks.

Outside of the medical and main, we said we found the quarter from a budget to actual perspective the company has performed as expected. In fact if you back up the health care increases and the main leaks, almost every department and every district came in at or below their budget targets for 2013 which are set very, very tight given the fact it’s the third year of the rate case.

Moving on, I want to take a couple of moments to talk about our successful equity offering that we had in March 20, was when we priced. The company sold 5,750,000 shares at $19.25 per share. We had eight names on the cover. Our lead banks were R.W. Baird and Wells Fargo Bank with R.W. Baird acting as sole book-runner.

In addition, we had six co-managers including Brean Capital, Janney, Ladenburg, J.J.B. Hilliard, Williams Capital and our friends up the street, Blaylock. Tom and I did a three day road show with numerous international calls. It was a pretty intense kind of three day period. And as a result, that the deal was 2.4 times oversubscribed which we are very, very happy with.

The strategy behind the offering was what I called a dual pipe, dual continent strategy. Dual pipe meaning 50% of the allocation was for retail account and 50% of the allocation was for institutional accounts. And then the dual continent had to deal with North America and also Europe. The institutional book which is half of the deal, 34% of the shares went international which we are very, very happy with. 71% of the shares went to new investors and then the retail book was oversubscribed as well.

So overall, we are very happy with the execution of our equity offering. We appreciate the well executed transaction by our syndicate team and we want to pass along a big thank you for the team that help pulled us together, we’re very happy with the results. And as Tom mentioned that one liquidity ratio that’s a rare occurrence in S&P rated companies, so we’re proud of that and this will help us ensure that we maintain that ratio.

Moving on as many of you have seen on March 11, 2013 the company I think for the first time in the company’s history issued guidance. That is not a normal process for Cal Water, and it’s not something that will view in the future, but we thought it was relevant to do it in Q1 for three primary reasons. First and foremost you have this whole deferred revenue costs issue with the RAM and MCBA. So you’re period over period analysis is going to be off because of that and we wanted to make sure people were paying attention to that and you have to back those numbers out.

Two, we have the cost to capital adjustment mechanism and that triggered and affected the 2012 results and also triggered and affected the 2013 results. So while that was adequately disclosed throughout our public fillings, I think people tend to miss that (inaudible) on a normal basis.

And the third reason why, it’s the third year of the rate case, the third year of the rate is always a very, very lenient for the company. We start to feel the effects of regulatory lags that just we talked about early on the medical and we didn’t want the street numbers to get ahead of the company’s current expectation.

So as a result, the company on March 11 put out guidance for net income of $35.7 million to $39.9 million. We believe that it’s still the range for the quarter. We don’t see – for the year, we don’t see any changes for that for the rest of the year and we are reaffirming that number going forward as I move into Q2.

Lastly I want to comment on the rate case. As Paul said, it’s 900 plus pages of pure reading joy. All of us Tom, Paul, the rates team, I think almost every engineer in company, literally it’s thousands of hours that went into to put in something like this together and it’s a very, very complex process.

I want to compliment the Cal Water employees and especially the rates team, for doing an excellent job at pulling this thing together and getting it completed on time. Overall I thought the work product was very, very good, and in fact I think one of the best that I’ve seen in my limited time at Cal Water, and we look forward to moving forward the General Rate Case, so good job on that.

Looking at where we go moving into Q2. Four main focus areas for the company. First and foremost, cost management and again that overhang of being the third year of the rate case is important. We continue to look at every P&L in every company, in every district every month and every quarter, so we’ll maintain a tight operating budget this year and look for more ways to be efficient in containing our costs.

Two, the rate case. So far we’re about 75% through the process and we remain on schedule. As we move into the settlement discussions, the company will do whatever it takes on our side of the process to make sure that the proceeding stays on schedule, and hopefully we would wrap up this year on time. But so far as Paul mentioned, we are on time and on schedule.

Number three, the capital program. In responding to the General Rate Case, a lot of engineers get pulled into writing rebuttal testimony. And now with that rebuttal testimony on file, it’s really important that we focus on our capital programs and achieving our capital targets for 2013.

