H2O America (HTO) Q3 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Q3 2012 SJW Corp.'s Financial Results Conference Call. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I would like to turn the call over to Ms. Suzy Papazian, Corporate Secretary and Attorney. Please proceed.

Thanks, operator. Welcome to the third quarter 2012 financial results conference call for SJW Corp. Presenting today are Richard Roth, Chairman of the Board, President and Chief Executive Officer; and James Lynch, Chief Financial Officer. Before we begin today's presentation, I would like to remind you that yesterday's press release and this presentation may contain forward-looking statements. The statements are only projections and actual results may differ materially. For a discussion of factors that could cause actual results to be different from statements in the release and in this presentation, we'll refer you to the press release and to the most recent Forms 10-K and 10-Q filed with the Securities and Exchange Commission. All forward-looking statements are made as of today, and SJW Corp. disclaims any duty to update or revise such statements. You will have the opportunity to ask questions at the end of the presentation. As a reminder, this webcast will be available until January 28, 2013. You can access the release and the webcast at the corporate website, www.sjwcorp.com. I'll now turn the call over to Rich.

Thank you, Suzy. Welcome, everyone, and thank you for joining us. On the call with me today are Jim Lynch, Chief Financial Officer of SJW Corp.; and Palle Jensen, our Senior Vice President of Regulatory Affairs. As Jim will discuss in greater detail, in this, the third quarter of the last year of our current general rate case, SJW delivered solid results as our flagship utility, San Jose Water Company, continue to control expenses and enjoy a rebound in customer usage resulting from relatively warmer and drier weather. Additionally, we continue to make every reasonable effort to further advance our pending California and Texas general rate cases and our application for proposed improvements to the Montevina water treatment plant. I will provide more detail on these and other regulatory developments later in the call. As San Jose Water Company we remain focused on operating efficiencies through scheduled and authorized capital improvements to our water system, our 2012 $98 million capital budget is nearly 3/4 complete. In other words, on time and on budget. We continue to streamline and optimize SJW Land Company's portfolio of properties completing the sale of our Florida warehouse property and executing a lease for the remainder of our Tennessee warehouse. SJW Land Company's portfolio of properties is now fully leased with high-quality tenants under long-term leases. Also, in spite of below average rainfall in California and the continuing drought in Texas, both operations have adequate water supplies. I will now turn the call over to Jim to provide you with a detailed review and analysis of the third quarter results and other financial commentary. After Jim's remarks, I'll provide additional information on our regulatory filings, water supplies and other key operational and business matters. Jim?

