California Water Service Group Q3 FY2020 Earnings Call

Ladies and gentlemen, thank you for being here, and welcome to the California Water 2020 Third Quarter Earnings Conference Call. Please note that this call is being recorded. I will now turn the conference over to David Healey, Vice President and Corporate Controller. Thank you, and please proceed, sir.

Thank you, Bridgette. Welcome, everyone, to the 2020 Third Quarter Earnings Results Call for California Water Service Group. With me today is Martin Kropelnicki, our President and CEO; Thomas Smegal, our Vice President and Chief Financial Officer; and Paul Townsley, our Vice President of Business Development and Chief Regulatory Officer. Replay dial-in information for this call can be found in our third quarter earnings release, which was issued earlier today. The replay will be available until February 5, 2021. As a reminder, before we begin, the company has a slide deck to accompany the earnings call this quarter. The slide deck was furnished with an 8-K this morning and is also available at the company's website at www.calwatergroup.com. Before looking at this quarter's results, we'd like to take a few moments 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, Form 10-Q, press releases and other reports filed from time to time with the Securities and Exchange Commission. I'm going to pass it over to Tom to begin.

Thank you, Dave, and good morning, everyone. We've had an exciting quarter at California Water Service Group as we discuss our California General Rate Case and other developments. I will walk through the slide deck and refer to slide numbers during the presentation. I want to start with Slide 6, which details the 2018 California General Rate Case. On October 14, the California Public Utilities Commission released a proposed decision regarding our General Rate Case, which was delayed and should have taken effect on January 1, 2020. This proposed decision approved the settlement announced in October 2019 and supports our positions on certain financial matters in the case. For the first two quarters of the year, we hesitated to record regulatory assets for some balancing account mechanisms, like the WRAM and MCBA decoupling mechanism, due to uncertainty about their recovery. However, we believe the proposed decision makes it very likely we will be awarded those accounts going forward. Therefore, we are now recognizing regulatory assets related to the water revenue adjustment mechanism, modified cost balancing account, and the pension medical cost balancing account, which will significantly boost our revenue for the quarter and year-to-date. Additionally, the commission will provide us with interim rate recovery, allowing us to calculate the figures in the interim rate memorandum account, for which we have also recorded a regulatory asset. I want to highlight a recent event that has bolstered our confidence in the General Rate Case. On Tuesday, the Public Advocates Office issued comments on the proposed decision. While they provided extensive feedback on various matters, they did not dispute our key recovery areas. Hence, we are optimistic that the final decision, expected no earlier than November 19, will permit those balancing accounts. This is positive news for the company. Furthermore, in this rate case, we are refunding to customers the excess deferred tax resulting from the Tax Cuts and Jobs Act, reflected as a reduction in our effective tax rate in our income statement. Consequently, you will notice a lower effective tax rate as we process these refunds. I must emphasize that these assessments carry some risk, relying on the CPUC's approval of the proposed decision with no significant changes. However, based on current evidence, we believe this outcome is likely, prompting us to include these figures in our third quarter earnings results rather than estimates. Moving to Slide 7, as a result of this determination, we have seen a significant increase in our net income for the third quarter, rising from $42.4 million to $96.4 million compared to 2019. Our earnings per share for the third quarter is $1.94, up from $0.88 in the same period last year. On a year-to-date basis, on Slide 8, our net income increased by approximately $30 million, totaling $81.3 million, up from $51.8 million in 2019, which translates to an earnings per share of $1.66, compared to $1.08 last year. As we quickly glance through Slides 9 and 10, you'll see that changes in earnings, revenues, and expenses remain standard, with increases in operating costs for wages and general increases in depreciation and amortization. There are occasional variations in unbilled revenue accruals and mark-to-market adjustments on some retirement plan assets, but these do not represent significant changes this quarter or year-to-date. I want to focus on Slide 11, particularly the earnings bridge, to underline our third quarter earnings. The first bar reflects a $0.80 change attributed to the delayed recording of regulatory assets from the first and second quarters. This amount represents net earnings that could have been achieved in those earlier quarters had the rate case been adopted as scheduled. It is worth noting that we might not achieve the same earnings per share of $1.94 in the third quarter of 2021, although that would be favorable. Turning to Slide 13, as we discuss earnings calculations for analysts and stakeholders, I want to highlight our earnings potential as a predominantly regulated utility across four states, which predominantly drives our revenues and net income. If adopted, the California rate case could yield a net income of around $76 million for test year 2020 based on an authorized equity return on a rate base of $1.5 billion. We also have about $110 million of rate base in other states expected to earn a similar return. However, equity returns depend on our costs aligning with adopted costs, and in New Mexico, Washington, and Hawaii, returns are also impacted by water sales. From 2023 onward, California earnings will also likely be influenced by water sales. Additionally, I want to clarify that we do not expect significant net income fluctuations resulting from changes in our unbilled revenue accruals or unrealized alterations in the value of retirement assets. Through the third quarter, these factors contributed about $9.6 million to our year-to-date net income. As we approach year-end, keep in mind that we expect unbilled revenue to decrease back to 2019 levels. Finally, there are a few other factors that have led to earnings being higher than core regulated earnings, including our unregulated activities, operational maintenance contracts, antenna leases, associated regulatory assets, and state tax timing differences. I wanted to make everyone aware of these factors. I'm happy to take any questions on that topic. Now, I’ll hand it over to Marty to discuss COVID-19.

