Pinnacle West Capital Corp Q3 FY2022 Earnings Call

Good afternoon, everyone, and welcome to the Pinnacle West Capital Corporation 2022 Third Quarter Earnings Conference Call. It is now my pleasure to hand the call over to your host, Amanda Ho. Amanda, please take it away.

Thank you, Matt. I would like to thank everyone for participating in this conference call and webcast to review our third quarter 2022 earnings, recent developments and operating performance. Our speakers today will be Chairman and CEO, Jeff Guldner; and our CFO, Andrew Cooper. Ted Geisler, APS President; and Jacob Tetlow, Executive Vice President, Operations, are also here with us. First, I need to cover a few details with you. The slides that we will be using are available on our Investor Relations website, along with our earnings release and related information. Today's comments and slides contain forward-looking statements based on current expectations, but actual results may differ materially from expectations. Our third quarter 2022 Form 10-Q was filed this morning. Please refer to that document for forward-looking statements, cautionary language as well as the risk factors and MD&A sections, which identify risks and uncertainties that could cause actual results to differ materially from those contained in our disclosures. A replay of this call will be available shortly on our website for the next 30 days. It will also be available by telephone through November 10, 2022. I will now turn the call over to Jeff.

Thank you, Amanda, and thank you all for joining us today. We continue to execute well on our operating performance and financial management. So as part of my operations update, I'll share with you our success in managing through one of the most challenging summer storm seasons that we've had in recent history. I'll also provide an overview of our rate case filing. And then Andrew will review our financial performance, including an update to our earnings expectations for the year due to higher sales growth and weather. Firstly, and very importantly, I want to recognize our field teams for doing an exceptional job, safely and quickly bringing customers back online after heavy storms swept through different parts of the state this summer. The extreme weather brought on damaging winds, heavy rains and flash flooding, which created a challenging environment where we saw a record number of poles damaged, and that's how we usually measure the intensity of a summer storm season. Typically, during a storm season, we'll see an average of about 300 poles damaged. This year, we replaced over 800. Many teams across the company worked together to restore service from our supply chain teams, getting the necessary supplies, our field crews working day and night, and our employees communicating with customers and making sure that they were kept apprised of the restoration efforts. Our careful long-term planning, resource adequacy, flexibility and innovative customer programs also proved beneficial through the summer. APS reached the third highest peak demand of 7,587 megawatts on July 11, and the temperature on that day was 'only', and I put that in quotes 'only' 115 degrees compared to our typical peak temperatures of 117 degrees or higher. Generally, every degree is worth about 140 megawatts of peak demand. So had we seen 117 degrees, we would have easily set a new record for APS energy demand this year. In addition, in early September, a heat wave hit the Southwest and the region once again saw a lack of available capacity, resulting in 15 declarations of energy emergencies by other utilities across the West. During this period, we served our customers reliably and also helped our neighboring utilities by making off-system sales to the western wholesale market. Those off-system sales directly benefit APS customers by lowering our overall costs while helping to maintain regional grid stability. For our own reliability, our baseload and fast-ramping assets, including Four Corners, Ocotillo and Palo Verde were ready when we needed them. Our nonnuclear generation fleet's equivalent availability factor, EAF, and that's the percentage of time that a generating unit is available and ready to perform when called upon, was 95% from June through September. The Palo Verde generating station's capacity factor for the same time frame was 100.2%. Finally, with the completion of the summer run, Palo Verde 3 safely entered its planned refueling outage on October 8, and we're getting ready to complete that outage in the next few days. I'm also happy to share that APS continues to make quartile gains in every single driver of residential customer satisfaction, and overall satisfaction is above industry benchmarks when compared to the company's large investor-owned peers. Continuing the