California Water Service Group Q4 FY2022 Earnings Call

Ladies and gentlemen, thank you for standing by. And welcome to the California Water Service Group Q4 and Year End 2022 Earnings Call. I would like to turn the call over to Tom Scanlon, Corporate Controller. Please go ahead.

Thank you, Mandy. Welcome, everyone, to the 2022 year and fourth quarter earnings results call for California Water Service Group. With me today is Marty Kropelnicki, our President and CEO; Tom Smegal, our Vice President, Chief Financial Officer; and Greg Milleman, our Vice President of Rates and Regulatory Affairs. Replay dial-in information for this call can be found in our year-end earnings release, which was issued earlier today. The replay will be available until May 1, 2023. 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 yesterday afternoon and is also available at the company's website at www.calwater.com. Before looking at this year's results, we'd like to take a few minutes 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 may 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 risks 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 want to start by pointing out Note 16, in the Form 10-K the company filed yesterday. During the fourth quarter of 2022, the company identified an immaterial error from regulatory liability and corresponding decreases to operating revenue and deferred income taxes that were not recorded in 2019. This is associated with customer refunds. The error does not impact customer billings or cash refunded to customers. The company corrected the error in the financial statements through a restatement of an opening retained earnings balance to the year ended December 31, 2020. For more details, please see the File 10-K. I'm going to pass it over to Tom Smegal.

Thanks, Tom Scanlon, and good morning, everyone. I'm going to discuss our full year and fourth quarter results, starting with page five of the slide deck where our financial results are presented. Our EPS for the year decreased from $1.96 in 2021 to $1.77 in 2022, down by $0.19. Our net income attributable to California Water Service Group dropped by 5.1 million or 5.1%. I want to highlight our capital investments, which rose by $34.6 million to a record $327.8 million in CapEx for the year. On the next page, it's important to note that a significant factor this year was an $11 million negative unrealized change in the valuation of our non-qualified retirement plan assets. This was a major influence on our results. Additionally, this year is the third year in the California General Rate cycle, and as we usually find in the third year, rate increases did not keep pace with rising operating expenses, which was the case in 2022. Moving to the fourth quarter, as shown on Slide seven, we observed that our unbilled revenue rebounded to expected levels, leading to a much better quarter compared to the fourth quarter of 2021. Our EPS for the quarter was $0.35 per share, compared to $0.07 per share in 2021. Net income for the quarter in 2022 was 19.6 million, an increase of 16.1 million. The primary driver behind this improvement was the reversal of unbilled revenue, which increased by 11.1 million, contributing to an overall increase of about $1.7 million in unbilled revenue for the year. It’s typical for us to experience fluctuations in unbilled revenue, usually ranging from a positive or negative million or two that tends to balance out. For the quarter, we also saw higher operating expenses for various reasons, including a minor general rate increase associated with the GRC step increase we implemented at the beginning of 2022. The significant factors affecting the year were the mark-to-market impacts, while the quarter's focus was on the recovery of unbilled revenue. We have several regulatory matters to update you on, and I'm going to turn it over to Greg Milleman to discuss our California cost of capital case.

Thank you, Tom. On Page 11, we discussed the cost of California cost of capital. There's really not much to report since the last quarterly report. There is no new news from the Commission. As of today, the following commission process states that the earliest we could see a final decision would be April of 2023. I'll turn it back to you, Tom Smegal.

Thank you, Greg. Because of the delay in issuing a decision, the company can't determine whether the commission is factoring in changes in market conditions or other reasons for reviewing the cost of capital for this long. So we really can't say where are the cases in terms of the timing, as Greg mentioned, as well as outcome. And as we've been talking about on the third bullet there on Slide 11. Given the success of our financing program, we know that we had a lower cost of debt that was in the application and we don't yet know whether the commission would apply retroactivity to the eventual cost of capital decision. We've seen and we've talked about a few things that lead us to conclude that that is not probable, given the facts and circumstances that we have right now. But if the commission were to go back and reference the beginning of '22, we would expect that the reduction in cost of debt alone would be an $11 million annual negative impact for the company. But that would be recorded in any current period, when we do see a final decision from the commission, if they go retroactive. Greg, turn it back to you for the rate case update.