Great. Thanks, Tom. I want to give everyone a quick operational update with the backdrop of COVID-19. But even with COVID-19, it was the worst fire season in California history. So in addition to COVID, we had to deal with a number of fires and then folding in the public safety power shutdowns that we had throughout the state at various times during the state as well as a couple of earthquakes. It's been a very, very busy year for operations. We've opened our emergency operations center a total of 18 times year-to-date. I think that's a new record for us. The EOC, our emergency operations centers, we basically follow a FEMA-type protocol in terms of how we deal with emergency situations. And very happy to say that despite dealing with a number of potential emergencies throughout the year, the company's operations have gone very, very well, and we avoided having any major disruptions of water service or lack of water service, especially during the fire season. Having said that, we still continue to operate with enhanced safety protocols to protect customers and employees from infections. Protecting employees and customers and public health remains our #1 priority. I'm very happy to share with everyone, and you may have seen this, we received the Stevie Award, the Silver Stevie Award as the most valuable employer for a COVID response. That was out of 700-plus companies competing for a Stevie Award. So we're very happy to win that award for our work on the COVID response and keeping our employees safe. While dealing with the pandemic, we've seen an increase in customer accounts aging from the suspension of collection activities. If you recall, early on in the process, Cal Water suspended our collections and shutoffs, and it was further ordered by the government to do so, but we had done it prior to any orders of the government because we recognize the need for water for our customers to help fight the virus. So our over-90 balances has increased to about $5.4 million. Only a portion of such amounts are typically uncollectible. We continue to monitor that very, very closely. We think it's indicative of the hard financial times as the pandemic has hit people and people have been ordered to shelter in place and maybe been on some type of assistance program and not able to meet their ability to pay their bills. We've increased our reserve for doubtful accounts by about $1.6 million to $2.7 million. So roughly 50% of that balance is reserved for, and we'll continue to monitor that as we move into the fourth quarter. Our incremental expenses dealing with the COVID were less than $100,000 in the third quarter, which we think is good. We do have a memo account in California and also a memo-type account in Hawaii. And as most of you know, a memo account, you expense the cost in the period it's incurred, but you track it kind of off the books. And when it gets to be a certain amount, you potentially have the ability to go back to the commission and seek recovery for those costs as they are incremental to what was planned in the business model. So we continue to track costs in our memo accounts associated with COVID in our operations. Water sales, in aggregate, have been close to the adopted level, so about 95% of adopted sales in California, with the increases in customer usage, obviously, with people being home, using more water, and that was offset by lower business and industrial uses during the quarter. In terms of liquidity, our liquidity remains strong. As of September 30, we had $113 million in cash and additional current capacity of $170 million through our line of credit. So liquidity has remained strong with the company throughout the pandemic, and we're positioned very well going into the fourth quarter. I'm going to turn it over to Paul Townsley now for an update on California regulation.