Thank you, Rich and thank you, to our listeners for joining us today on our call. Our 2012 third quarter and year-to-date results reflect an increase in revenue due to higher customer demand and higher rates when compared to 2011. The increase in customer demand was attributable to a continuation of the warmer, drier weather we experienced in the first half of the year in our California service area. This increase is partially offset by lower demand in our Texas service area as more seasonal weather brought some relief to drought conditions in the region. Revenue also includes the impact of a rate increase in California from higher water cost imposed by the our wholesale water supplier, the Santa Clara Valley water district, which went into effect in July. The water district implemented a 9% increase in the wholesale cost of water. The increase comes on the heels of a similar increase imposed in July 2011. As was the case in the second quarter, our third quarter and year-to-date results were also significantly impacted by a lower supply of our surface water in California. Through the first 9 months of 2012, surface water production was 1.8 billion gallons versus 4.4 billion gallons during the first 9 months of 2011. At the end of the quarter, our available storage surface water supply stood at approximately 250 million gallons. By comparison, we used approximately 800 million gallons in the fourth quarter of 2011. As a result of our reduced available surface water and the water district cost increases, we expect to experience higher cost for water production through the remainder of 2012. Revenue for the quarter was $82.4 million, compared to $73.9 million for the third quarter of 2011. The $8.5 million increase included $1.8 million due to higher customer demand, $6.3 million due to rate increases and $406,000 related to new customers. Water production cost for the quarter were $36.6 million, an increase of $4.6 million over the third quarter of 2011. The increase included $2.6 million in higher cost for purchased water and groundwater extraction charges, $1.7 million due to lower surface water supplies and $328,000 due to increased customer demand. Operating expenses, excluding water production costs, were $24.9 million in the quarter compared to $23.4 million in the third quarter of 2011. The $1.5 million increase consisted of $891,000 higher administrative and general expenses, primarily due to higher payroll and benefit cost and recycled water retrofit expenses. And $485,000 in higher depreciation expense related to new utility plant assets placed in service. Non-operating income and expenses included $910,000 gain on sale of a real estate investment we maintained in Florida, which closed in August; an interest expense on long-term and mortgage debt during the quarter of $5.1 million. Net income for the quarter was $10.1 million or $0.53 per diluted earnings per share, compared to $8.2 million or $0.44 diluted earnings per share for the third quarter of 2011. The sale of our Florida property contributed approximately $0.03 to reported diluted earnings per share. Turning now to year-to-date results. Operating revenue increased to $199.1 million in 2012 from $176.6 million in 2011. The $22.5 million increase included $7.6 million, due to higher customer demand, rate increases of $13.6 million and $1.2 million from new customers and new lease revenue from real estate operations. Through the 9 months ended September 30, 2012, residential and business demand was tracking approximately 6% and 3%, respectively, below amounts authorized in our 2010 rate case. Water production costs in the first 9 months were $84.1 million, an increase of $14.4 million over the first 9 months of 2011. The increase included $5.5 million in higher costs for purchased water and groundwater extraction charges, $5.2 million due to lower surface water supplies and $3.8 million due to increased customer demand. Operating expenses, excluding water production costs, were $73.8 million year-to-date compared to $69 million in the first 9 months of 2011. The $4.8 million increase consisted of $2.9 million in higher administrative and general expenses, primarily due to higher payroll and benefit cost and recycled water retrofit expenses. It also included $1.5 million due to higher depreciation expense and $644,000 in higher property and non-income taxes related to new utility plant assets placed in service. The expense increases were partially offset by $322,000 in lower maintenance expenses. Non-operating income and expenses included the Florida property gain on sale discussed previously and interest expense on long-term and mortgage debt year-to-date of $15.2 million. Net income year-to-date was $16.4 million or $0.87 per diluted earnings per share compared to $14.3 million or $0.76 per diluted earnings per share for the 9 months ended September 30, 2011. On our second quarter call, we discussed the California Public Utility Commission's cost of capital decision issued in July that, among other features, established San Jose Water Company's ROE at 9.99%. The decision also included a water cost of capital adjustment mechanism that provides annual adjustments to ROE based upon movements in interest rates. Due to a decline in the adjustment mechanism benchmark, which is the average interest rate of Moody's AA utility bonds, our ROE will adjust down 56 basis points in California to 9.43%. The ROE adjustment will become effective on January 1, 2013. As Rich mentioned, we remain on track to complete our estimated $98 million capital expenditure plan for 2012. Through the 9 months ended September 30, we have completed approximately $71.9 million of the plan and construction is in progress on another $27 million. Total utility plant in operations at the end of the third quarter was approximately $1.2 billion compared with $1.1 billion at the end of 2011. Turning to our Land Company operations. In October, we entered into an agreement to lease the remainder of our Tennessee warehouse building. The lease commences on or about November 1 and is a modified net lease with an initial 5-year, 4 months term and two 3-year renewal options. With the lease signing, all of our Land Company developed properties are now fully leased. With that, I would like to turn the call back over to Rich.

Thank you, Jim. Turning to regulatory matters in our California general rate case, legal briefs from both the San Jose Water Company and the CPUC's Division of Ratepayer Advocates were submitted late July. And on August 7, we submitted a brief which summarize the key elements of evidentiary record in support of the requested $90 million rate increase over the 3-year period, 2013 through 2015. One of the important drivers of the requested rate increase is declining customer usage along with increased operating expenses and a significant capital investment required to replace aging infrastructure and maintain the reliability of our water system. We expect a final Commission decision made in 2012, with new rates become effective on January 1, 2013. In a separate application, pending before the CPUC, San Jose Water Company is seeking approval to upgrade our Montevina water treatment plant to meet increasingly stringent water quality standards. In July, an amended scoping memorandum was issued which reopened the record and requested additional testimony. In response, San Jose Water Company submitted comprehensive testimony on September 24, that, among other things, provided information detailing the economic and environmental benefits of the upgrades. The original Montevina application was filed on September 30, 2010. And a final decision is not expected until late first quarter 2013. In spite of the lengthy regulatory process, we believe the improvements to our Montevina Water Treatment Plant will ultimately be authorized by the CPUC. In Texas, SJWTX's general rate case application, which was filed on August 2010, continues to wind its way through the administrative process. In late August, a separate hearing was held to litigate the issue of rate case expenses. Closing and rebuttal arguments have been submitted to the administrative law judge in the case and a proposed position is expected in December, with the final ruling by TCEQ Commissioners in the first quarter of the 2013. Moving on to water supplies. Following one of the driest winters on record in California, allocations of imported water from the state and federal water projects remained at 65% and 75% of requested amounts, respectively. The Santa Clara Groundwater basin, which is replenished by natural and artificial recharge, remains near capacity. Together, these sources of supply are adequate to meet adequate demand. As always, California's water supplies remain susceptible to multiple consecutive dry years, which is why we are working closely with the Santa Clara Water Valley district and other agencies to develop alternative drought-proof sources of supply, while Bay Delta stakeholders continue to address the complex social, economic and environmental problems associated with this key water resource. While last year's record drought in Texas is still having an impact, SJWTX's robust and diverse water supplies remain a key asset and a competitive advantage essential to our continued growth in Central Texas. I'm very pleased with the progress we have made in SJW Land Company. The recent transactions have enhanced the value of our real estate portfolio and demonstrate our ability to effectively manage our real estate holdings and efficiently utilize our asset base to generate cash flow. In summary, SJW has performed well in the last year of what has been a difficult rate case cycle. We remain keenly focused on controlling expenses in investing intelligently in our water systems. Over the long haul, our growing investments at our water systems could should contribute to sustained growth and profitability, earnings and dividends for our shareholders and reliable high-quality service for our customers. Thank you, all, for your continued interest and investment with SJW. With that, I will turn the call back to the operator for questions.

