Southwest Water Co. Q4 2007 Earnings Call Transcript

Southwest Water Co. (SWWC)

Q4 2007 Earnings Call

March 17, 2008 4:30 am ET

Executives

DeLise Keim - VP of Corporate Communications

Mark Swatek - Chairman and CEO

Cheryl Clary - CFO

Analysts

Debra Coy - Janney

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the full year 2007 Southwest Water earnings conference call. My name is Melanie and I'll be your coordinator today. At this time, all participants are in listen-only mode. We will conduct the question-and-answer session at the end of this conference. (Operator Instructions)

I would now like to turn the call over to Ms. DeLise Keim, Vice President of Corporate Communications. Please proceed.

DeLise Keim

Thank you, Melanie, and good afternoon, everyone. Welcome to Southewest Water Company's conference call for the year ended December 31, 2007. We issued our earnings release this morning, a copy of which can be found on our website at www.swwc.com. A replay of this conference call will also be available on the website.

With me today are Mark Swatek, our Chief Executive Officer and Chairman; and Cheryl Clary, our Chief Financial Officer. Mark will begin our call today with some comments on the year. Then Cheryl will talk in detail about our financial results, followed by additional remarks by Mark, and then an open question-and-answer period.

Before I turn the call over to Mark, I want to make you aware that our discussion today may include forward-looking statements that involve risks and uncertainties. Actual results could differ materially from those projected. Information concerning factors that could cause actual results to differ from those in the forward-looking statements may be found in our 2006 annual report on Form 10-K, under the Risk Factors section, and in our other SEC filings. A copy of these filings is also available on our website. During today's call, certain non-GAAP financial measures will be discussed. A reconciliation of these non-GAAP measures to the comparable GAAP financial measures can be found in the press release we issued this morning, which again is posted on our website.

Now, I'm pleased to introduce our Chief Executive Officer and Chairman of Southwest Water Company, Mark Swatek. Mark?

Mark Swatek

Thanks, DeLise. You know nobody likes to announce a loss, and a tough way to start the year out here, too. But much of what happened to our earnings in the fourth quarter was driven by two large non-recurring, non-cash charges. A $17.2 million goodwill impairments charge associated with our Texas utility business, and a $3.4 million charge associated with discontinuing part of our Texas service business.

Despite these events, our core utility business continues to perform well, and we're making significant strides in improving the operations and bottomline efficiency of the overall business, including management changes and progress on Cornerstone.

Let me first address the two one-time charges. The $17.2 million goodwill impairment charge to our Texas utilities was a result of testing under SFAS 142. When we purchased these assets, we expected continued connection growth and a certain amount of capital expenditures.

The housing market slowdown has resulted in lower than expected growth in this business for last two years. Furthermore, the systems have required more CapEx spending than originally anticipated, in order to bring them into compliance and to provide the level of service our customers deserve.

As we examine our fourth, our future growth projection projections, taking into account today's difficult market conditions, slowing connection growth, slower regulated rate relief in recognizing that more CapEx is needed to enhance system compliance, our testing results required us to reduce the goodwill included in the caring value of this business by $17.2 million.

The $3.4 million charge on discontinued operations, we pledged to a wholesale water and wastewater business in Texas. When the project was conceived in 2002, it was meant to support new developments, which had projections for rapid population growth. As it turned out, the population in the area has grown in a much slower pace. While the business generated modest cash flow, it has been a drain on the earnings of our service business, over $1 million in pretax per year.

And now with our housing slowdown, it appears it will be many more years before it could start generating positive earnings. As a result, we've decided to sell this business. While we pursue the sale, the business has been moved into discontinued operations. The $3.4 million charge we recorded represents the difference between what has been invested and today's market value.

One positive outcome of this action is that you're now able to see the true margins of our service business. Better service business is generating without this drain on the results. We intend to redeploy the proceeds from this sale to new opportunities, which better meet our investment goals.