Thank you, Marty. Moving to the California regulatory update, it has been a very busy year for Cal Water in this area. As Tom pointed out, we received a proposed decision in October, which set a new revenue requirement for Cal Water at $698.7 million for the test year 2020. The proposed decision also authorized $828 million in new capital expenditures over the three years of the rate case cycle. We filed a settlement agreement as part of this rate case, which resolved most issues. However, there were 11 litigated financial items that were not included in this settlement agreement filed with the commission. The administrative law judge sided with Cal Water on all 11 litigated financial items, approving the continuation of the water revenue adjustment mechanism, the sales reconciliation mechanism, and the pension and health care balancing accounts, as well as including an equity component in our AFUDC calculation and approving capital projects for advanced meter infrastructure and water treatment projects in Los Angeles. The commission is expected to make a decision on the proposed ruling at the earliest during its meeting on November 19. I would also like to point out that Cal Water, along with other parties, has filed a request for rehearing regarding the August 27 decision, which prevents us and others from using the WRAM/MCBA starting with our 2021 rate case filing, effective in 2023. This year has been busy, and 2021 will also be active as we plan to file our 2021 rate case and a cost of capital case this coming spring. Our regulatory team will have a lot to coordinate next year. Now, I will turn it back to Marty.

All right. Thanks, Paul. And I'm going to give a quick update on the capital investment program for 2020. Capital investments for the third quarter were $84.7 million, up 16% over the same period last year. Year-to-date, our capital investments are $221.3 million, up 13.5% year-to-date over 2019. The company has previously estimated we'd spend between $260 million and $290 million. We think we're in good shape going into the fourth quarter to achieve our capital investment program goals for this year despite what has been really a challenging operating environment. In addition, we announced on October 13 that we had completed and put into service our Palos Verdes Water Reliability Project, which is the largest project in the company's history, just shy of $100 million project to bring redundancy to the PV peninsula down in Southern California. So it's nice to have that wrapped up. The team did a fantastic job, again, working in difficult operating environments to get that project wrapped up this year. Hot off the press. Yesterday, the CPUC adopted a decision granting Cal Water's request for an additional $700 million of additional financing authority, which is expected to be used to help finance the company's capital program through 2025 or later. So this will allow us to go out and raise an additional $700 million of debt or equity to finance our capital growth program in the next 5 years. So that was good news as well. One of the areas that we've been super busy in, and frankly, we're probably the busiest in business development that we've been probably in the last 20 years with BD. And so Paul is going to give us an update on what's been happening on the business development side, Paul?

Yes, sure. On Slide 17, I have an update for our business development efforts. Cal Water is continuing a very strong new business development process and has had a lot of success this year. Year-to-date, our new development efforts have put over 25,000 new customer connections under contract, representing over a 5% growth in new customer connections across the company's subsidiaries. So far, in 2020, the company has closed on 2 acquisitions: the Rainier View water system in Washington and the Kalaeloa water and sewer system in Hawaii. And we have entered into contracts for acquisitions of the Animas Valley Water Company in New Mexico and the Gunner Ranch sewer system in California, which are both subject to regulatory approval. On the regulatory approval side, we are still undergoing regulatory review on 2 other acquisitions, that being the Kapalua Water and Sewer Company in Hawaii and The Preserve at Millerton water and sewer in California. If you turn to Slide 18, you can see some of the details of those projects that I have just talked about. In summary, our business development efforts are strong, as you can see from this matrix, and our pipeline of potential deals is robust. And I will turn that back over to Tom.