[Operator Instructions] And our first question comes from the line of Ryan Connors with Janney Montgomery Scott.

So I have just a couple of kind of housekeeping items and then more of a thematic question. So first off, Jim, you mentioned, you explained the reasons behind higher purchased water costs over the balance of 2012. Normally, that line item actually declines on a sequential basis pretty significantly in the fourth quarter, I presume that's based on the seasonality of demand, so I just want to be clear that when you say purchased water cost will be higher, that's on a year-over-year basis and not on a sequential increase?

That's right Ryan. It's on -- a quarter -- if I compare Q4 to Q4 2011, we would expect to have higher water cost as it relates to the unit cost of the water.

Okay, good. And then one thing that I just noticed in the quarter, interest expense dropped pretty significantly and yet you didn't talk about that or called it out. Can you just remind us of what's driving that and what the outlook as on that line item?

Well, included in the interest expenses is the -- that line item, within the press release, has not only our interest expense but other items, one of which is the gain on the sale from the Florida property. So when you take a look at the Q, you're going to see much more consistency on our quarter-to-quarter basis relative to what the actual interest expense.

I see. Okay, that explains it. And then finally I could calculate this but what approximately will be the top line impact of the ROE reduction associated with the AA bonds reset?

Ryan, this is Palle Jensen here. That's a little unclear at this point because we don't have the rates for 2013. So we can't estimate what the revenue impact will be. The return on rate base impact is, it's a reduction from 8 38 to 8 09. So that sort of the impact but I can't give you a revenue number at this point because, as you remember, we're supposed to have an outcome in our rate case by January 1 to which will be applied the new return on rate base number. You got to remember also that the rate case was filed under the return on rate base that was in effect in November of 2011. So there has been 2 reductions since that. So the rate case number is based on a return on rate base of 8 68 and we'll now go into January of 2013 to 8 09.

Okay, that's helpful. And then finally just kind of bigger picture, so just on California in general and, Palle, I guess you're a good person to talk, speak to this, but what's been -- obviously, there's been a lot of moving parts, a lot of new personnel in the commission, some of your peers having some things around collections and so forth, and there's been a lot of movement just in general. What's the company's take on the direction that the PUC is headed and the actions they're taking and reactions to things that have happen? Is your view there constructive or neutral? Just any take you have would be helpful to help us evaluate the environment.

Yes, I still believe the regulatory compact is strong in California. As you know, we have 3 new commissioners that came on under the new -- under Governor Brown and we have 2 commissioners that are sitting from the prior administration. And I think we have only had positive experience with the commissioners so far. As you remember, we had a positive outcome last December when we were able to get recovery of our MCRAM balance and so, my feeling is, for SJW, it has been a fairly positive experience at the commission. It's challenging because of new requirements associated with compliance issues, partly related to issues that have been cropping up because of the PG&E incident. But generally, it's more compliance, complexity than it is the regulatory compact as such that is being challenged.

Your next question comes from the line of Michael Roomberg with Ladenburg Thalmann.

I just wanted to ask your thoughts and understand how the reporting would be impacted if the general rate case is not resolved by year end in terms of -- in a hypothetical words, resolved by the end of the first quarter or thereabouts, would you record revenue on the P&Ls in line with how you've been doing so, thus far? And then essentially, knowing that if there is a delay, you'll be made whole through a retroactive increase, would you then record that as somewhat of a one-time item in the quarter that it is received and then amortized whatever that balance is over the next couple of quarters or so? How does that -- how do those mechanic work in that eventuality?

So Michael, we would continue to record revenue under the same rate structure we're currently on. We have applied for a memorandum account for interim relief for rates, such that once we do get a decision, we're able to capture and apply under the mechanisms currently available for recovery of the amounts within the memorandum account.

Okay, so in the quarter -- again, in the hypothetical that it is delayed, past the 1st of January, would you record that as a kind of a lump sum one-time item that makes you whole for the prior under collection or would it be amortized over the course on the revenue side?