progress that the company has been making over the last 2 years, APS' J.D. Power residential ranking through the third quarter firmly places the company in the second quartile for residential customer satisfaction. Our strongest performing drivers through the first 3 quarters of 2022 were customer care, both phone and digital; power quality and reliability; corporate citizenship; and billing and payment. Additionally, APS's J.D. Power business customer midyear results puts the company in the first quartile nationally. APS continues to be one of the most improved utilities in the nation for both residential and business customer satisfaction. And we've committed to our customers, shareholders and our regulators that a top focus of improvement for our team will be improving the customer experience. That's been a cornerstone of my strategy as CEO, and I'm incredibly proud of our employees and proud of our progress so far and looking forward to closing out this year strong. Turning to a topic that's certainly top of mind for many of us, the Inflation Reduction Act. While we continue to evaluate the potential of the legislation as the regulations are being written, the tax benefits provide an opportunity to make Arizona a leader in clean investments. A few of the provisions that will benefit APS customers the most include the creation of an 8-year production tax credit for existing nuclear facilities, the inclusion of the EV and EV infrastructure tax credits, new credits for storage and hydrogen, a 10-plus year extension of the clean energy tax credits and a 3-year extension of the existing PTC and ITC. Each of these represents a significant win for customers and for our industries. These incentives will help us to meet our clean energy commitment, and they will help us to enable the clean energy transition without compromising reliability and affordability. For a regulatory update, we filed a rate case on October 28, 2022. The key components of that filing include a requested 10.25% return on equity, a 1% return on a fair value increment, 51.93% equity layer and 12 months post test year plant. We've requested an increase in annual revenue of approximately $460 million, and we proposed that new rates go into effect on December 1, 2023. This is an important rate case. It supports investments in our energy infrastructure to ensure that all customers continue to receive the reliability that they count on and to increase resiliency under all weather conditions. We've made essential investments to maintain the health of the energy grid and to avoid outages. This rate case also helps to ensure that Arizonans have access to the energy they need when they need it as we make a reasonable and affordable transition to a clean energy future. We're securing the energy needs of Arizona without compromising on affordability or reliability. We're balancing investments that optimize existing resources with investments in cost-competitive clean energy generation that will power our state's future. Our filing contains proposals to further support our customers after a lot of work with stakeholders. We're proposing to enhance our limited income bill discount program to provide an additional discount for customers with the greatest need. And we're also proposing to eliminate in-network credit card and in-person kiosk payment fees for all customers. Programs and proposals like this demonstrate our commitment to improve customer satisfaction and make transacting with us more seamless and convenient. Lastly, we heard the commission's request for simplifying our adjustors. In response, we proposed a number of modifications to our suite of adjustment mechanisms. Specifically, we propose reducing the number of adjustment mechanisms from 7 to 4 active adjustors with the elimination of the lost fixed cost recovery mechanism and the environmental improvement surcharge. We also propose to modify our renewable energy surcharge mechanism to allow APS to invest in clean energy projects to support Arizona's growth while reducing the frequency of rate cases and smoothing out the financial impacts of the new projects. With this adjustment mechanism, tax credits from legislation like the IRA can reduce the overall cost of these investments, and we would be able to pass those savings to customers more quickly through an adjustor. Finally, we are not proposing any changes to our current power supply adjustor or transmission cost adjustor. As we look to wrap up 2022, our focus and priorities remain on improving our customer experience, continuing to engage with stakeholders to build alignment and executing on our mission of providing clean, reliable and affordable service to our customers. So I want to thank you all again for your time today, and I'll turn the call over to Andrew.

