Dan Ford - Barclays Capital
All right. We are going to move on to our last presentation of the day, which will be Pinnacle West Capital Corp. We’ve got James Hatfield, who is Senior Vice President and CFO to talk to us about a real stable story now, so Jim.
Thank you, Dan. And thank you to you and your team for including us in the conference. This year we are delighted to be here. We welcome the opportunity to discuss our company’s progress and outlook, and we think we have a good story for you.
So I just want to start with the required forward-looking statements and also our non-GAAP measures which we refer to as ongoing earnings as we go into the presentation.
So starting off on who we are? Pinnacle West is a holding company, market capital near $6 billion and price value $9 billion and consolidated assets of about $13 billion. We have over last three years of substantially divested all of our non-utility subsidiaries to streamline strategic focus during that three year period.
Therefore today’s focus will be on our principal subsidiary, Arizona Public Service, which now represents essentially all of our business. Arizona is largest and oldest electric utility. We serve more than 1.1 million customers and Arizona has been one of the fastest growing states in the U.S. historically. Arizona Public Service provides stable earnings and cash flow to support Pinnacle West.
Just looking at our value proportion, we really talk about our five key pillars to make this happen. First is capitalizing on the intrinsic growth that’s inherent in the Arizona population, maintaining operational excellence throughout the company, take advantage of compelling capital investment opportunities across the spectrum, continue improvement in our regulatory environment and then further strengthening our financial profile -- financial and risk profiles.
Our ultimate goal is to deliver superior long-term returns to shareholders to price depreciation, dividend growth and further multiple expansion.
So I want start first on one of our biggest advantages we have and that is ability to capitalize on the Arizona’s intrinsic growth. In Arizona we have very positive long-term demographics. On this slide on the left you see the APS customer growth in the orange, the population growth in Arizona in the blue and then you see the U.S. population growth in the green.
Overtime, the state growth is outpaced to rest of the U.S. and it’s also historically rebounded after recessionary periods.
Regarding the current economic recovery, economic growth in Arizona continues to improve albeit at a modest pace. Over the long-term the fundamentals that are been important to Arizona’s growth are still intact and APS’ customer growth rate will return to more typical levels. In the next four years that’s 2012 to 2015 we expect annual customer growth to average 2% with some acceleration from the 1% growth expected in 2012.
Although, hampered by the current recession over the long-term between now and 2030 we will expect APS’ customer base to grow significantly. Compound annual growth rate of about 2.6% over the timeframe which is more than twice the industry average.
We project strong rate base growth averaging about 6% per year over the next several years. The capital expenditure program underpins this rate base growth and we expect capital to been to average about $1.1 billion per year through 2015 and the left graph displays the traditional categories of capital expenditures, such as generation, transmission and distribution. I’ll discuses the major capital expenditure programs in a minute.
So we have constructive recovery in place for much of APS’ CapEx, minimal annual spend is expose to regulatory lags, the right graph depict CapEx by major recovery mechanism.
We expect about 80% of our cash flow over this or CapEx over this timeframe will be recovered either through mechanisms currently in this last rate case of 45% or 35% by depreciation cash flow. And so we’ll talk more about the recovery mechanisms and the projects more detail in the minute.
So I want to the second pillar, maintaining operational excellence. We believe the superior operating performance represents stable stakes for meeting our customers needs, achieving constructive regulatory outcomes and creating value for investors and so on the next slide I have some recent performance highlights.
We focus on maintaining top-tier performance companywide. So we’ve achieve that in the number of areas, customer satisfaction, APS continues in top decile among U.S. utilities. This summer APS ranked 3rd highest nationally among 55 large investor-owned utilities in 2013 J.D. Power Residential Survey.
Strong Nuclear and Coal Base Resources, we operate above or near industry averages and in terms of Palo Verde the largest U.S. nuclear power plant in the U.S. which we operate 29.1% we sold the NRC provide license extension in April 2011 shortly after the year Japanese disaster.