Thanks, Paul. I'll briefly go over our next two slides, which present our CapEx and rate base through bar charts. There's a bit more clarity on these charts compared to the past. As Marty and Paul mentioned, the CapEx approved by the commission is nearing realization. We are targeting a midpoint of $275 million for CapEx, which is very achievable in 2020 based on our progress so far. If you look at the estimated regulated rate base, we've updated this chart to include the proposed decision rate base in California, along with the rate base from other states that I mentioned earlier. We estimate our rate base for 2020 to be around $1.6 billion after the CPUC adopts the proposed decision and the settlement, not including the Palos Verdes pipeline project, which was nearly $100 million. This project is part of our advice letter initiatives, and we expect it to be factored into rates close to the beginning of 2021 or possibly even earlier, depending on the rate case process in California. This will comprise almost two-thirds of the advice letter rate base shown in this chart. I want to stress that the rate bases for 2021 and 2022 in California are subject to an earnings test. We did not have an earnings test this year due to the rate case test year, but every two out of three years we will undergo an earnings test that assesses our progress on capital investments and the effective rate of return before we can get additional rates in California districts. We should have an update on this by the year-end call to see what it might contribute to 2021. What’s presented for 2021 is the authorized rate base assuming we pass all earnings tests. Marty, I’ll hand it over to you for the wrap-up.

Thank you, Tom. First, I want to express my appreciation to Tom and Dave for their hard work over the past few weeks as we finalized the PD and collaborated with our independent registered public accountants, Deloitte & Touche. Both of you and your teams have done an exceptional job, and I know it's required a lot of effort to get everything completed. It's great to have the 2018 general rate case almost finished. While we were disappointed with the delay, it’s nice to have it wrapped up so we can move forward. We're also making progress on our 2021 general rate case, as Paul highlighted. During these last six weeks of what has been an incredibly disruptive year, Cal Water has remained well positioned and continued to execute our business plan, including growth in business development, dividend growth, and capital investment programs. Our safety program has been crucial in allowing us to sustain operations, with 91% of our employees working every day. Most of our field employees have been on the job throughout COVID, adhering to strict protocols to ensure their safety. We believe we are executing effectively and are in a strong position. In a year with limited positive news, I want to highlight a significant achievement. In late September, California’s legislature passed a bill we’ve been advocating for to help address our wildfire liability concerns. Senate Bill 1386, recently signed into law by Governor Newsom, clarifies that fire hydrants connected to public water systems are generally not intended to provide water for extinguishing fires threatening properties not served by a water service provider or for wildfires. Our government affairs team worked diligently with California lawmakers to establish this law, which we view as a critical milestone in differentiating our risk profile from that of the electric and gas utilities in California. This is an important step forward, and I commend the team for their efforts. Bridgette, we can now open the floor for Q&A.

Our first question comes from Ryan Connors with Boenning and Scattergood.

Thank you for the detailed remarks during the quarter. I believe you provided much of the information we were looking for. However, I have a couple of broader questions. First, regarding the overall impact of COVID-19 on the regulatory environment in California, it seems that there hasn't been any effect thus far. You mentioned the approval of the CapEx program and the increased financing capability. Is there any indication of how the economic pressures might influence the cost of capital and return on equity or affect the prudence of investments? Are there signs that regulators might want to slow down investments, similar to what some municipal systems are doing? Or does it appear that everything is proceeding as planned?

I'll start, and then I'll let Paul and Tom jump in as well. I think as of right now, it looks like it's all systems go. I think you're asking a very good question in that with COVID, hotel occupancy rates are down. There's no tourism. No one's going to Disneyland and Southern California. So you're going to have this multiplier effect that certainly affects the municipal systems. But for us that are rate-regulated investors on water systems, I think it's all systems go right now. The big thing that we're watching is really the customer accounts receivable and the aging of those receivables. And when we went through the recession in '08 and '09, the sub-prime crisis, it was interesting. Our bad debt went up, I think, 10 basis points. So clearly, the governor's order to suspend collections has popped up our receivable balances a little bit, but that's really limited to about 60,000 customers so far. So we're looking at that. The other thing I would say, Ryan, is for us, and it's been a difficult operating year, but we haven't stopped our outreach programs. We haven't stopped our philanthropic programs. You may have seen, we doubled our firefighter grants this year. We just did a community EOC exercise, where we had 43 government officials from local and municipal areas that we operate, who participated in a co-run emergency operations center. So we essentially set it up. They may not have the funding to do those exercises, so we'll set it up, and they'll come and participate with us. So we think all those things kind of get into the ESG side of being a utility. And so I think we got to all watch and see what happens. I think for us, with the rate case starting to wrap up, we're positioned well going into 2021. And I'm very happy with the business development work we've been able to continue to work on despite having COVID. Tom, any thoughts?

