Southwest Gas Holdings, Inc. (SWX) Q4 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Southwest Gas 2014 Year-end Earnings Call. My name is Mark, and I'll be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I would now like to turn the conference over to Ken Kenny, Vice President of Finance and Treasurer. Please proceed, sir.

Thank you, Mark. Welcome to Southwest Gas Corporation 2014 Earnings Conference Call. As Mark stated, my name is Ken Kenny, and I am Vice President, Finance and Treasurer. Our conference call is being broadcast live over the Internet. For those of you who would like to access the webcast, please visit our website at www.swgas.com, and click on the conference call link. We will have slides on the Internet, which can be accessed to follow our presentation. Today, we have Mr. Jeffrey W. Shaw, Southwest Chief Executive Officer; Mr. John P. Hester, President; and Mr. Roy R. Centrella, Senior Vice President and Chief Financial Officer; and other members of senior management to provide a brief overview of 2014 earnings and an outlook for 2015. Our general practice is not to provide earnings projections. Therefore, no attempt will be made to project earnings for 2015. Rather, the company will address those factors that may impact this coming year's earnings. Further, our lawyers have asked me to remind you that some of the information that will be discussed contains forward-looking statements. These statements are based on management's assumptions, which may or may not come true, and you should refer to the language in the press release, our SEC filings and also Slide #2 presented today for a description of the factors that may cause actual results to differ from our forward-looking statements. All forward-looking statements are made as of today, and we assume no obligation to update any such statement. With that said, I'd like to turn the time over to Jeff.

Hello, and welcome to our 2014 year-end earnings call. Appreciate your participation. I'd like to just, on Slide 3, touch upon some 2014 highlights. First of all, from a consolidated results standpoint, we achieved our second-highest earnings per share number, $3.04 per share, and we increased the dividend for the ninth straight year by 11%. With respect to the natural gas segment, we realized almost $117 million of net income. We added approximately 26,000 customers. We successfully concluded 2 general rate cases. We invested $350 million in our distribution system, and we received approval in Arizona to construct an LNG facility for purposes of reliability. In our Construction Services segment, we contributed a record $24.3 million of net income. We've completed a successful acquisition of the Link-Line Group of Companies, and we're continuing successfully to integrate the Link-Line Group of Companies with NBL -- NPL and have now combined them under the holding company, Centuri Construction Group. Slide 4, please. A few comments about CEO succession. As you know from public disclosures, I will be stepping down effective Monday. John Hester was voted by the board in a board meeting this week to be the President and CEO on Monday, March 1. We have a very robust succession plan, not only at the CEO level, but we also have it for all significant positions of the company. I think we are very proud of the way that we have proceeded in making this transition. And I think the table is set for John and the team, and most the team, by the way, are the same team I've had the good fortune of having surrounding me. Most of that team is in place, and they will continue to go forward, I think, with a real opportunity to continue to bring shareholder value, both in the gas segment of the business and also in the Construction Services segment of the business. So with that, I'd like to turn the balance of the call, at least for directing the call, over to John. And then we would be pleased to field any questions that you may have at the end of the call. John?

Thank you, Jeff. We all appreciate working with you as a team to advance the collective interest of our shareholders, our customers, and our employees over the past 20 years plus. You, as CEO, have overseen and orchestrated an unprecedented decade of rewarding returns for our shareholders, and we are enthusiastic about continuing that trend in the years to come. On behalf of Roy, Ken, me and the rest of the team, we wish you and Cynthia all the best in the years to come. Turning to the detail of our call outlined on Page 5. Roy will provide an update on our 2014 consolidated earnings, Natural Gas Operations and Centuri Construction Group, after which I will provide an update on regulation, customer growth and economic conditions in our service territories, our plan for capital expenditures, our dividend growth and our 2015 expectations and focus. As Jeff mentioned, our prepared comments will be followed by an opportunity to ask questions. With that, I will turn the call over to Roy.

