SouthWest Water Company Q2 2008 Earnings Call Transcript

SouthWest Water Company (SWWC)

Q2 2008 Earnings Call

August 11, 2008 4:30 pm ET

Executives

DeLise Keim – Vice President, Corporate Communications

Mark Swatek - Chief Executive Officer, Chairman

Cheryl Clary – Chief Financial Officer

Analysts

Heike Doerr – Janny Montgomery Scott

Michael Gaugler – Brean Murray

Presentation

Operator

Welcome to the second quarter 2008 SouthWest Water earnings conference call. (Operator Instructions) At this time I would like to turn the call over to DeLise Keim, Vice President, Corporate Communications.

DeLise Keim

Welcome to SouthWest Water Company's conference call for the second quarter ended June 30, 2008. 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 quarter and then Cheryl will talk in detail about our financial results followed by additional remarks by Mark and an open question and answer period. Before I turn the call over to Mark, I want to make sure you are aware that our discussions today may include forward-looking statements that involve risk 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 2007 Annual Report on Form 10K and other SEC filings under the risk factors sections. A copy of these filings are also available on our website.

Now I'm pleased to introduce the Chief Executive Officer and Chairman of SouthWest Water Company, Mark Swatek.

Mark Swatek

Our net loss this quarter was created by an additional write down of our discontinued operations. We are in the process of selling this wholesale water and lease water business and as negotiations have progressed, we determined that we needed to further reduce the carrying value to our current expected realized value. Continuing operations were probable in the quarter. Company wide, we booked higher revenues in the second quarter but higher expenses led to lower income. The utility business showed improvements over last year but the service business had mixed results.

Utility revenues increased as a result of the interim rate increase in Texas. In the waste water facility we acquired in Alabama at the end of January this year. Our California utility was essentially flat due to reduced consumption. We saw more normal weather patterns as compared to last years second quarter, plus there's a state wide focus on conservation since Governor Swarzenegger's drought declaration in the general economic conditions. These offset small step increase we implemented in July of 2007. Organic customer growth has flattened significantly as a result of the national economic conditions.

Utility operating income improved on the strength of these revenues, but a couple of cost categories caused our expenses to increase slightly as a percentage of revenue. In California, short water supply interruptions caused us to purchase more water from the Metropolitan Water District than this time last year which increased our production costs.

In Texas, we experienced high repair and maintenance costs. It increased depreciation expense associated with the capital improvement that we've implemented to bring this utility into compliance. For the remainder of the year, our rate strategy in Texas will be to continue our negotiations with our customers in our Monarch rate case and hope to reach an agreement before the end of the year. We have reached settlement on one of our smaller rate cases in Texas and will be filing a request for a small rate increase at another Texas utility later this month.

We began billing this year's California step increase of 3% which represents about $1.5 million in annual revenue in July, and we filed our next general rate case there with a requested increase of about $6.8 million in annual revenue. We expect a decision from the California PUC by the end of the year and will implement new rates in January 2009.

The New Mexico Public Regulation Commission accepted our application for a rate rider to cover the increased cost of sewage treatment which we started billing in January. This small increase is being held in escrow until litigation over the 11,000% increase in sewage treatment rates imposed by the Albuquerque Bernalillo County Water Utility Authority is tried and concluded. The commission also indicated support for our proposal to establish a regulatory asset for amounts paid relating to this dispute including legal fees and late penalty payments. Once litigation is decided, we will have the opportunity to request the recovery of these costs by filing a fully supported request for rate surcharge.

As I'm sure you'll recall, our sewage treatment provider is the same entity that has filed for condemnation of our utility there, so clearly these two cases are linked. The waste water fee trial is set for fall of this year, while the condemnation trial is set for April, 2009.

Revenues in the service business were down over last year's second quarter, some of which was caused by general economic trends but some was driven by management decisions over the last year. We made a decision earlier this year to shut down a construction management group in Austin, Texas. In the second quarter of last year, our Texas service business generated a little over $2 million in inner company revenues from these services. Because capital construction is such a bio function of our Texas utility asset management strategy, capital project management was more appropriately brought under the direct control of our Texas utility groups' new management team.

We also discontinued our electrical contracting business in Colorado last year which was a high risk, low margin business. It produced about $900,000 in revenues in the second quarter of last year. Both of these decisions were the right course of action needed to focus our service business on its core capabilities. However, these decisions will affect comparables for the remainder of the year.