These two non-recurring charges negatively impacted our results, and led to a loss in the fourth quarter of $0.53 per share, and a full year net loss of $0.33 share. We're not pleased announcing a loss for the year, but if you exclude the goodwill impairment charge for our Texas utility, we generated EPS on continuing operations, $0.11 in the fourth quarter, or a total of $0.34 for the full year

Now, let me address the performance of our underlying ongoing operations. We finished the year with revenues of $217.3 million, down $1.5 million from last years revenues of $218.8 million. Income from continuing operations, excluding the impairment charge, was $8.2 million, down $1.8 million from 2006.

2007 results were impacted by the same factors we've been discussing with you most of the year - the housing market slowdown, record rainfall in Texas, addressing legacy issues, and our investments in the future of Southwest Water through our Cornerstone Project.

Let me talk about how these factors affected our results. The consolidated utility business generated higher revenues, as a result of rate increases and acquisitions made in 2007. Organic growth in both New Mexico and Texas has been affected by the nationwide housing slowdown. We implemented a rate increase at the beginning of the year in our Alabama utility, a step increased at our California utility in the third quarter, and interim rates in the fourth quarter at a handful of our Texas utilities. The most significant of which was at our Monarch utility.

We acquired four utilities during the year. One in Northern Mississippi in the first quarter, two near San Antonio, Texas in the second quarter, and a wastewater utility in Northern Alabama in the fourth quarter.

Alabama continues to be an excellent market for us, as we closed in the Riverview Wastewater system and Birmingham in January 2008. We're very excited about this acquisition, which is the Company's second largest, as it serves more than 12,000 residents and is located in a high-population growth area, which serves the major commercial quarter. It is adjacent to our share Shelby County wastewater system, which will allow us to realize synergies to cross connections by combining the operations of the two systems.

We were also recently awarded the operations contracts for a new 8 million gallon a day water treatment plant in Shelby County. This new plant was funded, in part, by the proceeds the country received from the sale of their wastewater system to us in 2005. I think this shows how closely our service and utility relationships are driving new business in many of our markets.

Income from the utility business decreased, due to the impairment charge. However, excluding the impairment impact, the utility's operating income was up 8%, primarily from our California and Alabama operations.

Turning to the service business, when we compare the full year to the same period last year, revenues were down primarily due to the heavy rains in Texas, the housing market slowdown in both Texas and New Mexico, and the loss of revenues from contracts that were not renewed in the Southeast at the end of 2006.

Wet weather reduced the amount of construction repair projects we were able to carry out, and the housing slowdown decreased our new home construction, tapping, and inspection revenues for the year. Again, we have, and continue to take, actions to offset these factors.

Our Southeast services region was not performing up to our internal goals, so we made management changes in late 2006. Some contracts were not renewed in late 2006 and early 2007, which reduced revenues by about $9 million for the year compared to 2006.

However, due to the efforts of the new management team in the region, new more profitable contracts have been added, adding about $2 million of revenue in that region, and operating costs have been reduced considerably. I am very confident that this team can make this region a winner over the next few quarters.

The consolidated service business operating income is down significantly from last year. Much of this is due to the slowdown in construction projects, due to weather and the housing slowdown. In addition, the service business incurred two smaller non-recurring charges related to legacy issues.

The first, which we discussed in our third quarter conference call, was a $650,000 reserve recorded in the third quarter in anticipation of a settlement on fines for violations that occurred at a customer system that we had operated prior to 2006.The second was an $800,000 severance charge that we announced earlier this year, associated with a staff reduction within the services division.

The service business serves three distinctively different customer sets, the Texas municipal utility districts or MUDs, the municipal clients that we serve through operations and maintenance contracts, and Southwest Water's own utility business.

We restructured the service business in early 2008, to better serve the unique demands of each of these customer bases, to focus business development efforts for each unique market, and to eliminate structural redundancies. We flattened and simplify this division's management structure by removing one full layer of management.

Now each of the three customer groups has business leaders reporting directly to David Stanton, our Chief Operating Officer. We eliminated 12 management supervisory positions and 27 support positions, or approximately 3% of the service business employee base. And although we did have the results in certain severance charge, these actions represent about $2.6 million a year in salary-related costs going forward.

We continue to evaluate all aspects of the business. And during 2007, we identified several business segments that were neither core business functions nor profitable at the gross margin level. For example, in Colorado we shut down an unprofitable small electrical contracting business during the year.