Customer to the plants performance and management relationship with the NRC, we have top U.S. quartile and average time for customers for the past several years, and we had a very strong safety year in 2011 achieving our best safety year in the history of the company.
I only mentioned that because when you have a strong safety record it shows that you are paying attentions to the detail in your operations. We’re going to continue to pursue goal of zero recordable injuries.
And then Environmental, Sustainability and Governance Leadership, we run a reputation as a company that places high priority on environmental, stewardship and governance, and we’re appealing an -- to exclusive less by independent groups worldwide, including those shown on slide 10.
So now, I want to talk a bit about our capital investment opportunities. The energy-related investments underpin strong rate base growth. Selected capital investments, diligent planning and strong crossover site are essential for APS to meet customer’s growing energy needs reliably, consider environmental and public policy and earn attractive returns for investors.
Today, I'll highlight three of these programs, Arizona Sun, the proposed Four Corners transaction and then transmission. So, I want start with the Arizona Sun. Arizona has some of the best solar conditions in the world. You can see it here on the map on the slide. It's sunny over 320 days a year. Arizona regulators and legislators have been supportive by renewable energy in general, but more specifically supported by solar.
We intend to continue working cooperatively to realize Arizona’s immense solar potential, make our state the solar capital of the world, long-term benefits to company’s stake holders, a unique combination of well-positioned assets, as well as recognized leadership with existing and emerging energy trends.
In terms of the Arizona Sun program, this was where we are owning solar resources and putting them into right base. In 2009 -- element we were allowed to rate base was up to 100 megawatts of solar.
In our 2012 renewable energy charge plan, implementation plan, we ask for another $100 million -- 100 megawatts for 200 megawatts in total. Today, we have in service or commitment at 104 megawatts, we have 50 in service at the end of 2011 and we have projects in place for 54 megawatts at two additional sites. We expect that we've just gone through an RFP process and it should be name in over the next month or two additional Arizona Sun projects.
What’s unique about the Arizona Sun is we file every year under our renewable implementation plan and we get concurrent recovery throughout the year on these projects, so very good timely recovery of renewable projects.
In terms of Four Corners, this was a unique opportunity to step into South Cal, Edison shoes to purchase their interest in units 4 and 5. South Cal was similarly subject to, I think AEB-5, which really require them to divest generation under California legislation. We are the owner of 100% of units 1, 2 and 3 and the owner of 15% of units 4 and 5, and we operate all of those units.
This sort of came about in terms of their need to exit the plant. Plants say low-cost long-term resource for the company and somebody had to take, somebody or somebody is needed to step in their shoes or plant we close down. We think we found a unique opportunity here where we can purchase their stake in 4 and 5 for $294 million.
We will spend another $300 million in SCRs really by 2016. We will shutdown unit 1, 2 and 3, and so we have benefit to go to the environment by shutting down units 1, 2 and 3, sub critical older units, replacing the generation with stake 4 and 5, which are superficial newer units.
There is benefit to society, these units run in Navojo Nation, there is a mine. Mine mouth associated with this plan as well, collectively thousand jobs 800 are Native American. So this was a win-win for the company and the Navajo Nation as well.
Great benefit for customers, the lowest cost resource available to us and then we have a mechanism in which the docket set open in our last settlement, which require this on around December 1st, we will file a quick proceeding in Arizona, and should have decent rates, July 1, 2013, so very quick turnaround for me, regulatory perspective.
Remaining steps, we have Arizona and California approval. We have (inaudible) within approval. We are working on finalizing the contract now and we need a Section 205 transfer of ownership as well, expect it to be received in November.
Just in terms of transmission, we think that transmission is a good investment and it’s necessary to remain, to maintain reliability and deliver diversified resources to customers. Every year, we file a 10-year transmission plan with the ACC, our last year’s plan which was filed on January 31st calls for 269 miles of new lines, $550 million of new transmission investment. This does not represent all of our transmission investment. It is just everything 100 and tuning above, we include down the 69 KV transmission as well.
You see on the map in the yellow is where a lot of the solar concentration is going into service. We have to get that to the load pockets in both Yuma and Phoenix, and that's what gives us the opportunity to continue to build our transmission.