Thank you, Jeff, and thanks again to everyone for joining us today. I will cover our third quarter results, including the impact from weather. I'll also provide additional details around our customer and sales growth, O&M as well as our expectations for the remainder of 2022. We earned $2.88 per share in the third quarter this year, down $0.12 compared to the third quarter last year but above our original expectation. As has been the case all year, the unfavorable rate case decision is the driver for lower year-over-year results, specifically the reduction to net income from no longer deferring the costs related to the Four Corners SCR and the Ocotillo modernization project. Other negative year-over-year impacts include lower LFCR revenues, higher O&M, higher depreciation and amortization, and higher interest expense. Partial offsets this quarter to these negative drivers were lower income tax expense, continued customer and sales growth, and weather. Weather was a significant benefit this quarter compared to last year. The third quarter of 2021 was extremely mild, resulting in a large negative impact on margin. The third quarter this year was slightly warmer overall than normal, and coupled with higher humidity, resulted in a $0.23 benefit to margins. On customer growth, the third quarter remained in line with our guidance at 2%. In addition, we have experienced strong weather-normalized sales growth all year. The third quarter saw an increase of 1.3%, driven by C&I sales growth of 4.9%, partially offset by a decline in residential usage. We are no longer experiencing increased usage impacts from COVID work-from-home trends. C&I sales growth in 2022 has largely been driven by strong sales among a diverse set of small C&I customers and from ongoing expansion of several large C&I customers. Due to the beneficial weather and strong sales and customer growth, we are updating our full year 2022 earnings guidance to $4.20 to $4.35 per share. I will note that without the weather benefit, we would have expected to be in line with our original guidance as our sales growth would have offset our increase in O&M, which I will talk about later. Turning to the economy here in Arizona. Maricopa County residential housing permits started the year off at a fast pace and are trending to finish 2022 at a level comparable to levels seen in 2020 and 2021 despite macroeconomic risks. We continue to project steady population growth, largely driven by net migration, along with solid APS customer growth. Importantly, our growth is not solely reliant on residential housing or construction as the increase in business segments such as semiconductors, electric vehicle manufacturing, and data centers provide increased diversity in our customer base. In fact, in October, Aligned Data Centers announced an expansion of an additional 2 million square feet over 2 sites. Turning to O&M. We continue to experience cost inflation, which is affecting all areas of the business. Our O&M levels are further impacted by the need to serve the significant growth in our service territory. As a result, we have experienced cost increases in categories, including chemicals, contract services, equipment, and materials. We've been able to mitigate much of these cost increases through our customer affordability and lean efforts. In addition, similar to past years, the increased sales volumes and pension benefits have allowed us to flex up on spending to relieve some of those cost pressures and derisk future O&M spend. As such, we are adjusting our O&M guidance for the year and expect our O&M to fall within the range of $880 million to $895 million. While our total O&M is increasing in the near term, we still expect our O&M per megawatt hour to decline over the long term. We remain focused on O&M, and we continue to look for opportunities to create efficiencies, reduce risk and keep our costs low to maintain affordable rates for our customers. Finally, I will briefly touch upon our liquidity and financial health. As the Federal Reserve continues to raise interest rates to try to combat inflation, we are closely monitoring our financing needs. We continue to maintain a strong balance sheet and a well-funded pension. I would highlight that APS does not have any long-term debt maturities until mid-2024 and limited floating rate debt. A couple of weeks ago, our Board approved a 1.8% increase in our quarterly dividend per share. We grew our dividend for 10 consecutive years and continue that trend this year. We continue to be confident in our plan and intend to grow back into our long-term dividend payout ratio target of 65% to 75% in the future. We are grateful to serve a state that continues to grow and thrive, and the weather tailwind this year will allow us to derisk our O&M expenses while enhancing the financial resources available to provide reliable service. As Jeff mentioned, we will continue to focus on our regulatory outcomes while executing our long-term plan to deliver value for our customers and for our shareholders. This concludes our prepared remarks. I will now turn the call back over to the operator for questions.

Your first question comes from Nick Campanella from Credit Suisse. The next question is from Insoo Kim from Goldman Sachs.

First question on the IRA and just clean energy transition. I know it's a little bit early and we have the regulatory proceeding going. But as you think about the IRA impact on the various generation resources and what you had laid out so far in terms of the all-source RFP through 2027 and beyond, how does this change whether in terms of magnitude or just timing of what you have laid out so far?