We also made the decision to divest the wholesale water and wastewater project in Texas. We'll continue to evaluate and monitor other non-core business segments. And therefore, you may see some additional charges in 2008, as we continue to refocus the business on its key profit generating segments in core competencies.

I would like to comment our Houston MUD business. We continue to see improvement in their margins due to ongoing efforts to improve operational efficiencies and re-price contracts as they come up for renewal. Revenues in this region were only down slightly for the year, and margins were up, which, when you consider the loss of revenue due to the housing slowdown and weather, shows a phenomenal push by local management to make up those revenues in other areas of the business and improve overall efficiencies.

I'd also like to spend a moment on our Cornerstone business re-engineering project. As I've highlighted in past calls, this project is imperative for our future growth. Our legacy systems cannot sustain our current operations and, in fact, restrict the amount of growth we can effectively handle.

I am confident that Cornerstone will have a significant positive impact for our rate peers, as well as on the Company's performance as a whole, and on service business margins in particular. We expect you to portion this investment back in rates across our own utility portfolio, due to customer and hits service enhancements. The rest of the investment will drive savings in the service business, which you will see in improved margins and across the Company reduced SG&A costs.

In 2007, we capitalized $10.1 million for Cornerstone and expensed another $1.9, which shows up in our corporate overhead. We accomplished a number of critical Cornerstone activities in 2007. We totally rebound the company's IT backbone, and have established secure redundant data centers to assure business continuity.

We consolidated three call canters into one location on a single modem call center platform. This new call center is now scalable and capable of expanding to meet our future growth. We went live in January on a new Oracle financial platform for the entire company. This is the first time that Southwest Water has ever been on a single consolidated financial accounting system.

I went through four financial implementations in my career, and this has been one the easiest that I've been through. Well, a lot more to talk about next quarter, as we move in the phases of the project.

We are now consolidating all of our back office functions into one financial service center, which will be in place by the end of 2008. Other phases of Cornerstone, such as Customer Care and Billing, Work and Asset Management, and Mobile Workforce Management, are not scheduled to be fully implemented across enterprise until the end of 2009. And therefore, we anticipate our overhead expenses will continue to be at a higher level than our historic trends through that timeframe.

As we have parts of the projects implemented, we expect to begin to see savings come in from the increased efficiencies. Much of this will be realized in late 2009, but we lost some of these savings in 2008 as well.

And with that, I'd like to turn the call over to Cheryl for a detailed look at the numbers. Cheryl?

Cheryl Clary

Thank you, Mark, and welcome everyone. For the three months ended December 31, 2007, Southwest Water reported revenues of $57.4 million, operating loss of $11.3 million, and a loss on continuing operations of $10.6 million, or $0.44 per diluted share. This compares with revenues of $56.4 million, operating income of $6.5 million, and income on continuing operations of $3.3 million, or $0.14 per diluted share in the fourth quarter of 2006.

Excluding the impact of the impairment charge in 2007, our operating income was $20.1, and our income from continuing operations was $8.2 million, or $0.34 per diluted share. Companywide fourth quarter revenues increased $1 million from prior year fourth quarter results.

Revenue in the utility business increased by $2 million to $23.7 million, from 21.7 million in the fourth quarter of 2006. This increase was primarily due to rate increases in our California, Alabama and Texas utilities, as well as our recent acquisitions in Texas and Mississippi.

The service business revenues, which includes intersegment revenues from our utility business, decreased by $6.6 million to $39.8 million for the quarter, down from $46.4 million in the same period last year. This decrease was primarily due to reduced construction projects performed for our Texas and New Mexico utilities, reduced field work due to the housing slowdown, as well as a reduction in our contracted base in our Southeast regions. This more than offset our new contracts combined with out successful efforts to increase pricing on several of our current contracts.

For the full year, companywide revenue decreased $1.5 million from prior year results. Utility business revenues were up $7 million, but this was more than offset by decreased revenues of $15.3 million including intersegment revenue in the Services business, again, primarily due to the reduced construction and Southeast contract revenues.