Maybe I'll let Paul go first. I have some thoughts, but since Paul is closer to the regulatory side, I'll let him take the lead.

Sure. I really agree with what Marty said. The commission is concerned, and they've asked questions of all of their regulated utilities in terms of what are we doing to support our customers during this time of COVID. And we've been able to provide them good answers, many of which Marty just articulated. But I have not seen any evidence of changes in tenor at the California Commission or the other commissions that we do business in, in terms of changes to our business model or the commission's posture on us as a utility.

I wanted to add some optimistic thoughts. I've observed trends that might be temporary, but there's a noticeable movement of people from densely populated areas to more moderately populated areas where they can have their own space. This shift is influenced by the ability to work from home and the ongoing COVID situation. Most of the areas we serve, especially through Cal Water and our other utilities, are primarily suburban rather than urban, with fewer apartment buildings and condos. There seems to be a growing interest in relocating to those suburban communities. Given the varying economic impacts, I believe we will likely see an increase in demand for housing in the communities we serve. It's essential for us to ensure we have the necessary infrastructure and operational capabilities in place to accommodate this rising demand. I just wanted to share that perspective.

Thank you for your insights. I appreciate all of your thoughts on this matter. My next question relates to the issue of decoupling. We hold a slightly different viewpoint on this. We believe that while there may be some increased earnings volatility, it could be contained, and there might even be a positive effect on return on equity. I'm curious about your thoughts, especially in light of what your closest competitor in California mentioned earlier this week. Their comments suggested that while there may be some elevated volatility in earnings, the overall sentiment was that it is manageable and not particularly concerning. My question is, how significant do you think this earnings volatility is? Can you provide any quantification regarding its impact? Understanding this potential increase in earnings volatility is crucial for assessing equity value.

Let me highlight a few important points related to regulatory matters. I've been examining this since we received the proposed decision on the low-income rule over the summer. A crucial aspect for us, if decoupling is removed, is to recall how things were structured before decoupling was put in place. Previously, we were able to recover about 50% of our fixed costs through service charges and the remaining 50% through quantity rates. In many of our districts, especially those with low water costs, the situation is a bit different from what you might be used to. Approximately half of our water comes from pumped groundwater, and in those areas where groundwater is the primary source, there aren’t significant incremental water costs. When we adopted the decoupling mechanism, we aimed to adjust costs into the quantity rate to encourage conservation. This has led to a significant adjustment of our cost recovery toward quantity rates. The volatility we are concerned about mainly occurs in places we serve, such as Bakersfield and Chico, where rates have heavily favored quantity pricing. If we simply charged based on costs, customers might only pay a $40 monthly base rate and $0.10 per unit for water, which wouldn't incentivize conservation and goes against state expectations. Therefore, we need to work in upcoming rate cases to realign the rates, which could impact the conservation incentives for our customers. The most vital consideration is that the volatility we discuss must be symmetrical. It’s essential for us to develop a forecast in the rate case process that the Raker advocate or the commission finds acceptable, providing us with equal opportunities to earn above or below the authorized return each year while allowing us to achieve the authorized return on average. The focus of the rate case will be on adjusting the rate design, particularly in low-cost water areas, and accurately forecasting sales. If we successfully address these two aspects, we can manage volatility and ensure it is symmetrical. I'm sure Paul has additional insights to share.

Thank you, Tom. You expressed that very well, and I want to emphasize a few points. We were a successful utility prior to decoupling, we have continued to be successful during decoupling, and we will remain financially successful after decoupling. One of our major concerns is the decision made by the commission. We believe this decision is wrong because it removes a crucial tool for pricing aimed at water conservation, which is a primary policy goal in our state. If we are unable to charge high users significantly more for water, we lose an essential tool for promoting conservation. Additionally, we believe that low-use customers, who are often from lower-income households, will suffer from this decision as it will mean allocating more of our costs to fixed rates and decreasing the steps between the pricing tiers. As a result, a low-use, potentially low-income customer may face a relatively higher bill than they would have under a decoupled system. We truly believe this decision was incorrect for both state policy and our customers, which is why we have requested a rehearing on this matter.