Our California and Southeast [inaudible] generated increased revenue from new projects, primarily repair and maintenance projects in work at our Birmingham waste water facilities. However, these gains were offset by contracts lost though our Texas mud business due to new competition and a drop in demand for services related to new home construction as a result of the national housing slow down.

Operating margins in the service business were negatively impacted compared to last year by a number of factors. In Texas, the housing slow down impacted new home related construction service which generates a higher margin as compared to base services. It's an interesting phenomenon in Texas because new home construction continues. However, instead of high density development, it's a four to six units per acre. New home construction densities are now one to three units per acre which significantly reduces the demand for the services we provide.

Also in Texas, we lost about 7% of our contract base to new competition and we're still in the process of right sizing the cost structure of this business.

In California, we incurred high legal and consulting costs associated with the investigation by the California State Water Resources Board into our contract operations of certain waste water treatment facilities during the period of 2004 into 2006. We undertook an intense internal review and third party audit of these allegations during the second quarter, and we met with the Water Resources Board to discuss our findings as well as the corrected compliance actions we had already taken prior to learning of their investigation. Water Resources Board has indicated they'd be willing to consider settling the matter based on improvements in our compliance efforts.

The costs associated with this investigation were partially offset by reversal of the reserve reported in the third quarter of last year as a result of a favorable settlement of a contract dispute associated with a customer system that we operated prior to 2006.

I mentioned on this call last year that we felt the need to improve our focus on compliance. We've hired a senior leader responsible for company wide compliance. Since restructuring our compliance reporting and management, we've seen a significant drop in [inaudible] compliant issues as well as huge improvement in the safety performance across the company.

Our Cornerstone business re-engineering project continues to make significant progress. We went live in January on our new Oracle financial platform for the entire company. This is the first time that SouthWest Water has been on a single consolidated financial accounting system. I'm very pleased with the results.

We are now generating new, expanded management reporting capabilities that provide our managers with the information needed to monitor and improve performance. The information we're able to get out of the system has streamlined our financial reporting process, and it's really enhanced the visibility into our business. As an outcome of this, we now better define which costs are direct versus SG&A and you'll note a significant increase in direct costs, and a decrease in the SG&A costs for this quarter. These changes more appropriately reflect the true cost structure of the operations. It will drive better pricing for goods and services and focus on operating cost management.

We're well on our way to completing the consolidation of our back office functions such as A/P, payroll, accounting and procurement into our financial service center. The center is enabling us to streamline and improve our processes and we continue to reduce our administrative costs as we consolidate these functions.

We are gearing up for the implementation of the other phases of Cornerstone, including customer care and billing, work and asset management and mobile work force management. We'll roll out these new systems location by location in 2009, beginning with our California utility. This roll out will not be fully implemented across our utilities until the end of 2009. As we get parts of the project implemented, we expect to realize savings from increased efficiencies, but most of these savings will be towards the later half of 2009. We anticipate that the system will be implemented across our service business and the project completed by the end of 2010.

And now I'd like to turn the call over to Cheryl Clary, our Chief Financial Officer who will provide detailed information on our financial results..

Cheryl Clary

For the three months ended June 30, 2008 SouthWest Water reported revenues of $57.1 million, operating income of $3.4 million, income from continuing operations of $189,000 or $0.04 per diluted share and net loss of $787,000 or $0.03 per diluted share driven primarily by the write down to net realizable value of our discontinued operations.

This compares with revenues of $54.9 million, operating income of $5.6 million, income from continuing operations of $2.4 million or $0.10 per diluted share and net income of $2.2 million or $0.09 diluted share in the second quarter of 2007. Our weighted average diluted shares outstanding were 24.7 million shares.

Company wide second quarter revenues increased $2.2 million or 4% from prior years' second quarter results. Revenue in the utility business increased by $3.9 million or 17% to $27.5 million from $23.6 million in the second quarter of 2007. This increase was primarily due to a fourth quarter 2007 interim rate increase in Texas and acquisitions from principally the waste water treatment plant in Birmingham, Alabama completed at the end of January 2008.

The services business revenues which includes intersegment revenues from our utility business decreased by $2.3 million to $35.2 million for the quarter, down from $37.5 million in the same period last year. This 6% decrease was primarily due to lost contracts in our mud business, the shut down of our Colorado electrical contracting business at the end of 2007, reduced housing construction revenue due to the housing slow down in both Texas and New Mexico as well as the decision earlier this year to shut down a construction management group in Austin that Mark discussed. These were partially offset by increased revenues in California and Alabama.