For the fourth quarter of 2007, the company had an operating loss of $11.3 million, as compared to income of $6.5 million in the same quarter last year. This was primarily due to the two non-recurring, non-cash charges we took in the quarter that Mark discussed. Excluding the impairment charge, the Company generated the operating income of $5.9 million in the quarter.

Utility business operating loss in the fourth quarter was $7.8 million. However, excluding the impairment charge, the underlying business generated operating income of $9.4 million versus $7.5 million in the fourth quarter of 2006. This increase is primarily due to the increased revenues.

As a percentage of utility business revenues, adjusted operating income was 40% ,compared to 35% in 2006. The Services business operating income decreased $660,000 to $1.6 million, compared with $2.2 million in the fourth quarter of 2006. This decrease was primarily due to the reduced amount of construction work done for our utility business versus the comparable period, from the reduction of construction work for other clients due to the slowdown in the housing market, and from the one-time severance charge partially offset by improved margins in our Southeast division.

For the full year, companywide operating income was $2.9 million, as compared to $22.4 million in the prior year. Again, this decrease was primarily due to the non-recurring, non-cash impairment charge. Excluding the impairment charge, the Company generated operating income of $20.1 million in 2007, down $2.3 million from the prior year.

Utility business operating income, excluding the impairment charge, was up $2.4 million for the year, but this was offset by decreased operating income in services business of $2.2 million, and increased corporate costs of $2.5 million.

Looking now at companywide expenses, SG&A during the fourth quarter was $10.3 million or 18% of revenue, versus $8.3 million or 15% of revenues in the fourth quarter of last year. The $2 million increase in SG&A is primarily related to upgrades in staffing that we have put in place in both the corporate office and the Services business since this time last year, which includes salary, wages and related benefits.

The increase also includes $1 million of fourth quarter expenses for our Cornerstone project. As Mark mentioned earlier, due to the Cornerstone project, we anticipate SG&A as a percentage of revenues will continue to be higher than it has been historically. However, beginning with the second half of 2008, we anticipate being able to see some of the benefits of Cornerstone in our business process reengineering efforts.

The Company is transitioning its backroom functions, such as accounts payable, payroll, accounting, and procurement, into a central financial services center, which will streamline these processes and reduced cost.

Year-to-date SG&A was $36.6 million or 17% of revenues, versus $33 million or 15% of revenues in the prior year. Included in this amount is $1.9 million related to the expense portion of our Cornerstone project. Interest expense for the fourth quarter was $2 million versus $1.8 million in the prior year. This increase was due to an increase in borrowings on our revolving line of credit. The net effective interest rate on total borrowings was 6.8%, compared to 6.9% during the fourth quarter of last year. Interest expense was $7.7 million in 2007, and $7.5 million in 2006.

Our loss from continuing operations in the fourth quarter was $10.6 million or $0.44 per diluted share, compared to income from continuing operations of $3.3 million or $0.14 per diluted share in the fourth quarter of 2006.

Excluding the impairment charge, income from continuing operations in the fourth quarter of 2007 was $2.6 million or $0.11 per diluted share. For the full year, we had a loss from continuing operations of $5 million or $0.21 per diluted share, compared to income from continuing operations in 2006 of $10 million or $0.43 per diluted share.

Excluding the impairment charge, the full year 2007 income from continuing operations was $8.2 million or $0.34 per share. A reconciliation of the non-GAAP measures that I have just discussed to the comparable GAAP financial measures can be found in the press release we issued this morning, which is posted on our website.

Moving to the balance sheet, our company funded capital expenditures were $13.5 million during the fourth quarter. The majority of this investment was in regulated utility plant assets in order to continue to provide high quality service to our customers. We also invested $3.8 million in the Cornerstone Project. For the full year, our company funded capital expenditures were $40 million, including $10.1 million for Cornerstone

We ended the year with $47.3 million debt versus $130 million at yearend 2006, with total debt comprising 48% of total capitalization, which is on target with our goal of a debt-to-equity ratio of approximately 50:50.

