California Water Service Group Q2 FY2022 Earnings Call

Good morning and welcome to the California Water Service Group Quarter Two, 2022 Earnings Release Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. And finally, I would like to advise all participants that this call is being recorded. Thank you. I'd now like to welcome, David Healey, Vice President and Corporate Controller to begin the conference, over to you.

Thank you, Polly. Welcome everyone to the 2022 second quarter earnings call for California Water Service Group. With me today is Marty Kropelnicki, our President and CEO, and Tom Smegal, our Vice President, Chief Financial Officer. Replay dial-in information for this call can be found in our second quarter earnings release, which was issued earlier today. 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. Welcome to the second quarter earnings release call. I want to start with the financial summary on Slide five and I will discuss some details shortly. To provide the topline, our net income attributable to the Group is $19.5 million or $0.36 per share, which is significantly lower than $38.2 million and $0.75 per share in the second quarter of 2021. For the year-to-date period, we have a similar result, with our net income at $20.6 million or $0.38 per share, compared to $35.2 million or $0.69 per share in the same period of 2021. Moving to Slide seven, we will review some details. The main reason for the change in earnings relates to our unbilled revenue accrual. Having been with the company for 25 years and in management discussing financials for about 12 years, I want to remind everyone about our unbilled revenue accrual. This calculation represents the value of water used by our customers that has not yet been billed and is therefore not part of our regulatory mechanisms. This can fluctuate within the year, and we discuss it every quarter. In the second quarter of 2021, we experienced a significant increase in this accrual, which returned to a normal range by year-end. This year, reflecting that large increase from last year, we are seeing a large decrease in our unbilled revenue accrual, resulting in a $15.2 million change in revenue which significantly impacted earnings per share for the quarter. However, the company's unbilled revenue accrual at year-end is expected to be stable, and management believes it will likely remain within plus or minus $2 million of the previous year. Thus, while there is a significant swing this quarter, we expect all volatility to diminish by year-end, resulting in a normal unbilled revenue accrual. Additionally, this quarter has been affected by a decrease in the measured valuation of our non-qualified plan assets due to market conditions, resulting in a $6.2 million reduction compared to the second quarter of 2021. On a positive note, our general rate increases, including the step rate increase in California and changes in rates in other states, contributed $6.9 million. This is partly offset by changes in wages, depreciation, interest, and other operational and maintenance expenses typically expected due to time and inflation. Our capital expenditures for the quarter and year-to-date are on track and slightly higher than the previous period. I will skip over the bar charts as they largely reflect what I just mentioned, with unbilled revenue being the primary driver along with the market adjustments. Now, I will turn it over to Marty to discuss the California General Rate Case.

Great. Thanks, Tom. Good morning, everyone. Thanks for joining us here today for the second quarter results discussion. The General Rate Case, the 2021 California General Rate Case, California being our largest operating entity has continued, we have concluded on our hearings and briefs have been filed with the administrative law judge. We still anticipate that the GRC to have an effective date of January 1, 2023 and there has been no change in the contested items among the party. Having said that, there is still no major disagreement between the parties over sales and water production that was included in the General Rate Case. Accordingly, we have allowed the administrative law judge that a partial settlement may be filed sometime in August. Tom, do you want to cover the cost of capital, I think you look closer to that one.

Sure, thanks. Thanks, Marty. So very similar story procedurally with respect to our cost of capital proceeding in California, the hearings have concluded, the briefs have been filed and the ALJ has the cost of capital case under consideration. I wanted to remind the investing public that in our filing for cost of capital, we requested a lower cost of debt that had last been adopted in the last case. And if that were adopted along with no other changes to cost of capital, we would expect to see an $11 million reduction to our revenue coming out of California as a result of the lower cost of debt. That's our financing and refinancing program that brought our cost of debt down from 5.51% in the last case to 4.23% on a weighted average basis in this case. And so, we have not taken a reserve for that amount in part, because we don't know the timing, an effective date of the cost of capital case, and in part because there are two other elements to the cost of capital case that are unknown at this time. Those elements are the cost of equity, return on equity, and also the capital structure for the company. And so, investors should be aware that that's out there and the commission could make that retroactive, but we have not yet booked that into our results here in 2022. Marty, I will turn it back to you for drought update.