As you may recall, we’ve set a goal to put a $120 million to $130 million of capital in the ground and now we’re going to push forward with achieving those targets. And lastly and maybe most importantly continue to serve the customers, provide excellent water quality, and keep the company moving forward.

So with that, Tom I’ll turn it back to you.

Thomas Smegal

Yes. Thanks, Marty. Dianna, I think we’re ready for Q&A at this time.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We’ll take our first question from Jonathan Reeder with Wells Fargo.

Jonathan Reeder – Wells Fargo

Good morning, gentlemen.

Martin Kropelnicki

Hi Jonathan.

Thomas Smegal

Good morning, Jonathan.

Jonathan Reeder – Wells Fargo

Marty as always, I’m going to ask you the question, I like to try to reconcile to kind of an ongoing number for the quarter, so the obvious one that I’ll jump to is going to be the mark-to-market unrealized gain or loss on the retirement plan. So that was a penny that we should add back in for the quarter. Is that right?

Martin Kropelnicki

Let’s see here, yes, in Q1 it was little bit less and the penny was about $500,000. And I think we mentioned this at year end as well, these are long-term assets that the company holds and its non-qualified plants and they’re wrapping an insurance product so there is a payout if somebody becomes diseased, there is actually payout to the company.

Having said that, there are specific accounting rules around corporate on life insurance policies, and we have to reflect the change in the cash surrender value which reflects the change of the underlying assets on a monthly basis.

Last year, Jonathan, you and I’ve talked about this ever since I’ve been at the company. These things can be pretty volatile. So last year we went on a process to de-risk the investment portfolio, lowering the overall beta [ph] of the portfolio. So, so far it’s been working very well, so we haven’t seen the big swings, we expect that will continue but that was overall goal. So we had a slight pickup of about $500,000 and that’s about what we target internally as well in terms of rate of return.

Thomas Smegal

And just to clarify, Jonathan, the actual mark-to-market was a lot higher than – in the first quarter of 2012, it was $1.7 million, in the first quarter of 2012 versus $500,000 first quarter of 2013. And what we’re seeing in the first quarter of 2013 is consistent with the values that we’ve seen since we did the rebalancing. So maybe think about it that way that 2012 was very high and that had been bouncing around quite a bit before the rebalancing, but that number that we’re seeing in this first quarter is consistent with the last three quarters.

Jonathan Reeder – Wells Fargo

Okay. And then Tom maybe you can help me understand a little bit, the $3 million decrease in accrued unbilled revenue. I mean overall the revenue for the year you’re still going to I guess correct word is prescribed under your rates, I mean is that accurate first off and then I mean there is...

Thomas Smegal

Yes, let me go into that a little bit more detail just to clarify. Absolutely, but the RAM on the billed revenue and so we see a ballooning as we go through the summer months. We’re starting in the spring, ending in the fall of what’s called unbilled revenue accrual, and that’s – as I discussed the sales that we expect to have occurred based upon a model that’s been the model for years and years, but sales that we expect that have been incurred but we have not billed those customers for yet.

When we bill the customer, that becomes our billed revenue that flows into the RAM. And so we see – when we get towards the end of the year, that’s a very consistent figure. December, January, November all those months are low water use months. We tend to see a very clear pattern of the unbilled revenue, so we don’t see a lot of year to year change in that amount. We did see in this particular quarter a big change from what the unbilled revenue accrual was at the end of the first quarter of 2012 versus 2013.

So as we go forward, those customers will be billed for those amounts. And when those amounts are billed, the difference between the adopted and the recorded amounts of revenue will flow into the RAM.

Jonathan Reeder – Wells Fargo

Okay, so I mean the way to think about it just kind of the usage towards the end of the quarter that hadn’t been billed was lower this year versus last year in Q1?

Thomas Smegal

Exactly.

Jonathan Reeder – Wells Fargo

Okay, so there is really nothing in terms of I guess kind of adjusting to an ongoing earnings number that we would need to do on that?