And our next question comes from the line of Jonathan Reeder with Wells Fargo.

Yes, I appreciate the slide details. Can you discuss how the $0.80 related to Q1 and Q2 breaks down between the 2 quarters? When I was trying to reconcile it, I was getting closer to like $0.85 or $0.86. So I don't know if something kind of shifted a little bit from your previous quarterly reports.

Jonathan, we will provide more details in our 10-Q that we will file later today, and we can discuss it further after you've had a chance to read it. The differences between our estimates for the first two quarters and our current conclusions stem from the finalized rate design that the commission is set to adopt. We incorporate this into our billing system, which may result in variations between interim rates and WRAM/MCBA due to minor changes in how the rates are calculated. Additionally, while it might be a bit technical, we assess the collectability of WRAM amounts over the next 12 months versus future periods. Due to accounting rules, there is a discount applied to WRAM balances not collectible within 12 months, which may also be affecting our figures. We appreciate your patience, Jonathan, and we will help you locate this information in the Q.

Okay. Great. And then regarding the earnings power slide, I guess, if my math is correct, the 2 regulated pieces get you to about $1.60 of EPS, assuming you earn the allowed returns. Is that accurate? And then where do you see your earned ROEs plugging in relative to the allowed?

In the first year of a rate case, we expect to perform well in California regarding the earned return on equity in a regulated environment. We are approaching that target for California and even for other states. Historically, this has been a challenge for us, especially as we increased our investments in Hawaii. However, we have made significant progress in improving the earned rate of return in Hawaii, which is an important part of our non-California assets. From the core regulated business perspective, I believe we are in good shape regarding revenue and expenses relative to the rate case, considering we are only three quarters in. Additionally, there are other factors that I mentioned which could increase net income beyond what we might ordinarily expect for the year.

I'm considering that if we remove the year-to-date impact from the unbilled sales and the unrealized gains and exclude other income, just focusing on the core utility rate base, that brings us to around $1.60, correct?

Yes, I don't have the exact calculation in front of me, but it's roughly that. We could focus on the math. For everyone else listening, the rate base is multiplied by the weighted capital structure in California, where the equity allowed is 53.4% with a return of 9.2%. So you can calculate that based on approximately $1.5 billion of rate base. In other states, the debt-equity ratio is closer to 50-50. However, we typically receive the same authorized return of about 9.2% on the equity side. So whatever that number is, it is.

Okay. And then on the equity program side of your $300 million program, how much should you expect to pull down in 2020? I think you're at like $50 million halfway through the year.

Yes. Dave, do you have that number? I know it's in the Q, and we didn't cover it in the slide deck regarding the additional amount from the equity program in the third quarter. We may need to follow up on that or direct people to where it's listed in the Q.

Yes. I can't remember it right now.

Do you know what the total amount is that you expect to do in 2020 though or...

I think it's slightly under $100 million that we would expect to do. What we found in the program, particularly, there's been some volatility in the market from time to time, and there have been some days where we couldn't trade or couldn't trade very much. We're pretty new to this ATM program, to be honest. And so our objective of getting $300 million over 3 years, we're probably a little shy of that on a 12-month basis as we look at it right now. But that doesn't mean that we can't overachieve in year 2 and year 3 of the program. We're still targeting about $300 million of equity over that time span.

Tom, I was just looking at the Q line. For the first 9 months, it's $58.6 million.

Okay. And there's a little bit more to go in the fourth quarter.

I'm not showing any further questions. I'll now turn the call back over to Marty Kropelnicki for closing remarks. Thank you.

All right. Thanks. Thanks, Bridgette. So obviously, there's a lot of details that come out in our 10-Q that will get filed later today that we'll be around for to answer any questions anyone has. In the meantime, thank you for your continued interest in California Water Service Group. We appreciate your support, especially during these COVID times, and we hope everyone stays safe as we go into the Thanksgiving season. And we'll look forward to talking to everyone at the end of February or early March as we wrap up 2020 and release our financial results for the full year. So thank you. Be safe. And we'll talk to everyone later. Thank you. Bye-bye.

Ladies and gentlemen, that concludes the program. Thank you for participating. Everyone, have a great weekend.