Insoo, we've got a current IRP moving forward right now that I think we'll probably just continue. We may be able to see some benefits ultimately in that, but that's largely going to be focused, given where we are on probably PPAs. The real benefit to this, and this is kind of the key that I was trying to emphasize in the commentary, is that if we can use the react, that renewable energy adjustor to pass through the tax benefit concurrently with the investment, it really unlocks value for customers. We can pursue the most advantageous long-term investments for our customers and better mix the owned versus PPA assets. Again, I think the benefit of being able to flow those tax credits and the other incentives through an adjustment mechanism means you're not waiting multiple years to rate cases before you can get that benefit to customers. At the same time, you're smoothing out the rate impact. So it's really the combination of the smoother capital recovery, but also gradualism on the rate impact, and the ability to reflect the tax credit benefits immediately, which will provide long-term benefits to customers. The details of things like the nuclear PTC and other items are still getting worked out in the regulations. But I think we do see some significant benefits. Obviously, it can be in other areas like EV charging infrastructure.

Got it. Okay. And the other question, just in terms of thinking about 2023 earnings power guidance, should we still assume that until the rate case is largely finalized, you guys won't be providing '23 guidance?

Yes. Insoo, it's Andrew. Consistent with our practice in other rate cases, our plan right now is to not provide guidance while we're pending the rate case, though we certainly evaluate both our current year and future year guidance as we go through the year. One of the big things that will influence that decision will be taking a look at the procedural schedule in the case and making a determination at that point about whether we're able to provide guidance for 2023.

Yes. And Insoo, it's really important as we get that procedural guidance to see what we can do. We'll be able to update everybody on Q4 as well as with drivers.

Your next question is coming from Julien Dumoulin-Smith from Bank of America.

This is Dariusz on for Julien. The first question concerns the proposed clean energy, which is not a new rider but a modification to the existing one in the latest rate case filing. Could you discuss how you approached this situation differently compared to the previous rate case, where the proposal faced opposition and was ultimately not approved? What modifications were made and what is your confidence level in receiving support from key stakeholders this time?

Dariusz, it's Ted Geisler here. Happy to address that. We think there are several reasons why this really has an opportunity to create value for our customers. So it's more of an affordability opportunity for customers now than ever before, and that is a big difference between this proposal and the last rate case. A couple of reasons, and Jeff alluded to these. One, with IRA now being able to pass through production tax credits to customers, this mechanism and using the existing renewable energy mechanism really provides an avenue for us to be able to pass on that savings to customers without being able to include those carrying costs for capital investments. There was no way to then pass on those clean credits, and given that we operate in Arizona with some of the best solar radiance on the globe, we expect more production tax credits to be passed on to customers than just about any other area where you can install solar. So a big benefit there, and certainly, those production tax credits didn't exist when we proposed the last mechanism. The other item that's noteworthy is we continue to operate competitive all-source RFPs. Through those RFPs, we see the proposed projects and are able to identify that ownership opportunities provide tremendous value for customers in addition to balancing that with continued long-term PPAs.

And Dariusz, one other point to remember is that the proposal for the infrastructure tracker in the last case was broader. So this is really targeting clean energy investments, which is why it's tied to the renewable energy adjustment mechanism. Again, these are different, and we've seen carrying costs come through to the renewable energy adjustment mechanism before, so it's not a new concept.

Your next question is coming from Shar Pourreza from Guggenheim Partners.

It's Jamieson Ward on for Shar. In last week's rate case filing, you laid out quite clearly the importance of a higher ROE, and you make the case for 10.25%. Today, you reiterated your 5% to 7% EPS CAGR through 2026 off of a $4 base in 2022. Just staying high level and holding all else equal, if the commission maintained your current 8.7% ROE, is the bottom end of the range achievable? Or how should we think about how the ROE kind of plays in there?