Thomas Smegal

It’s really timing. I mean I would say it’s really timing that obviously what we estimated is an estimate and so you don’t always know that the customer is going to use exactly that amount, but what we do know is that when they do use the water and get billed for the water that’s going to go through the RAM mechanism and we’re going to get to the adopted amount of the revenue for California.

Jonathan Reeder – Wells Fargo

Okay, so I mean if we want to then – I guess approach the whole unrealized gains aspect as the $500,000 being somewhat of a normalized quarterly expectation on a go-forward basis, then there is really no adjustments that you would make to this $0.03 net loss. Is that accurate?

Martin Kropelnicki

I think that’s right. Jonathan, it’s Marty. I think that the goal of the investment products was to stabilize our long-term assets, we don’t have to be out there in aggressive growth funds, we wanted to bring the overall beta down. And Tom is absolutely right, we rebalanced at the end of Q1 and then going forward for two, three and four during 2012, it’s consistent with reforms so we are very, very happy with that.

The medical costs and the main leaks stuff, if that happens it would have been nice to be breakeven again like we were in Q1 of last year on a pro forma basis, but really when you get to that third year of the rate case and really health care and (inaudible) those are the kind of a big bucket [ph] that we really exhibit the regulatory lag and it’s just a function of process in where we are.

Thomas Smegal

And Jonathan, I’ll add one other thing just to fair bit to keep in mind and that is as we move through the California regulatory policy program, we’ve been metering a number of residential customers that had not been metered before in our Valley district. And we’ve set up since 2008 with a tiered rate program where the rate gets higher as you use more water increasing block rate structure.

And so those two as we move forward in the rate cases and in our program of metering are going to force more of the revenue into the second and third quarters on a go-forward basis and less of the revenue in the first quarter and the fourth quarter as we go forward. So we’re going to start – we’re going to continue to see a weakness of earnings in the first quarter or for the foreseeable future just because of the way the revenue is collected in our biggest area which is California.

Jonathan Reeder – Wells Fargo

Okay, that’s helpful to know. And then in terms of settlement discussions begin next week, I think in the past you’ve been able to work pretty constructively with the DRA, I guess what are the main issues that I guess you guys need to come to a consensus on, and do you think there is a path to getting a comprehensive settlement agreement in this year’s case?

Paul Townsley

Jonathan, this is Paul Townsley. We continue to have a good and productive working relationship with the Division of Ratepayer Advocates and with the other interveners in our case. I think the biggest difference between the DRA’s position, the Division of Ratepayer Advocates and ours has to do with capital, the amount of capital that they think we should be investing in each of our districts versus we are.

If you look at their report, their report is very detailed on very specific capital projects. I am quite confident that we will work through all of those issues on a project by project basis and will arrive at a reasonable settlement at the end of the rate case cycle. It’s just (inaudible) there, it’s just a process that we have to work through. We’ve done it many times before and I expect we will be successful.

Jonathan Reeder – Wells Fargo

Okay, and then lastly, Marty, I don’t know if you can kind of go into the non-California properties and I guess what did they maybe on a historical 12 month basis kind of what type of ROE are those earnings and what sort of growth on a going forward basis do you expect to come from that, I mean it seems that if you can get the ROEs up there and some of the investments you are making particularly in Hawaii, it could help out to the bottom line growth going forward?

Thomas Smegal

Jonathan, this is Tom, I can maybe pass to Paul for some details, but the key there for us is in the Hawaii area where we have active rate cases for most of our major rate making entities in Hawaii that would be in the Waikoloa, we have five different rate cases going on for Waikoloa systems as well as the Pukalani wastewater systems that on Maui and we are lagging in Hawaii right now. We do need a rate release there. We have a settlement on the Pukalani system that we made with the Consumer Advocate and we are waiting for the Hawaii Commission to approve that settlement.

We’re in various phases. Paul, I don’t know if you can relate, but I believe we’re in settlement discussions on some of the Waikoloa systems and in data requests on some of the others. We’re hoping to get resolution on those by the end of the year, but we don’t have a specific timeline for those things right now.