At December 31st, 2007, we had a syndicated credit facility of $100 million, with $51 million of outstanding borrowings at a weighted average borrowing rate of 5.7%. We had $47 million of total borrowing capacity available on our credit facility as of the end of the year. We use our lines to handle seasonal cash flow needs, fund our capital expenditures, and to finance future acquisitions.

In January 2008, we used the line to fund the $22.5 million acquisition of the Riverview Wastewater system in Birmingham, which reduced our borrowing capacity. However, in February 2008, we entered into a new credit agreement with several lenders that provides over $150 million revolving credit facility.

Also, in December 2007, we obtained $30 million equipment leasing line of credit to help with the financing of our Cornerstone project. At yearend, we had leased $4.6 million of equipment on this line, with a weighted average rate of 4.4%.

I'm pleased we were successful in completing these new agreements, especially in light of today's difficult credit markets. We ended the year with $3 million in cash. Please note that due to the complexities involved in quantifying the impairment charges, we will not be filing our 10K today, but we intend to file it shortly.

With that, I'd to turn the call back to Mark. Mark?

Mark Swatek

Thanks, Cheryl. We began 2007 focusing on operational improvements and bottomline efficiencies, and we never lost sight of those goals. As the year progressed, we uncovered several issues that needed to be dealt with in order to position the Company for future growth. And we're faced with the external factors, such as the housing market slowdown and the heavy rains in Texas.

Despite these challenges, we are excited about the underlying business that we're in. Water is an essential and limited resource. And our business model positions us to participate in the opportunities it presents, both through the utility ownership, and through the operations and management of municipal utilities.

We are well-positioned in the south and west, which puts us in the heart of much of the nation's water issues, and we're eager to be a part of this solution. The problems associated with drought and pollution will continue to be bigger issues in these regions, and we have the expertise and the people to help these communities.

We have all the fundamentals, the know-how, the experience and the positioning, but we don't yet have the smooth running engine we need to leverage our position into a nationwide powerhouse. We took several steps during the year to put us on the right path, building this vision and creating a solid successful company.

We are implementing our Cornerstone project to upgrade and integrate all of our IT systems across the company. We redesigned our service contract pricing model and continue our systematic approach for contract and pricing reviews. We've restructured our service business around the three distinct customer's bases they serve. And we began to prune non-core and underperforming assets, and we dealt with several large legacy issues.

I'm very enthusiastic about the steps we are taking to create the kind of sustainable growth that I believe all of you can get excited about too. I'd like to thank you for your attention this afternoon. We'll be happy to answer any questions at this time. Operator, please open up the lines for questions.

Question-and-Answer Session

Operator

Yes, Sir. (Operator instructions). And our first question comes from the line of Debra Coy with Janney. Go ahead.

Debra Coy - Janney

Thank you. Good afternoon all of you.

Cheryl Clary

Good afternoon.

Debra Coy - Janney

A couple of follow-up questions. One, Mark, can you or Cheryl talk about where you see that we are in the services business from a margin standpoint. You mentioned that backing out discontinued operations gives us a better sense of the underlying margins.

But since we haven't seen all the numbers yet, and there is a few moving parts, can you talk about what you think the kind of run rate operating margin is in this business currently? I know we've seen some improvements that have been masked by various items over the last couple of quarters, including this one.

Mark Swatek

Well. I think that what you'll see when you get the numbers is, it's running at 3%. And that does include the one-time legacy issues of the legal reserve, and the severance fees in this year. So I think if you add those back, we're probably pushing around 4%, 4.5% where that business is. And we're still looking to get it up into that upper single-digit range within the next -- It's going to take us until we get through Cornerstone.

Debra Coy - Janney

Sure.

Mark Swatek

I think we'll see some improvement this year through the reorganization, but we really aren't going to be able to get the efficiencies that we need to drive that those margins up until we get Cornerstone fully in place and are able to automate a lot of our support functions.

Debra Coy - Janney

Sure. That makes sense. And you also mentioned that you are continuing to review the portfolio and that there could potentially be additional charges. Can you talk a little bit about how you see the portfolio now? We've been doing the review process for a year. I know it's a long process.

Do you think you have some sizeable operations still in there that might not be meeting your standards that might be candidates for divestiture or shutdown? Would it be smaller contracts? What do you see when you look at the portfolio from here?