Thank you, John, and let me also offer my congratulations, Jeff, on a highly successful career. So I'll provide a summary of the 2014 operating results, recapping the primary factors that impacted the change from 2013, and I'll give some commentary along the way around the 2015 expectation. So let's move to the slides, Slide 6. Consolidated net income decreased from $145 million in 2013 to $141 million in 2014. As a result, basic earnings per share decreased from $3.14 to $3.04, which is our second-highest earnings year in history. Our Construction Services segment showed strong improvement between years, while gas segment results declined. Lower but solid returns on our investments underlying company-owned life insurance or COLI policies was the primary reason for the gas segment decline. Let's move to Slide 7 and natural gas segment highlights. Jeff touched on most of these items earlier. So I'll just comment that operating margin increased 1.5% as a result of customer growth and rate relief, and also, we had a number of successes on the regulatory front, which John will highlight later on. Slide 8. This slide summarizes the gas segment income statement. Operating margin increased by $13 million between 2014 and 2013, while operating expenses increased just $11 million or 1.7%. As a result, we saw slight operating income improvement of $1.8 million between years. Other income, which includes COLI, decreased $5.1 million between years, and net interest deductions grew by $5.7 million due to a financing we did in late 2013. Net result was a $7 million decrease in the gas segment contribution to net income from $124 million in 2013 to $117 million in 2014. Moving to Slide 9. This slide summarizes the change in operating margin between years. Rate relief contributed $8 million in incremental operating margin, most of which was attributed to California. Customer growth also contributed $8 million as the company increased its customer count by 26,000 or 1.4%. The other margin decrease resulted from customers outside the company's margin tracking mechanism and is not something we would view as a trend. For 2015, we expect an overall operating margin increase of nearly 2%. This will be driven by customer growth similar to 2014, California and Paiute rate relief and margin from our infrastructure tracking mechanisms. Slides 10 and 11 relate to our operating expenses. Operating expenses increased $10.8 million or 1.7% between 2013 and '14, which was a little better than our previously provided projections of 2% to 3%. There were several main factors influencing these favorable results. O&M expense actually declined by 1% due to a reduction in pension expense and favorable medical claims experience for which we are self-insured. Depreciation expense increased 5% and general taxes 4%, as a result of a 6% ramp-up in gas plant. The depreciation change partially reflected a $3 million annualized reduction approved as part of the general rate case in California. Looking ahead. Pension expense will be significantly higher in 2015 due to our required adoption of a new mortality table. As a result, we forecast overall operating expenses to increase in the 3% to 4% range. Moving to Slide 11. The mitigating factor to operating cost increases comes from productivity improvements. One measure of that is the customer-to-employee ratio, which improved from 858 employees per customer to 879 between 2013 and 2014, an increase of 2.4%. This has been a long-term focus of ours as we have embraced technology and process changes to help manage our headcount. Slide 12. Other income declined from $12.3 million to $7.2 million between years as 2014 returns on investments underlying our COLI policies, while strong, were $7 million less than 2013's. Miscellaneous income increased by $1.9 million, mainly due to interest received on PGA balances. Now with regards to COLI, we think returns in the range of $3 million to $5 million would represent a normal level, but these returns are influenced by market forces and therefore are subject to volatility. On the next slide, we look at financing activity. Net financing costs increased by $5.7 million between years. This resulted primarily from a $250 million 4.875% note, which was issued in October 2013 to finance capital expenditures. For 2015, we anticipate net interest deductions will approximate the $68 million recorded in 2014. Next, we'll turn our attention to the Construction Services segment, starting on Slide 14. First, some highlights. Our Construction Services segment had a very strong year in 2014. With the acquisition of the Link-Line Group of Companies effective October 1, 2014, they are now referred to collectively as Centuri Construction Group. Revenues increased 14% to $750 million -- $740 million, while construction expenses increased 13% over the prior year. NPL's contribution to net income increased $3.1 million to a record $24.3 million. Slide 15 provides a snapshot of the NPL -- or Centuri income statement over the last 3 years. The trend line for all significant line items is very favorable and reflects solid organic growth as well as 1 quarter's results from the acquired companies. We'll walk through the line item changes, starting with revenues on Slide 16. Construction revenues increased from $651 million in 2013 to $740 million in 2014, an improvement of $89 million or 14%. Acquired companies' revenue accounted for $54 million of the revenue increase, while growth of replacement work from existing NPL customers was responsible for the remaining $35 million. This acquisition significantly expands our Construction Services operating base. For 2015, we estimate operating revenues for Centuri will range from $950 million to $1 billion. Moving to Slide 17. Construction expenses increased by $75 million or 13%. Acquired company construction costs totaled $49 million, and costs associated with additional pipe replacement work and legacy NPL accounted for the remaining $26 million. Also contained within the construction expense increase were $9.5 million of higher G&A costs. $3.7 million of that increase was attributable to operations at the acquired companies, while onetime acquisition costs totaled $5 million. Also note that the depreciation expense increase of $5.9 million included $1.5 million resulting from the amortization of finite-lived intangible assets recognized from the acquisition. Such amortizations, albeit at a lower annual run rate, will continue for many years. With that, let me turn the time back over to John Hester.