Paul Townsley

Yes. Thank you, Tom. Our water based operations in Hawaii are the five Waikoloa systems. We last week had responded to the Consumer Advocate on a proposed settlement on the Waikoloa water rate case, but more specifically we really believe that the terms of that will be the templates for settlement on the other Waikoloa cases. So as Tom said, we’re behind on that, but we are – now that the rebuttal on the California case has been filed, we are really turning our attention back to that and expect to resettlement on the Waikoloa water case and then following shortly thereafter some of the other Waikoloa cases.

Martin Kropelnicki

One thing – this is Marty, Jonathan. One thing I would add, there is a distinct difference in the other states than California. California, we have pushed back the rate making, so as Paul mentioned, the capital debate that we have with the DRA, that’s on a forward looking basis and in Hawaii, New Mexico, and Washington it’s on a backward looking basis. So it’s historical rate making state.

So we have to get the plants in the ground. You start the depreciation and then you file the rate case process. So I’ll say it a different way, Hawaii is losing money right now as we have always rate cases up in there, we need to get settlement on because all that new plants been put in service and its being depreciated. Washington has a little bit different business model and that they tend to make all their money over a 90 or 120 day period when they get the warmer weather over the summer.

So typically they will be breakeven to a slight loss for eight months out of the year and then we get to the summer months and that’s when they’ll make all their money. So it’s all different. And then New Mexico, New Mexico makes a little bit of money for us but just not a very big operation. It’s just a small, small operation. So our focal point really is on the Hawaii rate cases. When we were interviewing for Tom’s replacement and ultimately we hired Paul. Paul has experience in the Hawaii regulatory market and that was a real big plus for us.

So he was able to kind of step right into the role and help facilitate the rate case in California, but he also knows the other states that we operate in. So we think that will help facilitate the process.

Jonathan Reeder – Wells Fargo

And so with Hawaii, I guess, what’s kind of the allowed ROE, and I guess following the completion of all these rate cases, how close do you think you can get to actually earning or what’s – I guess just the embedded regulatory lag percentage in the state?

Thomas Smegal

Jonathan, it’s going to be a little bit different to tell, I know that they are fond of rate base, so it maybe a little bit of time before we get to the top number there. The ROEs that they’ve been allowing have been little bit higher than California, but not significantly higher than California.

Jonathan Reeder – Wells Fargo

And how close do you think you can – I mean (inaudible) since the case takes so long and they are phasing in, I mean is it something where if you guys run it properly I mean is it maybe in the mid-single digits just given the structural lag in the historical rate making?

Martin Kropelnicki

So let me put me it this way. I think we made a tremendous amount of investment in wastewater treatment plants or that we knew we’re there when we bought the systems. And that was the opportunity in Hawaii was to purchase these systems and refurbish the wastewater treatment.

For those wastewater systems in particular, those are the major investments that we will have needed to make for a significant period of time. And so by getting rate relief for those systems – for those investments in those systems I think we’re going to be a lot closer to the operate ROE on the wastewater side.

Now on the water side as we have in California and everywhere, we have a continuing need to put in, in investments in main lines and pumps and lot more infrastructure on an ongoing basis. There may be some lags associated with that, although frankly the areas where we serve water, there haven’t been the issues with the commission as that is the issues on the wastewater side, I think because of the big percent of rate increases related to wastewater assets that’s been a source of some of these delays with the commission. Paul can answer a little bit more.

Paul Townsley

My history in Hawaii with the Hawaii PUC is that in general it’s a pretty fair commission. And that it provides the utility company a reasonable opportunity to earn its return. Given the relative size of these investments in Hawaii in the wastewater systems to pick some of the non-compliant issues, we have to – it may take us a little bit longer to get there, but once those are fully in rate I expect that we’ll have a pretty good opportunity in the state.