Yes. Jamieson, it's Andrew. We look at both the 5% to 7% long-term EPS growth rate range as well as the rate case application, both of which we examine holistically. The 5% to 7% has reasonable regulatory recovery built into it through the whole package of the rate case. It also has our sales growth forecast and our O&M management incorporated. So there are many components, and it's really hard to parse those out, either from a regulatory recovery perspective or the components of that 5% to 7%, which we are, as you said, reiterating this quarter.

Yes. And Jamieson, this is Ted. I'll just add that the proposed ROE has nothing to do with what would be required to achieve some earnings range. It's all based on the expert testimony of Dr. that he concluded through the various models that are run and introduced in the testimony. So it's really based on his evidence that is defining and defending the 10.25% request.

Got you. Yes. No, I get that with the upper end there. I guess what I was wondering was sort of further to the point that you make in your testimony about attracting investment into the state and to the utility. The current level of the ROE that the commission has set, is that something that is sufficient to get you there? If it's not something that you're able to parse out and break out separately, that's fine. I have a second question I can move on to. But just wondered if there was a straightforward answer to it, or if it's not that simple.

No, I think that's a great point. One, we try to make clear in the testimony is that, given the growth we're experiencing, there is significant capital that we need to raise up of the growth. We are very concerned about our ability to do that given the unprecedented low current ROE. Second, we're on negative watch by credit agencies and this rate case and how the commission views a competitive and prudent return on equity is under careful consideration. To the extent that you end up getting further downgraded, that ultimately increases costs for customers. There's an opportunity to preserve our access to capital and mitigate future interest expense as we raise capital to keep up with customer growth, which is all part of why we believe the 10.25% is a more appropriate ROE than the current level.

Got it. That makes sense. I'll move on to my second question here. I appreciate the color. Several other utilities have mentioned that their pension headwinds for 2023 have gotten worse again over the past few months due to market performance. Can you remind us whether your rate case captures the entire year? Or if it will just be up until the June 30 test year? And if it is just half of 2022, does that mean that there's, I guess, 0.5 years of a drag that would carry on until the next rate case? Or how should we think about what's incorporated into the rate case and what would ultimately end up in rates and what isn't?

Yes, Jamieson, thanks for the question. Our pension remains very well funded. Like others, we continue to watch the market and have seen losses this year across most asset classes. Ultimately, from a rate recovery perspective, we are in a split test year at June 30. What's known today is the pension expense from year-end 2021. When we get to the end of the year and we mark our assets to market and know whether there are losses that need to be amortized, we evaluate materiality of those losses. At that point, we'll determine regulatory strategy, but the last rate case serves as an example of how we managed this in a split test year.

Your next question is coming from Sophie Karp from KeyBanc.

My first question is about, I guess, all the puts and takes in the rate case application here. You are proposing a lot of modifications and eliminations of some recovery mechanisms. Can you just maybe give us some rundown on how these changes would impact your ability to reduce your regulatory lag?

Yes. Sophie, Ted here. Really, the intent is to try to be responsive to the feedback we've gotten from commission and stakeholders and simplify the adjustors. When you think about the 7 we have now, eliminating the environmental adjustor and LFCR, sweeping current balances and base rates is a way to simplify that, having fewer adjustments throughout the year. The DSM adjustor largely remains similar to what it has been, although it has to recover some of the fixed costs currently in the LFCR, but that will be combined with other elements of the existing DSM mechanism. The renewable energy mechanism remains larger than it is today, other than expanding it to include carrying costs of new clean investments going forward. As Jeff said, PSA and TCA remain the same, and then TEAM is focused on income tax adjustments. So as a result, it can remain an asset for now. It's a good opportunity for us to simplify the bill, simplify adjustments throughout the year for our customers.

And Sophie, your point on the important change here really is addressing that by using the renewable energy adjustment mechanism to both flow back the tax credits to customers and also to get more investment. This could help keep us from having to file rate cases more rapidly. That's crucial as we have regulatory lag from the recent rate case, so this will be an important adjustor to monitor for more concurrent recovery and to hopefully push out rate case filings.