Thanks, Roy. Moving to Slide 18 and regulation. I'd like to provide an update on our general rate case activity in our California, Paiute Pipeline and Arizona jurisdictions, followed by an update on our Arizona and Nevada infrastructure mechanisms and finally, a report on our Arizona LNG and Paiute, Elko lateral projects. Turning to Slide 19. We received a decision on our most recent California general rate case application in June of last year. The decision provided for an increase in 2014 future test year margin of $7.1 million, along with a decrease in depreciation expense of $3.1 million. We are on a 5-year rate case cycle in California, and the general rate case decision further provided for annual post-test year attrition margin increases of 2.75% per year for years 2015 through 2018. Southwest Gas made a filing in November of last year requesting a $2.5 million margin increase for 2015 under the annual attrition provision. The request was approved by the California Public Utilities Commission in December of 2014, and new rates became effective at the beginning of this year. On Slide 20, we provide some detail on our most recent Paiute Pipeline general rate case resolution. Recall that this case was originally filed in February of last year under a filing requirement included in Paiute's prior rate case settlement. While Paiute originally requested a $9 million revenue increase in its application, a settlement was reached this past September which will provide a $2.4 million revenue increase, along with a $1.3 million reduction in depreciation expense. The new rates were effective this past September. Also noteworthy in the latest settlement was an agreement for Paiute's largest customers to extend their transportation contracts by an additional 5 years. The Federal Energy Regulatory Commission officially approved the rate case settlement earlier this month. Under a provision in this latest settlement agreement, Paiute is now obligated to file its next general rate case no earlier than May of 2016 and no later than May of 2019. Turning to Slide 21. In Arizona, we are now likely officially into the historic test year for our next Arizona rate case. Recall that in our last decision that provided for new rates effective January 2012, we had several provisions governing the timing of our next general rate case filing. Specifically, those conditions require that our next application be submitted no earlier than April 30, 2016. Furthermore, that filing may use a test year ended no sooner than November 30, 2015. As was the case with our recent filings in other jurisdictions, we will be looking to revisit our currently effective depreciation rates. When all is said and done, rates from the upcoming application may be effective no earlier than May 1, 2017. Moving to Slide 22 for an update on our various infrastructure mechanisms. Our Arizona customer-owned yard line program continues to proceed smoothly as we look to chip away at the 100,000-or-so Arizona customers that have this service configuration. The program was approved as part of our last Arizona rate case decision and provided that Southwest endeavor to survey 1/3 of this population of customers per year and offer to provide utility facilities to replace customer facilities if they were found to be leaking. We subsequently asked the commission to provide us authority to replace customer facilities that may not be leaking in a Phase 2 program. The commission approved the Phase 2 program expansion in January of last year. The commission authorized a surcharge in June of last year to collect annualized revenues of $1.5 million, and we anticipate submitting a filing to update that surcharge later today, with mid-year 2015 effectiveness expected. In Nevada, Southwest continues to partner with its Nevada regulators in the interest of pipeline safety with proactive pipe replacement proposals and our gas infrastructure recovery mechanism. The Public Utilities Commission of Nevada originally approved regulations supporting these safety-oriented interests in January 2014. Pursuant to these regulations, in 2014, the Nevada commission approved $14.4 million of early vintage plastic pipe replacement to be completed in 2015. Separately, Southwest submitted a gas infrastructure rate application last year and was authorized to institute a surcharge effective January of this year to collect $2 million annually. Proposals for a 2016 pipe replacement program and an updated recovery surcharge will be made later this year. Turning to an overview of our Arizona LNG proposal on Slide 23. Southwest submitted an application with the Arizona Corporation Commission in January of last year seeking preapproval to construct a $55 million liquefied natural gas storage facility in southern Arizona. The idea was prompted by Southwest's experience with customer outage several years ago that resulted from an upstream interstate pipeline supply disruption occurring due to severe weather. Late last year, the ACC preapproved the project and included a provision to defer project costs up to $50 million through November 1, 2017. Any gas costs associated with the facility will be recovered through the current purchased gas adjustment mechanism. Construction of the facility is expected to take 24 to 30 months. Closing out our regulatory overview