Jonathan Reeder – Wells Fargo

All right, so it sounds like over the next two to four years we should see some meaningful improvement really out of the Hawaii and then kind of getting up to earning in the sales [ph]. Is that fair?

Martin Kropelnicki

Yes. I think that’s fair, Jonathan, yes.

Thomas Smegal

The only comment I’d put on there, Jonathan, is you will lag in Hawaii despite the difference in rate making because you have to get the plant in the ground and we’ve spent probably close to $100 million over in Hawaii now in these rate cases that we’re filing are really critical and they are big. You don’t have a lot of big water companies in Hawaii. So resolving these are really a critical factor for us.

Jonathan Reeder – Wells Fargo

I appreciate the addition insight, thanks.

Operator

We will take our next question from Heike Doerr with Baird.

Heike Doerr – Robert W. Baird

Thanks. Tom, can you give us – can you drill down and give us a little more info on A&G costs, and also tell us a little bit more about the uninsured property taxes or I think I missed a part of that?

Thomas Smegal

Okay. Thanks, Heike. So the A&G expense includes effects of increased pension and health care costs that, Marty, talked quite a bit about, the detail in our health care claims. They were substantially higher this quarter than in the comparative quarter in the prior year.

We do have salary increases for employees that tend to go into effect on January 1. So we did see that effect on the A&G expense. And then what you are referring to is the uninsured loss. Again, Marty, talked a little bit about that. Those are the expectations of claims on property damage, particularly for some of the major main leaks that we’ve had in the past few months. And we have a self-insured retention of about $500,000 on these items and most of these claims have been under that.

So what we see is that is – I hesitate to say random because you never know if it’s random or if there is some pattern to it, but there have been more main breaks that have caused property damage that reflected in this quarter than had been reflected in prior quarters. And that’s the source – Marty, did you have the exact number on – it’s about $800,000.

Martin Kropelnicki

$800,000. And if take that coupled with the Delta in health care claims that explains the full bearings in A&G. Now other different components that have moved around like, Tom, said wages are up but that was offset by savings in other areas.

Heike Doerr – Robert W. Baird

Is this enough as an item that’s uninsured property main leaks, saying that you would amend your rate case to reflect it?

Thomas Smegal

No, if you look – and in fact let me give you the size of leaks that might help. In East L.A., it was $350,000. It had to do with a water main that was put in back in the 1940s. It was 18 feet in the ground and it ruptured. It was up on a hill, so it washed down the hill, washed out a retaining wall and there were four multi unit dwellings at the base of that hill.

So that one – just finding that main was a lot of work and then we had a number of families that we had to put up in a hotel and so forth, but the East L.A. team did an outstanding job responding to the emergency, but that becomes an expense. So there is a main piece of that where we fix the main depending on the size it could be capital, but there is a lot of expenses, we’re dealing with the people, the cleanup et cetera that becomes all expense.

Bakersfield, we had a one for $175,000 in downtown Bakersfield. We had one in Stockton for $110,000 and we had one in Westlake of $150,000. So none of these individually are material, none of them on individual basis raised to the level of what were self-insured retention is, but in the aggregate it becomes a blip on the A&G line because it was about $800,000.

Heike Doerr – Robert W. Baird

Okay.

Martin Kropelnicki

And Heike, when I say for rate recovery, is that we look at this with the commission on a kind of a five year average rolling basis. And so this is a one quarter blip in this area. We’ll have to look at the whole year, we’ll have to look at what’s been the experience. We do have these losses overtime, I can think of loss with the main breaks overtime. It’s just that unfortunately these three or four instances got concentrated and are being recorded in this quarter.

Heike Doerr – Robert W. Baird

Okay.

Thomas Smegal

By way of example if you look at Q1 of last year, we had about $200,000 worth of expenses associated with main leaks.

Heike Doerr – Robert W. Baird

Got it. And just to drill down on pension and health care costs further, if we kind of lump employees into three categories, retired, kind of corporate management and then the kind of greater employee base, how do these costs breakdown. Is there one group whose costs are rising and dragging up the group or you’re seeing it as a pretty steady increase against in all three categories?