Okay, Michael, what we have applied for is interim -- what is called interim rates, which is allowed under the rate case plan provisions and what that allows us to do is for us to determine any level of interim rates we want from 0 to CPI as of January 1, 2013. What we also have done and which is standard is, requested the memorandum account that will become effective January 1 and that memorandum account will ultimately track any difference between what the commission ultimately decides and what the rates were as of January 1, 2013. So no matter how long the rate case decision may be delayed, the company will be made whole back to yet January 1, 2013.

Right, okay. That, I understood. I was just trying to determine whether or not it would be recorded as a lump sum payment or revenue item in the quarter in which the case is finally determined that would cover that under collection in the prior quarters, if there's a delay. If that's the way that they would make you be whole.

Usually -- I will let, Jim, address the issue about the financial recording of that, but the regulatory recovery will be a surcharge over a time period depending on what the balances in that memorandum account.

And, Michael, once we are allowed to put that-- a balance, once we are allowed to charge our customers for that balance, we get the authorization to do so, that would be when we would record it for financial statement purposes.

Got it. And just moving on to the Land business. Is there any way that you could kind of break out the additional revenue that you expect from this new lease that goes into effect on November 1?

We typically don't do that on a property-by-property basis, but what I can tell you is that when you take a look at the impact of the new leases that we have signed, specifically in Tennessee in the current year, in consideration with the remaining of our portfolio, the Land operations will be accretive to our earnings per share going forward and they currently are accretive when you exclude potential TI improvements to our cash flows.

Got it. And then lastly on the Texas operation, I know there had been a number of kind of small tuck-in type acquisitions that were in the backlog, if you will. Some of which were close, some of it weren't. Can you just kind of update where things stand there? What you've done and what you intend to do over the next year or so?

Sure, Michael. Rich Roth here. We've been adding -- I think, the sort of organic growth in the service area without acquisitions is somewhere between, I think, it's around 30 customers per month. So pretty nice sort of customer growth just from infill and so forth. We're probably not as public on sort of the acquisition front, but we are active. We have several acquisitions pending. They ranged from -- and most of these are on file with the TCEQ where we seek STM sale, transfer and mergers. So we probably average about 1 a quarter. They vary from 50 connections to 200 connections and the backlog there is, I want to say there's probably, I think, one that the board just approved yesterday, which has actually been filed with the TCEQ or will be shortly and then there's one that we're working that's a little larger. So the consolidation of the smaller systems in that Central Texas, Comal County area continues along and I think our customer growth rate down there is anywhere from 3% to 5% a year, if you kind take an average going back several years there. So, continue to see -- actually, there's some new rough tops going in. These multi-phased developments are now getting into the latter stages or latter phases and they're continuing to build out. We also seeing that some higher density projects are coming in the area there as they expanded 281 which is a sort of a parallel corridor to the I-35. It's -- we watched it carefully but all signs are pretty good down there for continuing stream of tuck ins. We don't see anything big on the horizon but we've continued to add systems pretty regularly.

[Operator Instructions] Our next question comes from the line of Michael Gaugler with Brean Capital.

Rich, this question is kind of directed to you. You made some comments earlier in the call about water supply and where that's kind of stands today. What I kind of like to get from you is your thoughts, looking out over the next couple of quarters here with the supply where it is, how concerned are you? And then have you had this level of concern in the recent past with some other droughts we've seen previously?

Sure. It's a really good question, Michael. In the past 3 or 4 years here, since we didn't have WRAM. We were stuck with USIC [ph] we found our major wholesale supplier, the Santa Clara Valley water district continuing to sort of yo-yo on mandatory and voluntary conservation 10% or 15%, and we don't think that's a very good public policy. I think district has realized that too. And so what our concern is, Michael, and it's not just ours but the district, is these multiple dry year scenarios. So if everything is average, we're in pretty good shape. But when you have these multiple dry years then you have -- it impacts the imported water from district as well as our local supplies and the imported water comes from the Bay Delta. So what we're trying to address and what we're trying to work with the district on, is to avoid those multiple dry year scenarios and ergo, not have this sort of yoyo-ing of supply and asking our customers to continually adjust their demand to whatever the weather is. And so we're working with the districts and we think there are several viable supply alternatives for those multiple dry year scenarios. So I'll stop there and say that, yes, it is a concern and as long as the Bay Delta remains unresolved and it's a very complex issue then, ultimately, the supply reliability for this multiple dry years remains an issue.

And no further questions at this time. I will now turn the call back to Mr. Roth for any closing remarks.

Well thank you, everybody and thanks for your patience and forbearance. We have a lot of final decisions that we expect in the fourth quarter and so we hope to have a very substantive and positive call in February when we release our year-end results. And thank you, again for your intention and interest in SJW.

Thank you for your participation in today's conference. This concludes the presentation. Everyone may now disconnect and have a great day.