Mark Swatek

Well, I think that what you look at contracts-to-contracts, you're going to keep contracts. We are constantly….

Debra Coy - Janney

Right.

Mark Swatek

…reviewing. They are up for renewal. We run it two to five years typically, contract ranges, and so as we go in for renewals -- we're still renewing it at over 95% of our contracts. But we've got lot more disciplined in our pricing model now, and we are fully pricing contracts. So that that will continue as we go on.

There are certain business pieces that make up the enterprise that we’ll look at. I really can't go into detail about those since we haven't made any decisions, but we've got some things that we are looking at. Nothing is big, but there are some things there that we have plans in place to turn it around, and we're continuing to monitor them.

Debra Coy - Janney

Okay. And moving over to the regulated side of the business, a couple of things. Looking at you've done the asset review taking a write-down on the Texas business, you haven't really broken what the earnings are in that business, relative to California or Alabama, but obviously, Texas has been under earning.

Now, we've written down the asset base. It sounds like you still have a fair amount of work to do there to bring them up to an allowed rate of return, so will we be looking additional rate cases in Texas? Or, how are you thinking about getting their business earning what it should be earning?

Mark Swatek

Clearly, we put a new focus into our Texas business. We've got a new manager in place. We're really focusing right now on compliance, and trying to get through all that we need to get through to get all of our systems up to speed and back into compliance with the TCEQ regulations.

We clearly are going to be going after rate cases. I think that it is the name of the game, and it's going to be something that we are going to have to work diligently at. It's not going to happen overnight. I think that there is not much more I can really talk about at this point.

Debra Coy - Janney

But suffice it to say, more to be done. And you talked about the CapEx, where you came in for the year? Cheryl, can you give us a sense of how we should be thinking about for CapEx for 2008 for Cornerstone plus the regulator operating business?

Cheryl Clary

Yeah. I think, Debra, in the past several years, we've been at around $30 million of CapEx without the Cornerstone project.

Debra Coy - Janney

Right.

Cheryl Clary

We spent a little bit over $10 million in 2007. We talked about in our last conference call that we were going to spend about $27 million in capital, and that $27 million for Cornerstone will be spread over 2008 and 2009. Probably more of that will be in 2008 than 2009. Is that okay?

Debra Coy - Janney

Okay. So staying at around 30 in the base business, and then another.

Cheryl Clary

Yeah. I think that's probably about right. And that's where we've been for the past several years, and Mark talked about compliance work that we were doing in Texas, but yes.

Debra Coy - Janney

Sure, and then another tarnish, and then a bit smaller in '09 for Cornerstone?

Cheryl Clary

Yeah. That's probably fair.

Debra Coy - Janney

Okay. And last couple of housekeeping questions. This one, I think I know the answer to, Cheryl, since you've talked through the new credit agreement. So we've had this issue rising, certainly, given the current credit environment. Do you have any adjustable rate securities or auction rate securities that might be susceptible to refinancing?

Cheryl Clary

No, we don't.

Debra Coy - Janney

Okay. I thought so based on what you had just said.

Cheryl Clary

Yeah.

Debra Coy - Janney

And then just finally, can you give us any better sense of what's the definition of soon, in terms of the filing of the 10-K?

Cheryl Clary

Well, we have 50, we filed the 12b-25.

Debra Coy - Janney

Yup.

Cheryl Clary

This afternoon and 15 days. We're working with our auditors as diligently as we can to get to the finish, we will probably do it before, certainly before, the 15 days.

Debra Coy - Janney

Okay.

Cheryl Clary

As soon as possible.

Debra Coy - Janney

Okay. Thank you.

Operator

(Operator Instructions) Ladies and gentlemen, I am showing no further questions at this time. I'll turn the call back over to Ms. Keim for closing remarks. Please proceed?

DeLise Keim

Thank you. And thank all of you for joining us today. Remember a replay of this call will be available shortly on our website www.swwc.com and this concludes Southwest Water Company's full year 2007 conference call.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. That does conclude the presentation. You may now disconnect. Have a wonderful day.

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