Thomas Smegal

Well, Heike, remember that the pension is coming to a balancing account.

Heike Doerr – Robert W. Baird

Right.

Thomas Smegal

So both the pension and the supplemental executive retirement plan are covered by the pension balancing account. So when we say there is an increase in the cost in this area, that’s also reflected on the revenue side.

Heike Doerr – Robert W. Baird

Right, good reminder. But the health care costs aren’t?

Thomas Smegal

The health care costs and in this particular quarter, we see an increase in the employee health care cost as being the big driver. There have been past quarters and past years where the retiree health care costs has been the driver. So I wouldn’t say that it’s exclusively one or the other. In this particular quarter, the variance seems to be on the employee side.

Heike Doerr – Robert W. Baird

Okay. And to end with a big picture question, we’ve seen Aqua and American address portfolio optimization in exit states that didn’t really have the growth that was worth management’s time. What keeps you in Washington and New Mexico instead of shopping those systems around?

Martin Kropelnicki

I’ll take that, Heike. That’s a good question. And I think it varies depending on what part of the footprint you are looking at. Up in Washington, there are still thousands of small individual water systems, so there is still a lot of room to aggregate and kind of roll up water systems in Washington the same way we did in the Hawaii. New Mexico is a little bit different and that – in New Mexico, there are lot of developments that we were watching and we moved in around those developments thinking at some point in the future they’ll grow and that will be there to be their water provider.

Nonetheless you’re point is valid, I mean at some point part of this game is making sure you have a large base, and a larger the base the more you can spend that margin on cost to the base. So we’re always looking at that. For us the smallest part of operations is New Mexico and they contribute to the bottom line. It’s not much, but we’re not losing money on them.

Hawaii has been a lot of investment and a lot of management bandwidth to grow in Hawaii. We believe we’re the largest investor on water utility now in the Hawaiian Islands. Giving those rate cases then become really important. And in Washington, it’s a function of – still continuing to grow and we have our growth plans and we’re always out there looking at acquisition targets. And I think Washington will continue to grow. It’s not going to grow at the rate that we grow in Hawaii, but we think they are solid properties.

Heike Doerr – Robert W. Baird

And are there other states that you have your eye on if we kind of turn the question around and say where would you like to grow instead of calling back. Are there more opportunities for you in the non-regulated side, contract ops, regulated system acquisitions in California or in other states?

Martin Kropelnicki

Yes, that’s a very, very good question and it’s also something that we spend a lot of time talking about internally. Given our S&P rating and our balance sheet, we clearly have room to lever up and do a good size acquisition. The problem is you don’t see a lot of good properties that come on the market, but typically when you do and if there are certain areas that we’re in, then we will participate in that process.

Some of you may recall the Lower Colorado River Authority a couple of years ago was selling assets. We were an aggressive bidder in that process, but ultimately pulled out due to the politics being pretty extreme in the State of Texas. So we’re always out there looking and we’ll continue to look about that. And my personal opinion is that you’re going to see a lot more of these kind of concessionary models, where you’ll see cities and counties that are struggling.

They’ll take the water assets or drop it into a new trust, they can monetize those assets and then they’ll enter into like a 30 year agreement with an operator to come in and operate that. And that allows you to avoid getting above from the local citizens, it allows the cities to get money from those assets, and it allows experienced operator to come in and take control of the system and operate it well. So my bet is going to be the concessionary model that you’re going see a lot more deal when this pop up. And yes we’re interested in those.

Heike Doerr – Robert W. Baird

Great, thanks. I appreciate your insight on that.

Martin Kropelnicki

Thank you.

Thomas Smegal

Thanks, Heike.

Operator

(Operator Instructions) At this time, I show there are no further questions, I would like to turn the call over to Mr. Smegal for closing remarks.

Thomas Smegal

Well thank you all for your continued interest in California Water Service Group and we look forward to talking to you again next quarter. Thanks very much.

Operator

This does conclude today’s conference. We thank you for your participation. You may now disconnect.

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