On Slide 12, is the California general rate case update. As of today, the decision is two months late. There is no new news on when we will see a proposed decision. However, since the decision is late, we have opened interim rate memo accounts that will allow us to track the difference between the current rates and the final rates that come out of the decision, which will be effective January 1, 2023. Additionally, we received approval to increase rates in most of our districts by 4%. That we will commence starting April 15, 2023. Moving on to Slide 13, with a focus on the coupling, it's a reminder that at the start of this year, we are no longer decoupled. There will be annual variability in the sale and production, the water sales revenues as well as the production costs. But we knew that was coming. To mitigate this in our 2021 rate case, we addressed it primarily by shifting more recovery at fixed costs to fixed service charges and using more realistic water mix sources to have a more accurate representation of water production costs.

Great. Thanks, Greg. As we talked about in the last conference call data the third quarter, Governor Newsom signed in California on September 30 a new law asking the CPUC to reconsider decoupling, which was a big win for the water industry in the state of California. Shortly after that law was signed by the Governor, the California Public Utilities Commission filed a motion to dismiss our California Supreme Court case. They said it was null and void based on the new law signed by the Governor. We disagree with that notion. I'm very happy to report that the courts dismissed the CPUC motion to dismiss and so we are moving forward with our case with the California Supreme Court here during the first quarter of 2023. That case has been fully briefed. We anticipate having oral arguments before the State Supreme Court no later than mid-year of this year. So that court case is moving forward. I think all indications are going in the right direction, and we look forward to having our discussion with the courts here sometime over the next quarter or so. Greg, do you want to go through that California tracker status for 2023 of the delayed rate case?

Certainly. Thank you. On Slide 14, you will see various mechanisms or trackers that the Commission allows to track losses in revenues and expenses. These will all become effective January 2023. All but two of them cannot be calculated until the 2021 rate case is finalized, and the component parts and pieces are set by the final commission decision. The first two items, however, the incremental cost balancing account, and the conservation balancing account, we settled with Public Advocates on the component parts of those accounts. Therefore, we're able to calculate those now. The other mechanisms will need to get the final commission decision before we can calculate them, but the mechanisms themselves are not in dispute. I believe it goes to you now, Marty?

Yes, thank you. I want to give a little update on where we are at the drought. Everyone has been following the storms during the first quarter of 2023. It's been a wet and wild winter in California. Having said that, a storm really is a drop in the bucket. We had a lot of rain the first two weeks of the year as an atmospheric river hit the West Coast all up and down the state, which was good news from a water supply perspective, filling up many reservoirs in Northern California. Then we had a very dry February until this week where we got more snow and blizzard-like conditions in the mountains. Groundwater levels respond very slowly to seasonal changes, and one storm really doesn't change things. Snowpack is very healthy right now, well above 100%. But the thing to really watch as we go into the spring is what happens to the snowpack during the month of April. If you remember during April of last year, we lost the majority of our snowpack as it melted quickly when the weather warmed up. That's really driven by climate change. The economics of water in California haven't changed; we still have over 40 million people, and we're the largest agricultural state in the union with a very strong industrial base, making California the fourth largest economy in the world. While we get excited about the storms because we're happy to see the rain, the reality is we're far from out of this situation. Monitoring the snowpack's longevity will become crucial. Conservation efforts continue; our customers did well, shown by a press release we sent out earlier this week detailing that our customers had nine consecutive months of conservation savings. Overall, Q4 2022 showed an 8.2% reduction compared to last year and was 70% below adopted rates. Our drought expenditures for the quarter were about $500,000, reported in a memorandum account. We're allowed to track those. Our total balance in that account is just under $2 million as of now. So, all eyes are on April to see what happens with the snowpack; we hope to get more snow between now and then. However, we must see how long it lasts. The heightened awareness of issues surrounding the Colorado River has significantly increased. While it does not directly affect California Water Service, it does impact some of our wholesalers in Southern California, and we will continue to monitor that. More updates will be shared on the drought as we move into spring. Moving on to Page 16, we want to discuss our capital investment. As Tom stated, the silver lining of what has been a challenging year was our capital investment. We had a revenue record of $328 million of total capital invested, which is very healthy and even better than we anticipated, thanks to the procurement, engineering, and operations teams for their efforts to make that investment. There were significant supply chain challenges during 2022 that we had to overcome to keep that capital flowing. Q4 capital spending increased, given the favorable weather conditions until the year's start. We are seeing more capital invested in our subsidiary companies, which is a very good sign of our business development efforts paying off as we add new service connections across various states. We expect an increase in capital expenditures for non-California utilities in 2023 as well. Again, with our subsidiary companies, we anticipate that capital investments will continue to increase, although not to the size of California in total dollars as a percentage increase; the capital expenditures in our subsidiaries are growing at a very healthy rate. I'll discuss that more in a moment when we cover the business developments.