Great. A couple of things going on with the drought. First and foremost, the drought continues. I think, as we've seen the heat wave, not just in the U.S., but really around the world, it highlights the continued need to focus on supply resiliency and sustainability. California, as we mentioned last quarter, saw the State Water Project deliveries cut to 5%. That has been impacting some of the regions that solely rely on the water from the State. For us, customer usage is down 5% in the second quarter, compared to 2021, but I think the broader trend is the most important. If you look at the water savings number or conservation number year-to-date, it's 2%, it's 5% for the quarter, but if you look at just the month of June, it was over 11%, and that's a good sign that our drought programs and messaging to our customers is starting to take hold, and I would expect that number to grow as we go into the drier summer months, July, August, and September. In terms of drought spending, if you remember, all the State is on a stage of drought alert from the State of California, where we have spent about $400,000 during the quarter that's recorded in a memorandum account, which is incremental cost that has been used to respond to the drought for recovery at a future date, and the total balance that balancing account now since 2021, which is when the government declared the drought, is about $1.2 million. So drought messaging has started to take hold going into the dry summer months and we want to push that number up as high and as close to that 20% target that we have as a state as possible. A couple of other items to watch in the second half of the year: one is capital spending, as Tom mentioned, our capital spending was up 6% year-over-year and while we're very, very happy with that, I want to make sure we're very clear about this as supply chain issues have continued around the globe. We're not immune from those supply chain issues. Our team internally has done an excellent job at mitigating those risks that threaten our ability to get capital in the ground. But the longer those risks continue to go on, the greater the probability of an effect on Cal Water, and so there is some uncertainty as we go into the second half of the year on our ability to get all the capital in the ground if we hit any supply chain issues. As I mentioned, the team has done an excellent job at mitigating those issues, but obviously, it gets harder as these delays and supply chain issues with the procured items we need to get the capital in the ground go on. In addition to that, with the rate case, we don't have regulatory approval on some items yet. So, if you recall the rate case, the way our rate case cycle works, it includes the 2022 capital program. So, as we go through this GRC cycle, we're making some assumptions and we're prioritizing the high-risk capital projects that we think we need to get done as a company that are top of the list in terms of critical, but we don't have assurance of those until the commission actually approves the 2021 General Rate Case. The other thing I'd like to point out is that our bad debt reserves remain high at about $6.7 million, primarily driven by California, and the other states we have started the collection process coming out of the COVID pandemic. In California, we are just starting that process now, it’s a 90-day process to start shutting off people for non-payment. Our first notices actually went out this week to start the process. So prior to this week, collection activities have been zero as we waited for commission approval to start the process. So customer response will be critical. What we've seen in the other states that we operate in is that once we started the collection process, customers started to pay their accounts and so that will be a factor to watch in the second half of the year. Going on to the next page, Slide 13, just a quick update on business development. The business development pipeline remains strong as we go into the second half of the year. On this page is the highlight of projects we've closed, projects that the commissions have recently approved, and projects we've announced during 2022. In total, there are over 3,600 water connections that are in process, as well as over 4,000 wastewater connections. So as we go into the second half of the year, the BD team is very busy and we expect that activity to continue as we move into 2023. Tom, do you want to cover the capital and depreciation?

Sure. And just as a reminder for Slide 14 and 15, we've made no changes to these slides and we wouldn't expect to make changes until we had a significant event coming out of California regulation or any new project that we announced and so you'll see Slide 14, the capital spending targets, shown there, those are relative to the California General Rate Case request, no changes, except for the update on the year-to-date figure, and the same with the rate base, that rate base is relative to the California General Rate Case request plus the rate base in our other states. And Marty, I'll turn it over to you for a summary.