Year to date, company wide revenues increased $5.1 million or 5% from the prior year results. For the second quarter 2008, company wide operating income decreased $2.3 million from the same quarter last year. As a percentage of revenues operating income was 6% compared with 10% last year.

Utility business operating income in the second quarter was up 9% to $9.2 million versus $8.4 million for the second quarter in 2007. This increase is primarily due to the higher revenue marginally offset by increased water production costs in California and increased depreciation and repair and maintenance costs in Texas. As a percentage of business revenues, operating income was 33% compared to 36% in 2007.

The services business generated an operating loss of $923,000 compared to operating income of $1.1 million in the second quarter of 2007. Operating margins were impacted by the loss of Texas mud contracts due to increased competition, a slow down in new housing construction, the closure of the Colorado electrical contracting department and a $1.2 million increase in legal fees and other expenses associated with the California State Regulatory Agency investigation Mark discussed. These impacts were partially offset by a $700,000 reversal of an accrual due to a favorable settlement of a contract dispute associated with a facility we operated prior to 2006

Year to date, company wide operating income decreased $3.6 million from prior year results.

Now, looking at company wide expenses for the second quarter of 2008, consolidated SG&A expenses were $9.1 million representing 16% of revenue. Prior year amounts have not been reclassified to conform to the 2008 presentation because the information to do so is not available and the cost to develop it will be excessive, so I don't have a comparable number for you.

Corporate SG&A expenses were $4.9 million compared with $3.8 million in the second quarter of 2007. The increase includes $900,000 of expenses relating to Cornerstone and $600,000 in non recurring consulting costs associated with the establishment of our new financial services center, a centralized function that provides back office financial services across the entire company. These were partially offset by other savings. Year to date SG&A was $18.7 million representing 17% of revenue.

Interest expense for the second quarter increased $157,000 to $2 million from $1.9 million in the same period last year related to increased borrowing on our revolving line of credit principally associated with our Birmingham acquisition and our capital spending. Average borrowing was $188.6 million versus $141.2 million in the second quarter of 2007 and the net effective interest rate came down 5.3% from 6.6% percent last year.

Income from continuing operations for the second quarter decreased $1.5 million to $891,000 or $0.04 per diluted share down from $2.4 million or $0.10 per diluted share in the second quarter of 2007. Income from continuing operations was negatively impacted by $1.6 million in temporary increases in operating expense and associated fees relating to the business process improvement and $1.2 million of cost associated with Legacy legal and compliance issues in our services business and a $1.1 million loss of gross profit margin from the lost contracts and lower housing construction revenue in our Texas market. These were partially offset by increased operating income from our utility business, new business associated with our recent acquisition, the reversal of the legal accrual in the service business due to a favorable settlement of a contract dispute and cost savings in corporate SG&A.

Moving to the balance sheet, our company funded capital expenditures were $7 million during the second quarter compared to $9.6 million in second quarter of last year. The majority of those investments was in regulated utility plant assets in order to continue to provide high quality service to our customers. We also invested $1.7 million in the Cornerstone project.

In 2008 we expect to spend approximately $44 million on company funded CapEx including up to an approximate $14 million in Cornerstone related expenditures. We maintain a $150 million syndicated credit facility which gives us flexibility to finance our growth, handle seasonal cash flow needs and fund our capital expenditures.

In January 2008 we used the line to fund the $23.3 million acquisition of the Riverview Waste Water System in Birmingham. We are looking at alternative financing opportunities for our Alabama utilities but at this time those dollars remain on our mind.

At June 30, 2008 we had $98 million of outstanding borrowings on the line, a third of which is our Alabama utility asset at a weighted average borrowing rate of 3.3%. We have the ability to elect to increase the credit facility up to an additional $75 million during the term of the agreement.

In December 2007, we also obtained a $30 million equipment leasing line of credit to help with the financing of our Cornerstone project. At June 30, we had $4.2 million remaining on this line with a weighted average interest rate of 5.4%. We anticipate moving additional Cornerstone capital expenditures to this line over the next few months which will bring down our line of credit.

As of June 30, we have $29.2 million in working capital, $50 million of total borrowing capacity is available on our $150 million credit facility and $25.4 million available on our Cornerstone leasing facility. We ended the quarter with $180.6 million of debt with debt comprising 55% of total capitalization which is on target with our debt equity ratio of approximately 50/50. Cash on hand at the end of the quarter was $3.9 million.

And with that, I'd like to turn the call back to Mark.