We do have constructive rate treatment under the formula rate adjuster. So we file after we close the form one every year, the formula rate with FERC, it’s approved, goes into effect May 1 for our wholesale jurisdiction, which is about 87% of total or, excuse me, 13% of total jurisdictional.
We file our proceeding in Arizona for the other 87. This year, we went into effect August 1. Under the settlement, we’ll be able to file that formula rate at FERC, get FERC approval file by tariff in Arizona and have this go to effect May 1, so again, reducing our regulatory lag.
I’m going to talk a little bit about improving our regulatory environment. Obviously, for integrate utility regulation is key. We were able in December, last year filed in January of this year, a very constructive settlement, negotiated with 22 of the 24 parties active to the case.
The level of selling parties demonstrates the support and collaboration among APS’ staff and other parties like the residential utility consumer organization, our large customers and so on.
It was approved May 15 of 2012. Notably, that was approved 11.5 months after the case was filed. And if you think about one of the goals in our 2009 case was to continue to reduce regulatory lag. Our prior cases had taken anywhere from 18 to 22 months, so this was done in half a time. It's also the quickest resolution for major Arizona utility rate case in recent years.
I think also more importantly, it’s the second consecutive multi-year settlement. We had our first one in 2009, that covered ’10 and ’11, and it continues to build upon the constructive regulatory environment that was contained or obtained in 2009.
There are certain provisions in here that are important to both customers, stakeholders and obviously, shareholders, and I'll highlight those on slide 17.
But first just the numbers of the rate case, one key in this rate case was no net increase to customers with base rate increase of $116.3 million. I talked about Arizona Sun, we currently recover that under the surcharge $36.8 of that moved into base rate that was all Arizona Sun projects completed by May 31, 2012 and we totally offset that with fuel of $153 million.
The other thing that’s been set up in this case are some really constructive additional items that really allow rate gradualism that come into place, so we did get 15 months of additional test year plan, so we had a 2010 test year rates into effect on July 1, so we have rate base additions through March 31st.
We have a new mechanism which is called the lost fixed cost recovery or LFCR. It’s a mechanism to address the negative impact of energy efficiency and distributed renewable energy, think of it as partial de-coupling. It allows us to recover the lost fixed costs really to the distribution system.
We had a 90%, 10% power supply adjustor that is now a 100% pass through. It continue to de-risk the balance sheet from a regulatory perspective. We streamlined for future rate changes the transmission cost adjustor. Well, I mentioned earlier automatically going to the fact it same time focus into effect. And we did improve our environmental improvement surcharge rider, which recover certain carrying cost for government mandated environmental capital expenditures. It has captured $5 million revenue requirement a year, but it’s better than nothing.
I’ve talked about earlier to Four Corner, keep the docket open to allow quick recovery of Four Corners costs. On the expense side, we obviously with the stay-out till 2015 trying to de-risk the sale of my process. We have one of the lowest discount rates in the country on pension expense at 4.42%. So we don’t think that there is a lot of downside to continue to lower interest rates going forward.
One other things that, it’s out of our control and has been hitting us with double-digit increases a last couple of years has been property tax increases. Of course, APS is the largest property tax payor in the state of Arizona and the way our assessments work is when residential and commercial valuations saw, we get the make up the difference. So we’ve had 8% and 14% acreage of last couple years.
We were able to obtain in this settlement, partial expense deferrals starting at 25% on July 1, 2012 going to 75% in 2014. These only cover the increased assessment ratios not additional plan into service. But we do feel like we’ve managed to also begin to minimize that potential negative impact.
External rate case filed on our after May 31, 2015 rates so again going to affect July 1, 2016 best effort places of course, but four year sales. And lastly, I just want to talk about strengthening our financial profile. We have made substantial progress on our returns, continuing our multi-prong approach to improve our ROE, but its starts with the support of electric utility rates.