Thanks, Tom. So where are we? In summary, as Tom mentioned, the change in the unbilled for the quarter was a major item, market volatility that we've all seen and lived with throughout 2021 has lowered the unrealized valuation of certain retirement plan assets in our non-qualified plans and those will float up and down based on market condition changes and volatility. The core business remains strong as we await regulatory outcomes in California and for those of you that have been with us a long time, as you know, it's the third year of the rate case process for us. It's always the hardest time of the three-year cycle for Cal Water, the California entity, as we wait for regulatory approval of our General Rate Case. So we have the most amount of regulatory lag at this time and as we wait, all eyes are on the commission as we try to resolve the cost of capital and the 2021 General Rate Case. Management remains focused on the drought, that's a big deal. In California, we're going into the peak summer months, August, September, and October for fire season and obviously mitigating supply chain issues and of course the collection now of receivables for past due for customers who haven't paid their water bill in a while. Between that and focusing on the General Rate Case, it's going to be a very busy second half of 2022 for the company. And of course, closing out, I'd just like to say that the growth opportunities that the BD team worked on have remained strong and I expect that to continue as we go into the second half of the year. So with that, Polly, we will open it up to questions. Polly, you there?

Sorry, apologies. And your first question comes from the line of Ben Kallo and that was from Baird. Your line is now open.

Hey, gentlemen.

Good morning, Ben.

How are you?

Good, how are you?

Good. Tom, regarding the unbilled revenue estimates you mentioned at the start, I have a question about Slide 15. Have you considered providing annual guidance for the full range, especially given the complexities of operating in California?

So we have discussed that internally, we've not come to any conclusions on giving annual guidance. The remainder is of course with Slide 15 that we are a company whose profits are relative to its rate base.

Great.

And so, what we're showing there is the estimated regulated rate base of the corporation in total, including California and the other states and the opportunity to earn a return on investment is what drives a company like ours. So, generally speaking, over time we would hope to earn the authorized return on the investment in rate base and that's generally that was shown on Slide 15.

And that would be the $1.95 for ‘22?

No, sorry, that $1.95 that's $1.95 billion of rate base.

Okay, I understand. Sorry, I was reading that incorrectly. And then Marty, just on your CapEx deployment, are you noted that you guys are on schedule for the year, but obviously all the risks out there, could you just maybe talk through how it's changed since last quarter? I think maybe I asked the same question then, but, if it's gotten better in supply chain or same to same got worse?

Sure. In many ways, the situation has deteriorated, particularly regarding lead times for ordering capital inputs. For example, the lead time for ductile iron has increased from eight to twelve weeks to twenty-six weeks. Considering the number of capital projects we undertake annually and the time required for design, permitting, and procurement, this prolonged procurement process could slow us down. When I say slow us down, I mean it will take longer to get capital projects underway, especially in California, where we operate under a prospective test year. Our objective is to get the approved capital into the ground as efficiently as possible. We're experiencing longer timelines for ordering materials, so the team has started putting in orders earlier and expanding our supplier base. We have also stocked up on items we may not need immediately but anticipate requiring in the next six to twelve months. The team has done a commendable job keeping us on schedule, but we are facing a global supply chain issue that is causing delays, particularly for water main materials. Our aim is to avoid any impact, but the likelihood of achieving that is quite low given the current constraints in the supply chain.

It does. Tom, back to the cost of capital. Obviously, interest rates have changed since you filed, does that have any bearing on the decision or is there a way for you guys to go revisit that or no?