Well, Sophie, we're in a historical test year environment. The timing of this rate case was able to capture the first half of expenses in 2022. Ultimately, we rely more on our Lean Sigma and internal cost discipline to manage through those challenges. While we can’t really propose pro formas and projections given the jurisdiction we are in, we manage that and drive costs efficiently.

Your next question is coming from David Peters from Wolfe Research.

I'm curious about the election next week. I know it's difficult, if not impossible, to predict. I don't think there's polling data at that level, but could you share your thoughts on what you currently see higher on the ballot? Also, in your experience, does what happens there usually influence the outcomes further down the ballot?

Yes, David, it's a tough one in Arizona, particularly when you've got an election like this where I think most polling is showing pretty close margins in different races. In Arizona, you do see things where people tend to move around the ballot. We've had cases before where we elected a Democratic governor but had Republicans in both Senate seats. Your point is likely the most relevant for the Corporation Commission elections, as there's not a lot of polling done at that level. Our strategy is always to work with all potential candidates to ensure we've met with them and to inform them about our plans and how we see the world because at the end of the day, we need to work with whoever gets elected.

Yes, that makes sense. Another question I had was just on the composition of the O&M increase. Obviously, Andrew, you spoke to inflationary pressures, but there's also a piece required to keep up with the growth you are seeing. You also said you pulled forward some from '23 to derisk future periods. Could you just help parse that out a little?

Sure, David. Yes. As I mentioned, you captured the key factors. We also had historic storms in there. There are many factors driving O&M this year. When we think about the average range we are taking to mitigate some of that cost inflation, it compares actual 2021 O&M to the new '22 guidance range, yielding just over a 2.5% increase year-over-year. Our cost mitigation efforts, along with the growth in the service territory, are allowing us to maintain efficiency as we increase our spending on O&M. There are numerous factors at play, and it is difficult to discern each piece. However, we believe we have successfully blunted the impact of higher O&M. Regarding the capital plan, our CapEx level is the baseline of where we are today. This takes into account that we are signing numerous PPAs to respond to reliability needs and customer growth. This will substantially increase our CapEx. We are fortunate to have the PSA mechanism as a way to recover some of those PPA costs as we navigate this rate case. The numbers currently reflected are our current baseline. We will continue to evaluate the capital plan. The outcome of the rate case will be the best indicator for balancing PPAs and self-built assets and what that means for generation CapEx moving forward.

Your next question is from Paul Patterson from Glenrock Associates.

A lot of questions have been answered. I apologize if I missed this, but regarding the tax adjustment mechanism, I am curious about maintaining it as inactive. How does that interplay with the renewable energy adjustment charge? And I think you mentioned the tax benefits moving through that. Why maintain it as inactive? Or how would the TEAM have worked if it was active regarding the IRA?

Yes, Paul, this is Ted. TEAM was established early to focus on adjustments and income tax levels, primarily to pass on federal tax reform. The opportunity for production tax credits we have in front of us for future solar investments as a result of the IRA is intended to be constant and tied to the production levels of solar that is procured. Our intent is to recover those costs in the production tax credit mechanism. We believe that to be materially different from what TEAM was set up for.

Okay. I think I understand. But why maintain it as inactive? Is it a case of future tax reform?

That's exactly right.

In terms of the renewable energy adjustment charge, you mentioned the benefit in terms of regulatory lag for customers. Would there also be potential regulatory lag reduction benefit for shareholders as well?

Yes. We certainly would expect it to improve inventory lag for our ability to continue to finance these investments. Ultimately, that benefits the company and customers, both in terms of rate gradualism and likely could extend or delay what otherwise would need to be a rate case to recover those costs.

That concludes our Q&A session. Ladies and gentlemen, this concludes today's event. You may disconnect at this time, and have a wonderful day. Thank you for your participation.