We were earning into 7% and 9% range through the 2009 settlement. The 2009 settlement was a step change and under returns and we earned near 9% in both 2010 and 2011. And we have a further step improvement in earned returns with big settlement and I will talk about the outlook here in a minute.
So that was a big part of it, already can’t realize solely on regulatory. So we are really focus on costs that’s going to be essential to produce competitive financial results and I will talk about that also in a minute. So, in terms of costs we have a lot of going on. We have benefits so to speak of an aging workforce. We are going to have at least 220 employees retire each of the next four years. So one way to manage costs where we making sure that we don’t have one for one hiring of those that retire.
We are doing a lot of our cost initiatives for one other thing, because of the workforce attrition, we need to make sure that we have a sustainable operating model for the company going forward. And part of that is making sure that we are documenting processes, procedures, policies, making sure that we know who has governance rights as those long-term employees walk out the door making sure that the next generation behind them yes, they will not have the knowledge at those other that left, but they will have a manual due to work.
Some other things we’re doing is asking the employees to do less with less, focus on what’s important. We are currently in a process of centralizing certain functions in the company and I will give you one example. We just recently combined -- call at the financial business large group or financial planning on analysis, which was decentralized throughout the company. We combined that group under May on July 25th able to reduce through the synergies bring in despair group together, reduction of about 10% of that workforce.
I think as we get the group up and running by the end of 2013 slightly we can reduce another 10% of the workforce as we document our processes. And using the really go forward word, which is simplify, standardize, automate. So that’s one thing. We’re also have shadow IT and shadow training some other areas out there, there will be in the process consolidating that will continue to help us well.
The other thing we are doing as we are really focusing on benchmarking and focusing on process improvement. Our goal is to be bottom of top quartile by the end of '14 across the company. Some areas are already there are close to there. The benchmarking gives us a sort of the roadmap where to go, where we have opportunities.
So, we have a lot going on. We are very confident of our abilities to manage cost but its really about creating a sustainable future for APS in the next generation. From an ongoing EPS perspective, we gave guidance at the end of second quarter. Earnings 2012 $3.35 to $3.50, I will point you to the back to really the assumptions are underpinned that.
I think more importantly we are in a position now to earn and average of 9.5% ROE at least over this stay out period of time. So again, as I talk about sort to step change in earnings, we’ve gone some 7 to 8, 9 to 9.5.
In terms of dividend, I want to point out. Our dividend yield today is about 4%, so its inline with industry average. We come a long way from 2008 to today on the verge of junk credit at S&P, we are now BBB plus to both Moody’s and Fitch and BBB on positive adequate with S&P. So we’ve repaired the balance sheet, gone to two rate cases where constructed settlements. We are hitting our numbers from a earnings perspective and I take the next thing to do with the 61% payout ratio based on the mid point of guidance is for the Board of Directors in October to address the dividend level.
To the extent they increase the dividend, which of course is their call. We will talk about going forward there will be a compound annual growth rate of dividends on an annual basis as opposed to targeting any payout ratios specifically. We want to make sure that increase is sustainable, that if we step our toe for example look forward at additional rate outcomes that we can sustained just to continue grow the dividend and do that what they still a very good payout ratio.
In terms of shareholder returns, we have done well over the timeframe. You see the last five year at Pinnacle West and Green compared to S&P 500 and where you see S&P 1500 utilities so strong returns, and we intend to continue to do so.
So lastly, I just want to leave you with our value proposition. [Pinidea] is no longer a regulatory story, it’s an execution story. We have a clear path to earnings growth through the based rate stay out to the mechanisms that I mentioned earlier. The Four Corners transactions, the Renewable Energy Surcharge Arizona Sand, the TSA, the EIS and then what we the lost fixed cost recovery. So those mechanisms will continue to add gross margins throughout the state.
Due to the clear path for earnings growth, the board will address the dividend in October. Additionally, in a declining ROE environment, we have an authorized 10% ROE through 2015. More importantly, we have the ability to earn at least 9.5% during the stay-out period.