I just want to do a quick update on our capital investment on Slide 18. We've shown the capital investment for 2022. We continue to achieve CapEx that is three times our depreciation rate. That's now a total of seven years where we've been doing our best-case CapEx. And you'll see that remember, 2023 and 2024 are dependent upon the CPUC decision and direction that we get from the CPUC in California regarding the 2021 general rate case. No changes were necessary on Slide 19; that's our estimated regulated rate base, particularly as it relates to California. We're awaiting a ruling, as we discussed, which would determine the regulated rate basis in 2023 as well as 2024 and 2025. So, Marty, I will turn this back to you.

Great. On Page 24, we are going to wrap up and discuss what to expect during 2023. First and foremost, as we've discussed, there isn't a lot of new news regarding the cost of capital in the general rate case. We are waiting, along with most water utilities in the state of California, regulated by the PUC. This creates some short-term regulatory uncertainty as we wait for the two key decisions. We continue to work with the Commission and will do everything we can to expedite those decisions, but ultimately the ball is in their court. As we approach the end of the first quarter, financial reporting will become more challenging because we are officially decoupled from decoupling, but we don’t have a rate order with mechanisms laid out yet, as Greg mentioned. Like we have in previous years with GRC, we have anticipated mechanisms and trackers that we think we'll be using when approved. We'll provide as much information as possible on both sides of the fence, so to speak, to enable you to see what the numbers are pre and post, based on what we think those trackers will yield. So we ask everyone to please bear with us until we navigate through the two decisions. Once those decisions are made, it will clarify much of this. However, it will be somewhat confusing to make sense of things in the interim, especially as we transition from being decoupled and await the GRC decision, which ultimately approves track structures and costs to capital, etc. We'll continue to focus on regulation. Clearly, we'll also make progress in business development. Our team has been very active, and we have a full pipeline. We'll remain attentive to risk management, including our supply chain issues and climate change issues affecting the company long-term. Over the next few weeks, we’re excited to publish our third ESG report, sharing the progress made in battling climate change and ensuring sustainability for our customers. Lastly, I want to address any potential questions regarding our changes in leadership. You might be wondering who this Tom Scanlon is and what happened to Dave Healy. Dave Healy retired as our Corporate Controller, which was part of a planned retirement. We're fortunate to have Tom Scanlon joining us. He has an undergraduate degree in Finance from Marquette University in Wisconsin, an MBA from the University of Illinois. He is a CPA with a robust background in financial reporting and construction management. He has been our Director of Financial Reporting since 2010, making him part of the succession planning process here at California Water. He is very qualified for this position. Given that construction management is a substantial part of our business, he was a great asset when we added him in 2010. I also want to recognize Justin Skarb, who was promoted to Vice President of Community and Governmental Affairs. He joined California Water in 2009, was promoted to Director in 2017, and officially became an officer of the company effective January 1, alongside Tom Scanlon. Justin holds a BS in Political Science from Arizona State University and a Master's in Communication from Cal State Hayward. He is currently completing his Juris Doctor, expected in 2024. Additionally, we want to welcome Shawn Bunting, who has joined as our Vice President, General Counsel. He will replace Lynn McGhee, who officially retires at the end of this month after 19 years of service with the company. Shawn has an impressive 15 years with American Waterworks, in several senior leadership roles. He holds a Bachelor of Arts in Political and Criminal Justice from Gettysburg College and a Juris Doctor from the University of Pittsburgh Law School. He is also a U.S. Marine Corps veteran. Let's officially welcome Tom, Justin, and Shawn. On behalf of everyone, I want to thank Lynn and Dave for their contributions. We are grateful at California Water to have had such a smart, thoughtful, and creative leadership team. Change is never easy, and we'll miss our colleagues, but we support them in their retirement pursuits. One of the advantages of working with a company like California Water is the excellent benefits and retirement program we offer, allowing employees to enjoy their lives post-retirement. Thank you so much for your service, Lynn and Dave. You will be missed. With that, we want to open it up to questions, please.