Ben, that's an interesting question regarding the regulatory process. I don't mean to be vague, but the initial data we submitted was from 2020, specifically from the end of that year, as used in the analysts' input models. We did have hearings and briefs where we aimed to highlight to the commission that since those data points were collected, there have been significant changes in the interest rate and market environments. It is up to the commission, the administrative law judge, and the five commissioners to acknowledge this and make decisions that reflect the newer data, although they are not required to do so. One mechanism we’ve had in California for many years is a water cost of capital adjustment mechanism. When evaluating the Moody's AA Utility Bond Curve, if there is a change of more than 100 basis points, it can trigger a change in the return on equity by 50% of that change. For instance, a 100 basis point shift in the Moody's AA Curve would lead to a 50 basis point adjustment in the cost of equity. However, there is a cap, meaning that a shift of 99 basis points would not lead to a change. Based on the current data compared to the baseline Moody's AA, it seems we are close to triggering this adjustment for 2023. If the commission chooses to leave the data as is and implement the cost of capital adjustment mechanism, we could see a potential increase in the authorized return on equity by up to 50 basis points. Yet, it's based on a 12-month weighted average, so it largely depends on the interest rates observed over that timeframe, rather than a single point in time. It appears more likely that this might trigger for 2024, given the current interest rates, but we would need sustained higher rates over several months to activate the weighted average. Overall, we hope the commission will consider the recent data and ensure that companies receive a fair and reasonable return on equity in the current market environment.

Thank you. For my final question, with energy utilities raising rates, I’m curious about how that affects your rate case. Does it play any role in the commission's decisions to raise rates given the increases in other areas? Additionally, how does it affect your rate payers who are contesting your rate case? Thank you.

Let me address this from a mechanical perspective first. Since the 1970s, California has allowed water utility companies to use a tracker mechanism for costs related to power, purchased water, and pump taxes. Therefore, changes in electric power rates do not significantly affect the company's finances as they are essentially passed through. However, from the commission's viewpoint, we are in an interesting and somewhat confusing situation. I have reviewed the brief from the ratepayer advocate in our rate case. Initially, back in January and February when they submitted our testimony, they highlighted the negative impact of the economy and the job losses related to the pandemic. Their recent statements have shifted focus to inflation and the effects of a strong economy on our customer base in California. There is a populism element to consider when dealing with any appointed or elected official representing the public. Overall, electric power costs are not our largest expenses; they are probably around fifth or sixth in terms of impact, compared to costs for purchased water and employee wages. While it is a consideration for the commission during our rate evaluations, we hope the process remains more focused on the mechanics. Marty, feel free to add anything if you'd like.

Yes, I was trying to think back, Tom, at my time here with Cal Water with you, I mean, I've never had a commission not to consider input cost to production, and then to your broader point of, well, if they're raising rates, you can't raise your rates. I've never heard that argument raised by the commission; that's always been input costs into our production. The other thing I would say in terms of just affordability, in general, if you look on Page four, where we have kind of our corporate strategic map. The first thing you see is affordability and so we try to stay very focused on affordability, what it means to our customers encompassing everything that we do, including those power input costs. So when we do our rate case planning and look at where we're driving to for the next three, six, nine, 12 years, we try to take affordability under advisement, and I think that's really kind of paid off for us, because the last part of your question was, you're talking about customers who might be intervening in our rate case, and we have a couple of intervening parties in this current rate case; there are two cities and they've always kind of been involved, but they've been pretty silent the last couple of rate cases. So, we don't have a lot of intervenors kind of hitting us on that side about affordability, and I guess because we've done a pretty good job of trying to balance that with the needs of growing the rate base and the capital needs of the company and the needs to protect and promote water, health, and conservation within the State.

Thank you guys very much. I appreciate it.

Bye, Ben. Have a good day.

And we will pause for any final questions. There are no further questions at this time. I'll turn the call back over to Marty Kropelnicki.

All right. Polly, thank you, everyone, thanks for joining us today. As mentioned, all eyes on the California regulatory activities and fire season and the start-up of the collection process in the state of California and we'll look forward to giving everyone an update when we end Q3 and I guess that will be, Tom, the end of October, will be the next earnings call that we'll update everyone. So, thanks for joining us. Be safe, have a great day and we'll talk to you soon. Thank you.

This concludes today's conference call. You may now disconnect.