Although, we did not put in the forecast, we have zero sales growth through this timeframe net of our programs. Any quicker recovery to the economic recovery in Arizona would be upside to the forecast. And lastly, I’m confident about our ability to manage cost through the stay-out.
Our goal continue to provide superior returns through price appreciation, dividend growth and further multiple expansion.
And Dan, with that, we’ll have to answer the questions.
Dan Ford - Barclays Capital
Few minutes for question as the microphone is going around. First, I’d like to get an update on what you’re seeing in the local economy trends because that’s your percent growth. There is an opportunity if its like not that low?
Well, we still think there is a lot of downside of zero actually but we’re starting to see -- we're starting to see very good signs, the latest couple of months on housing data has been very strong. Real estate agents will tell you it’s a sellers market, lack of supply in the market. We haven’t seen a lot of new constructions but we do have developers coming to us talking about plans for the future. We’re just typically 18 to 24 months out.
On the, sort of commercial non-residential side, we have just across the street from us Arizona Health Science Center just built 225,000 square foot teaching facility and on August, 250 square foot research facility. Of course, those will bring in teaching and research jobs, entail although that our service territory has build on a $5 billion fabricating plan which would be their largest in the U.S.
And so we’re not ready to call recovery. We’re seeing some decent signs but I think we look to fiscal clip and all the other things that are out there. There is a still a lot of uncertainty and so we’ll wait and see in that regard.
Dan Ford - Barclays Capital
On the Four Corners, if I remember well, the FERC said some thing recently about how California ought to be proceeding with respect to trying to reduce the amount of coal fire generation. Does that event have any potential for making Southern California Edison, not want to close the deal for the California Public Notice Commission to sort of retract their approval?
Probably, not likely at this point. We’re couple of months away from acquisition. By law, they are not able to import that power in the California. We don’t have agreement on the barricade on Four Corners but we’re assuming that (inaudible) equipment which South Cal, so they can upfront. So I don’t think it’s going to have an impact on the near term. I think longer it’s like could have an impact.
Dan Ford - Barclays Capital
Any other questions. Maybe you can just walk us through the financing plan. It’s a pretty robust capital expenditure program, intent just to grow the dividend to more of an industry normal. I want to touch on how much you will add the equity ratio drift between here and the end of your rate stay-out, technically not, critically important to almost that we are in.
Yeah. I think we think about equity. We do not need equity proceeds until at least 2014, which was really be mainly to support the equity ratio on the next rate case and keep it consistent with the 34% we had in the last two.
So financing wise, we’ll finance Four Corners with an issuance of debt. Dollar for dollar, we had requested into the deferral process in a prior proceeding. So Four Corners have already been through a proceeding in Arizona covering other issues.
Return on equity under deferral. We were denied that. We do get a full cost of debt on 100% of the transaction price. And so we’ll issue right around that to be able to a point of commission that this was dollar for dollar financing. Other than that, we don’t have any maturities again until 2014 and might do some fixed income in late ‘13 for refinance from a debt in ‘14 and then we will need equity again assuming that there is a texture.
0.9, I mean, if 1.1 variance on an annual basis is pretty large but we only have about 20% of that 1.1 as unrecover to mechanism or cash. So it’s not building up a lot of financing aids during that time frame.
Dan Ford - Barclays Capital
Arizona was to become a solar capital of the world and you guys start somewhere -- how are the 104 megawatts solar that’s in service and I think on by you, you said, how are they doing. I can please without their producing or any problems with black.
No problem so far. We’ve been very pleased. Our process is typically we put out RFP and most of our cases the panel makers have brought forward a suggested projected most of them have either EPC. The company inside of them like First Solar or they have alliances with EPC. We do progress payments and so we take a very little risk until and during that construction cycle but already the money has been approved for resi as well. And so we won’t proceed on a project until we get approval.
We’ve done a variety of technologies. We got First Solar, SunEdison, SunPower, Zolon. So we’re not sort of betting on technology risk so far to date no issues probably producing certainly at maybe slightly ahead of what we thought from a power perspective.
Dan Ford - Barclays Capital
No other questions. Thank you very much.
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