The floor is now open for your questions. We have a question from Angie Storozynski from Seaport. Please proceed.

Thank you. I wanted to start with the fact that the decoupling mechanism went away, but you are still under the conservation mandate. So again, I'm just trying to understand where the exposure is, right? Because under the conservation mandate, the sales volume or changes in sales forecasts is not something that should impact your earnings. Again, I'm trying to understand where the sensitivity here is, given that the conservation mandate is still in place.

Sure, Angie. This is Tom Smegal. Greg, if you could fill in when I get to the end of my knowledge here. We do have a filed account – one of the accounts that Greg mentioned, that's called the DRMA, which is the drought revenue memorandum account. That is something for the non-decoupled companies like SJW or some others that’s been in place with them for several years. It allows tracking of lost sales during a declared drought. We are in a declared drought currently; the Governor declared it a couple of years ago. We're tracking the costs associated with that. So, if you're not decoupled, you can track lost revenue and potentially recover that later. It's important to note, this is subject to an earnings haircut, I think a 20 basis point reduction in ROE associated with that. The timing is unknown though, considering we have had such a wet winter. The Governor could declare the drought over, and if that happens, that account will no longer track revenue losses. Greg, do you have anything to add to that?

No, you covered all the relevant points, Tom.

Okay, I understand. Previously, I looked at the fourth-quarter slides from previous years. You had a slide showing simplified math for your earnings. While I know that it's difficult this year, given that you're waiting on at least two major decisions, can you please give us a sense of what the non-California rate base is? How should we think about those other drivers, as you typically have? Yes, well, I know much remains unknown, but at least what would help us estimate our earnings potential for this year?

We don't report in segments. It is somewhat challenging to extract the non-California rate base from our filed documents. We’ve described the company as generating around 90% to 92% of our revenue from California, which similarly holds true for our rate base considerations. Unfortunately, I don’t have the precise numbers in front of me, and we generally don’t disclose them publicly. Some calculations are embedded in that number on Slide 19, which is the rate base. I want to say that this follows the same pattern, with about 90% of that rate base being projected for '23, '24, '25 in California. However, I can't provide more specific details, as the regulations differ per state. In some cases, we have predicted rate bases, while in others, we report on actual rate cases, making it rather complicated. Fortunately, California is clearer because it will be specified in the decision regarding the rate base there.

Okay. Lastly, on the financing side, you've been very active with asset acquisitions. How are you financing those acquisitions, and what was the actual equity ratio at the California utility at the end of 2022?

The response to your first question is that most of these acquisitions, if you refer back to the acquisition slide 17, are relatively minor. We've funded these with corporate cash drawn from retained earnings and the ATM equity program along with our lines of credit. The largest acquisition on that list is probably the Lake Section, which we just announced, and we haven’t paid for it yet. That will come from those funding sources later. Regarding the equity layer at California Water Service Company, I see Tom across the table with me with a calculator. Unfortunately, we don't have that information readily available, but we will calculate that and try to provide it another way. I don't have that information on hand right now.

If I said it's around 50%, would that be accurate?

As of the third quarter, it was trending upwards. One issue in the cost of capital case was determining if the capital structure was appropriate; it was getting close to that 50% range as of the third quarter. Unfortunately, I don’t have the final data for year-end.

Thank you, guys. Thanks.

Our next question comes from the line of Jonathan Reeder from Wells Fargo. Please proceed.

Hey, good morning, gentlemen. I was hoping you could elaborate a little bit on the drivers of this substantial 35% increase in other operating expenses. I think it was about $30 million higher than in '21. Are those items non-recurring, or can we assume that's a good base moving forward?

This is Tom Scanlon. I'll answer that. The increased operational expense predominantly relates to accounting requirements for deferring revenue based on guidance. This involves looking ahead and estimating the collection of receivables; anything over 24 months must be deferred. Each quarter, we re-forecast, reverse, and rebook those accounts accordingly. We also record our conservation expenses in that category. Since we are at the end of our GRC, we have a balancing account in which several programs accelerated during the final year were recorded. Additionally, we experienced an increase in bad debt expense or reserves allocated for uncollectible accounts. Mid-year in 2022, we were allowed to start disconnecting services for non-payment, but many accounts are still under review, making it challenging to execute that process. These factors primarily drove the increase in operational expenses.