with Slide 24. Our proposed 35-mile -- $35 million Paiute lateral to interconnect Paiute with Ruby Pipeline and increase gas supply deliverability to Elko, Nevada remains on track. Recall that an open season was conducted in 2013 confirming sufficient customer interest in the project. A certificate application for the lateral was then filed in June of last year. Earlier this month, we received a preliminary favorable environmental assessment from the FERC that stated that "approval of the proposed project with appropriate mitigating measures would not constitute a major federal action significantly affecting the quality of the human environment." A final FERC order approving the project is anticipated in the next few months, which should facilitate a desired in-service date in November of this year. Moving to our update on customer growth and regional economic conditions on Slide 25. You can see that our service territories have experienced meaningful customer growth over the past several years with 26,000 customers being added in 2014. For 2015, we generally expect net customer growth of approximately 1.5%. Slide 26 illustrates broader employment trends across our service territories with each of our states experiencing gradually declining unemployment rates over the past few years. Conversely, Slide 27 provides further detail on employment growth metrics. As the table illustrates, each of our states observed improving year-on-year job growth in 2014 compared to 2013. The impact of our customer growth and pipe replacement efforts can be seen on Slide 28. This slide shows that our gas utility plant has grown at a compounded annual growth rate of 5.2% over the past few years. Slide 29 shows our past and projected capital expenditures. 2015 capital expenditures are expected to total $445 million, and Southwest continues to invest in facilities to serve customer growth and increase pipeline safety, along with funding major projects like the Elko lateral and the Arizona LNG plant. Over the coming 3-year period, capital expenditures are projected to total $1.3 billion. Slide 30 provides a more detailed breakdown of 2015 capital expenditures. From a policy perspective, we think the tracking mechanisms addressing pipe replacement have worked well for both customers and shareholders, and we anticipate growing importance of these mechanisms in the years to come. Again, our 3-year projection of capital expenditures beginning 2015 are estimated at $1.3 billion. Turning to Slide 31 and dividend growth. We were happy to announce that a $0.16 increase in our annual dividend was approved by our Board of Directors earlier this week. The increase represents another double-digit percentage increase in the dividend and is a larger increase than authorized last year, bringing the total annual dividend to $1.62. As we previously indicated, our dividend policy is to increase our dividend such that our payout ratio approaches our local distribution company peer group average, while maintaining our strong credit ratings and ability to fund future rate-based growth. Moving to Slide 32 and 2015 expectations. As Roy indicated, we expect our 2015 Construction Services revenues to range between $950 million and $1 billion, with operating income anticipated at 6% of that amount. Net interest deductions for this business segment are estimated between $6.5 million and $7.5 million. Collective expectations are considering noncontrolling interests of 3.4% retained by the sellers of the Link-Line Group of Companies. Also, please keep in mind that foreign exchange and interest rates can impact Construction Services segment results. Turning to Slide 33 for 2015 expectations regarding Natural Gas Operations. As previously mentioned, we anticipate 2015 customer growth of 1.5%. Operating margin is expected to grow by 2%. We expect operating costs to increase by 3% to 4%, which includes a 2015 pension expense increase of $8 million to reflect revised mortality tables, as Roy indicated earlier. Company-owned life insurance returns are projected to range from $3 million to $5 million annually depending on broader market returns. And finally, as we also previously mentioned, we currently expect 2015 capital expenditures to total $445 million, including expenditures associated with our Paiute, Elko lateral and Arizona LNG project. Wrapping up with Slide 34. Our strategic focus will continue to rely on the principles that have made us successful and rewarded customers and shareholders alike. We'll take a long-term business view and look to continue our established track record of effective execution. We will adhere to our core value of integrity in our relationships with customers, shareholders, employees and regulators. We will efficiently deploy capital that increases the safety and reliability of our gas distribution systems. We will continue to work with our regulators to ensure timely recovery of our cost of service. We will seek to capitalize on profitable growth opportunities in both our regulated and unregulated business segments. We will maintain a financially strong company as indicated by our solid capital structure and credit ratings, and we will continue to review the level of our dividend as an important component of our shareholders' total return. With that, I'll turn the call back to Ken.