Mark Swatek

It's been a tough and interesting quarter as we responded to both external and internal forces that impacted all aspects of our business. The weather's been good across all of our geographies this quarter but drought awareness and national economic slowdown have combined to hit both organic growth and customer usage.

However, our focus on growing our utility operations is showing results. The new Birmingham acquisition and the strengthened management approach in both operations and rate making have allowed us to effectively respond to these external factors and maintain our utilities profitability. The new management approach to the service business is also showing results by improved regulatory compliance and safety performance, elimination of high risk, low margin service offerings and new contract development efforts.

However, we must also resolve the Legacy issues that this management team inherited and we are doing so professionally, openly and successfully.

We are dealing with impacts of the nationwide economic slowdown where we've seen a significantly lower organic growth across all aspects of our business, and particularly in our businesses that support new home construction. We responded to this by reducing supporting staff, taking work that we would have subcontracted in the past and bringing some of it in house, and eliminating non-critical businesses.

In spite of these tough economic conditions, we continue to invest in strengthening our systems and infrastructure and are completing major upgrades in how the company operates. This will result in a much stronger, streamlined SouthWest Water that will be ready to capitalize on the next wave of growth and unlock the shareholder value that is inherent in this business. We appreciate your patience.

We will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Heike Doerr – Janny Montgomery Scott.

Heike Doerr – Janny Montgomery Scott

Can we maybe start with the contract losses in the Texas market to competitors? Are those muds that you're losing business to? Is that some of the other private water companies that are in the State? Can you maybe expand on that a little bit?

Mark Swatek

Purely and simply as we went through last year and were consolidating our service businesses and keep in mind that we had multiple different businesses operating in the same areas, we consolidated a bunch of businesses together in the Houston area. One of the former executives of one of those businesses had left the firm. He started his own and he took some of his old contracts with him and this represents about 7% of our contract base in the mud business in the Houston area. To be honest, we think we're through that process now and we continue to grow our mud business.

Heike Doerr – Janny Montgomery Scott

As we talk about moving expenses from the SG&A line into the business line, year over year we're going to have an unclean comps going forward. Are you going to disclose anything, maybe an 8K that helps restate 2007 so we can do clean year over year for our modeling purposes?

Cheryl Clary

That's a good question. We went live on our Oracle system in 2008. I think we have a much better reflection of what the SG&A expenses are versus the direct. We talked about it in our 10Q and I think because of our old Legacy system, because we had multiple Legacy systems it's just almost impossible to go back and restate to make them comparative at all, so it'll be hard through the rest of 2008, but I think when you get to 2009, you'll have pretty good numbers to compare 2008.

Heike Doerr – Janny Montgomery Scott

I shudder to think what my modeling is going to be like for the next couple of quarters.

Cheryl Clary

I think if you focus more Heike on the 2008 costs and SG&A costs, which is what I talked about, I think it'll be easier to get there rather than trying to do a comparison with '07.

Heike Doerr – Janny Montgomery Scott

Going forward, are there going to be any publicly stated goals as far as where we think margins are going to land?

Mark Swatek

Not at this time.

Operator

Your next question comes from Michael Gaugler – Brean Murray.

Michael Gaugler – Brean Murray

I was wondering if you could talk a little bit about what you see in terms of the acquisition pipeline. You've knocked down a couple of smaller ones under your belt since you've taken over, and I'm wondering what you're seeing out there and what the better geographic regions are for you at this particular moment.

Mark Swatek

We've got a pipeline with a number of opportunities that we're looking at right now. We still like the geography we're in and we're continuing to look for opportunities. We expect as we are getting valuations that are into the zone of reality from where they had been, we're starting to see some folks realize that the numbers that they were asking for some of these businesses were outrageous, which is good. It puts them to the point where they make more sense for us to do the acquisitions.

The housing slowdown has impacted an awful lot of businesses out there, particularly the smaller water companies that have relied on new housing growth, and I think some folks are starting to get a little tight and are looking for alternate ways to realize their economic dreams. So I think we're going to continue to see some opportunities arise.

The other thing I think is happening is we are getting some more interest on the part of municipalities. Some of the areas that we've been very successful in, we continue to have discussions with other folks so I think there continues to be some opportunity there.

Michael Gaugler – Brean Murray

You see any opportunities to swap assets with other operators? I'm thinking about American now.

Mark Swatek

Those are always good discussions to have and we're not opposed to any of those discussions.

Cheryl Clary

Thank you all for joining us today. A replay of this call will be available shortly on our web site www.swwc.com and this does conclude SouthWest Water Company's second quarter 2008 conference call.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!