Okay, so it appears that a significant portion of that increase has a revenue impact too, right?

That's right, Jonathan, yes.

I don’t know if this is for Marty, but why did the board only go with a 4% dividend increase in '23? I know it had been more like an 8% pace the last three years, and the payout ratio based on what should be normalized EPS is around 50%. Why didn't the dividend grow as quickly as historically?

Good question, Jonathan. We keep our payout ratio within certain bounds. Clearly, there’s uncertainty right now with the pending rate cases and capital structure. We believe one of our primary responsibilities as a company, beyond serving customers, is to ensure we can deploy capital effectively. Given the uncertainty we see at the Commission, we felt it prudent to have a lower dividend increase this year and continue reinvesting in the business. Of course, as conditions change, we will reassess our approach. We've successfully increased dividends every year for over 70 years. We don’t see ourselves changing course in that regard. However, we felt it was a time to be more conservative until we navigate through those two hurdles with the California Public Utilities Commission.

Okay, thanks for that. Lastly, regarding the Lake Section, New Mexico acquisition, can you disclose any details on the purchase price or associated rate base amount there? Do you expect that deal to close in 2023?

We believe that we'll close the deal in 2023. However, we have yet to file with the New Mexico Public Utilities Commission, so we can't discuss the purchase price yet. I can say that we're value-driven buyers, and we aim not to overpay for assets. We assess the cost per connection and the potential for investment to bring those systems up to our standards. While these deals may not be large from a monetary standpoint, they are sizeable to the subsidiaries, growing them significantly. Thus, we think 2023 will provide decent opportunities for business development unless adverse external market changes arise.

Our final question comes from the line of Davis Sunderland from Baird. Please proceed.

I wanted to inquire about visibility into the current supply chain environment. You mentioned it could have a greater impact last quarter than this quarter. It seems you've managed to overcome some challenges, but I wanted to ask specifically about lead times for lead piping or any other significant materials. Do you think these factors will impact your capital investment this year?

Certainly. I think I've got 'supply chain' tattooed on my arm; it's been a major focus for me along with the procurement and engineering teams over the past two years. We aren't purchasing any lead pipe, just to be clear. We've noticed significant changes in lead times for ductile iron, PVC, etc. These challenges seem to have peaked in Q3 to Q4. For ductile iron, lead times have extended from four to six weeks initially to as much as a year now. This situation arises from suppliers being unable to ramp up production quickly; they try to balance supply and demand while managing tight margins. However, suppliers are increasing production, which should alleviate some delays in the near future. Our consistent purchasing has also bolstered our relationships with vendors, ensuring we get prioritized service. It appears we've reached a peak, and things are starting to improve. While price increases are likely due to inflationary pressures, we're managing that situation. So barring any major global disruptions, I believe we’re on the downtrend of this issue, and things will begin to stabilize.

Thank you; that is helpful. For my follow-up, I’d like to hear more about the business development project pipeline. It's exciting to hear about New Mexico. Can you share anything specific about your focus, such as attractive geographies or priorities in terms of water versus wastewater?

Certainly, excellent question. Looking at a broader view, we've successfully closed deals in all five states, including Texas. The market remains decent, and our pipeline continues to fill up. Seller and buyer expectations do pose challenges, but we're engaging in both water and wastewater transactions. Texas has seen more wastewater collaborations, whereas California and Washington focus more on water systems. We’re keen on ensuring value in each acquisition; we won’t overpay for a system without room for investment. Thus, we're seeing active business development, and we expect '23 to follow suit, barring significant external economic setbacks. While most deals are smaller in scale, they hold substantial value in driving growth for our subsidiaries anyway.

I would now like to turn the call over to Martin Kropelnicki for closing remarks.

Thanks, Mandy. As we move into the first quarter, all eyes are on the California Public Utilities Commission to resolve the cost of capital and finalize a proposed decision, hopefully within 2023. We’re also closely monitoring the Supreme Court case regarding decoupling and, importantly, the snowpack, as its outcome will greatly influence our drought responses. Thank you for joining us for another year-end conference call. We appreciate everyone's support, and we look forward to updating everyone at the end of the first quarter at the end of April. Thank you very much. Have a great day.

Thank you, ladies and gentlemen. This does conclude today's call. Thanks for your participation. You may now disconnect.