Thanks, John. That concludes our prepared presentation. For those of you who have accessed our slides, we have also provided an appendix to the slides, which includes other pertinent information about Southwest Gas and can be reviewed at your convenience. Our operator, Mark, will now explain the process for asking questions. Mark?

[Operator Instructions] Your first question comes from the line of Matt Tucker from KeyBanc Capital Markets.

Congratulations on a great 2014 and to Jeff and John. By the way, it's actually Grier Buchanan on for Matt. First, I wanted to ask about the construction business. We saw that Enbridge's LDC has a roughly $700 million expansion project. I think it's currently underway in the greater Toronto area. Is Link-Line -- or should I say, Centuri getting any of that contracting work?

They're not directly involved in that. I mean, Enbridge is their largest customer, but their -- they have a set contract with them for -- in a certain -- in their -- within their certificated area that they've been assigned value to, but not necessarily on that expansion project.

Okay. And could you give a little color on, historically, maybe the proportion of distribution work they've -- of Enbridge's distribution work they've gotten, I guess, as a percent of total contracting spend?

Given that we only have a quarter's worth of data, I don't want to really go back into the prior period where we just -- even though we have some history, it's probably less reliable than what we would see going forward. And so I think we'll just have to kick that can down the road a little bit and give you some more...

Fair enough. And I was a little confused about the language on Slide 16. Is that $34.6 million reflecting -- sorry, $34.7 million reflecting work done for Southwest as well as legacy NPL?

No, that was more the legacy NPL. So they're all their other customers. So the acquired companies kicked in $54 million of revenue, and then NPL's preexisting customers increased their -- or we increased our revenue from them by $35 million.

Great, that's helpful. Shifting to natural gas. Could you talk about the expected operating margin expansion in 2015? I didn't know if that was reflecting customer growth or change in mix. Any color you could provide will be helpful.

Yes. Really, the -- we talked about, from a customer growth perspective, we were expecting maybe a similar level of operating margin increase as we got in 2014. And then we have some California rate relief, some Paiute rate relief, impact of our various trackers that would provide a similar level of the customer growth. And so when you combine all that, we're saying overall operating margin should increase right around 2%.

Great, very helpful. And just one more. Sorry if you provided this, but when do you expect construction to begin on the LNG facility? And will your LDC file for a recovery mechanism?

We expect that construction to take place later this year. Right now, we're in the process of identifying which parcel of land we want to construct the facility on. We've got several available to us. Depending on what piece of land we pick, that impacts the type of facilities that get constructed. We'll then go to a bid to get some quotes on engineering, design and construction, and that process will take most of this year.

Okay. And do you anticipate filing for a recovery mechanism on construction costs?

Well, we have a -- we do. We have a deferral mechanism that they authorized, and then our tentative plan is that when we file our next Arizona rate case that we would have a proposal embedded in that to address the recovery of those costs.

Your next question comes from the line of Chris Sighinolfi from Jefferies.

Congratulations, Jeff and John, on the new role. I just want to follow up on 1 thing to start, and I don't know if this is for John or for Roy. At the time that you guys had announced the Link-Line acquisition, I believe the sellers maintained roughly like a 10% indirect equity position in the Canadian assets that was -- at some later date, could be converted into a smaller equity stake in the consolidated. Do I take the rebranding to Centuri and then the minority interest listed on Slide 32 of 3.4% to mean that, that happened -- that conversion happened?

Not that it happened, Chris, but that -- the 10% of Link-Line, yes, is convertible into 3.4% of Centuri, and our expectation is that they will eventually exercise that option. And so we're recording then our results as if it had been exercised, essentially. That's why we're assigning the 3.4%.

Okay. That's helpful, Roy. Dovetailing on the previous question about the LNG facility, and I'm sorry if I've either forgotten the details or if you stated it and I didn't hear it. But with regard to the pursuit of liquefaction on site, I know that, that wasn't approved initially. Is there an opportunity to go back, John, at some later date and reexplore that opportunity?

Yes. That's a good question, Chris, and there definitely is. The facility is going to be designed so that, that liquefaction facilities, should we and the commission desire to have it added in the future, can be done without any disruption to the existing facility. So I think the plan is that we'll initially start it up using trucked-in LNG. We'll see how it works. We'll evaluate how easily that commodity is available and what the cost of it is and then take a wait-and-see look if we want to move to the liquefaction facility addition.

Okay. And I guess a final -- kind of maybe a more philosophical question for you, John. Given that the LNG facility sort of owes its roots to the outage that we saw on EPNG a couple of years ago and sort of a local source of reliable supply. There was one of your peer companies that recently had been talking about trying to develop longer-term reserves on behalf of utilities kind of to provide, if you will, a long-term physical gas hedge on the price as well as security of supply of the product. I was just -- and they had discussed recently the fact that they were seeing interest and actually signed some utility counterparts for such arrangements. I was just wondering your appetite, the company's appetite, the board's appetite to pursue something like that on behalf of Southwest Gas customers as well as if you've had any discussions with your regulators about something akin to that type of framework.

Another good question, Chris, and I would say that, personally, I'm very interested in that. That's something that we have been looking at internally. We have had some preliminary discussions with our Arizona regulators philosophically, is that something that they would be interested in. And I think, as you indicated, there are a couple of different positive angles on that for customers, not just the reliability of supply, but also the built-in pricing hedge that, that type of asset would provide for customers. One of the things that we're looking at internally now is, if we can find an appropriate property, preferably in the San Juan or Permian Basin, that would allow those supplies to be delivered out over El Paso to our Arizona customers and if we're able to find a property that's a good fit and that we think is priced at a level that would benefit our customers, that's something that we would look to continue to discuss with the Arizona commission. And it may be even something that we could formulate a preapproval type of filing around to ensure that we're all on the same page with respect to the benefits and the cost recovery of that type of asset.

[Operator Instructions] Your next question comes from the line of Derek Walker from Bank of America.

Just a quick one on Construction Services. Do you have a sense on what the impact of FX is in that segment? Obviously, we've seen a pretty drastic change between the Canadian and U.S. dollar since you've acquired the assets. And what are you assuming in that -- I think it was the $950 million to $1 billion in revenue. What sort of FX rate are you assuming there? And then last one there is just, what is sort of the net tax assumption that you're using for that segment?

Yes. This is Roy. A couple of things. Well, first of all, yes, the U.S. dollar has strengthened quite a bit from the time we announced the acquisition, and today -- it was on the low $1.10, $1.12 range at the time we announced, and today, it's more on the $1.24, $1.25 range. So there's been about a 10%-or-so change. When we did that forecast, $950 million to $1 billion, we were using today's rates, the current rates. So that does include where we are -- where that exchange rate stands today. In terms of the tax rate, the Canadian tax rate all in is roughly 27% on that portion of the business. That would leave NPL's combined tax rate in the 36%, 37% range.

I would now like to turn it over to Ken Kenny for closing remarks.

Thank you, Mark. This concludes our conference call, and we appreciate your participation and interest in Southwest Gas Corporation. Have a good day.