American States Water Company
Q2 2008 Earnings Call Transcript

Published: 8 Aug 2008

[Operator:]

Welcome to the American States Water Company conference call discussing second quarter 2008 results. If you have not yet received a copy of this morning’s news release announcing earnings for the quarter, please call 909-394-3600 extension 710 and one will be faxed or emailed to you. If you would like to listen to the replay of this call, it will begin this afternoon at approximately 2

[Robert J. Sprowls:]

Good morning or afternoon Ladies and Gentlemen and welcome to the presentation on American States Water Company’s second quarter 2008 results. I am Bob Sprowls, Chief Financial Officer of American States, and Floyd Wicks, President and CEO of the company is also with me today. As usual following the conclusions of our prepared remarks the call will be opened up for questions. I would like to remind you that certain matters discussed during this conference call are forward-looking statements intended to qualify for the Safe Harbor from liability established by the Securities Litigation Reform Act of 1995. I ask that you review the forward-looking information disclosure in our Form 10K and Form 10Q on file with the Securities and Exchange Commission. The factors underlying the company’s forward-looking statements are dynamic and subject to change. Therefore, these forward-looking statements speak only as of the date they are given. The company is under no obligation to update them. However, we may choose from time to time to update them and if we do so, we will disseminate the updates to the investing public. During our presentation today Floyd and I may refer to American States Water Company as AWR, our flagship subsidiary Golden State Water Company as GSWC, and American States Utility Services as ASUS. Before I talk about the results, I would like to mention that we plan to file the 10Q tomorrow and within our 10Q we have divided nearly each line of our income statement by segment; that is, water, electric and contracted services. This should provide more transparency on the results of American States Utility Services. Having said that let’s begin with the results for the quarter. Basic and fully diluted earnings for the quarter ended June 30, 2008 were $0.54 and $0.53 per share respectively as compared to basic and fully diluted earnings of $0.42 per share for the same period ended June 30, 2007. Net income for the second quarter ended June 30, 2008 increased by 26.8% or $0.11 per diluted share to $9.3 million compared to $7.3 million for the same period in 2007. The $0.11 per share increase in diluted earnings for the second quarter of 2008 is due to the following items. First, we recorded a pre-tax unrealized gain on purchase power of $1.7 million for the second quarter of 2008 or a gain of $0.06 per share compared to a $236,000 unrealized loss for a loss of $0.01 per share for the same period of 2007, a net increase of $0.07 per share. As many of you are aware, unrealized gains and losses on our purchase power contracts have been impacting Golden State Water Company’s earnings since 2002 when Golden State entered into certain purchase power contracts that qualified as derivative instruments under SFAS No. 133 accounting for derivative instruments and hedging activities. On a monthly basis the related asset or liability of the purchase power contracts is adjusted to reflect the fair market value of the derivative at the end of the month based on the then-forward energy prices and the quantities to be purchased during the remaining term of the contract. Unrealized gains and losses will continue to impact the company’s earnings until the contracts expire on December 31, 2008. Golden State Water has recognized these contracts at fair market value on its balance sheets resulting in a cumulative unrealized gain at fair market value of $3.0 million at June 30, 2008. The cumulative gain of $3.0 million recognized on the balance sheet is expected to be recognized as a reduction to income by the end of the contracts which expire on December 31, 2008. Secondly for the quarter, the dollar water margin increased by $3.0 million or $0.10 per share due to increased water rates approved by the California Public Utilities Commission subsequent to June 30, 2007. The effect of the rate increases was slightly offset by a decrease of approximately 1.5% in water sales. Third, American States Utility Services, AWR’s subsidiary, recorded a pre-tax operating loss of $608,000 for contracted services for the second quarter of 2008 declining by $2.1 million or $0.07 per share as compared to the second quarter of 2007 due primarily to a significant wastewater expansion project in 2007 at Fort Bliss. ASUS recognized pre-tax operating income of $2.1 million from the wastewater expansion project during the second quarter of 2007. While ASUS’ subsidiaries did undertake similar construction activity in the second quarter of 2008, the projects were on a smaller scale and there was no singular significant project. Fourth, Golden State Water Company recorded a net pre-tax gain on the sale of property of $238,000 or $0.01 per share during the three months ended June 30, 2007. There was no similar gain in the same period of 2008. Fifth, Golden State Water Company recorded $480,000 of interest income or $0.02 per share during the second quarter of 2008 in connection with the Internal Revenue Service’s examination of AWR’s 2002 income tax return. Lastly, higher other operating expenses at Golden State Water Company contributed to an overall net decrease of $0.02 per share to the results of operations. The $0.02 per share net decrease is mainly due to an increase in administrative and general expenses due to higher labor and employee benefit costs and an increase in depreciation and amortization expense reflecting among other things the effects of closing approximately $55.2 million of additions to utility plants during 2007. The increase in other operating expenses was completely offset by a lower effective income tax rate, ETR, of 38.4% for the second quarter of 2008 compared to 41.6% for the same period of 2007. The decrease in the ETR is principally due to changes between booked and taxable income that are treated as flow-through adjustments in accordance with regulatory requirements. Now on to the year to date 2008 results. Net income for the six months ended June 30, 2008 increased by 2% to $14.6 million compared to $14.3 million for the same period in 2007. Basic and fully diluted earnings were $0.84 per share for the year to date June 30, 2008 as compared to basic and fully diluted earnings of $0.83 and $0.84 per share respectively for the same period in 2007. The $0.02 per share increase in diluted earnings for the six months ended June 30, 2008 was [inaudible]. First, due to increasing energy prices during the first six months of 2008, AWR recorded a pre-tax unrealized gain on purchase power of $4.5 million or $0.15 per share compared to a $2.5 million unrealized gain or $0.09 per share for the same period of 2007, a net increase of $0.06 per share. Second, the dollar water margin increased by approximately $5.7 million or $0.19 per share during the six months ended June 30, 2008 due to increased water rates approved by the California Public Utilities Commission subsequent to June 30, 2007 and a favorable supply mix change. However, this increase was partially offset by a decrease in water sales. A 5% decrease in water sales during the six months ended June 30, 2008 resulted in a $3.5 million decrease in water revenues. The 2008 water revenues were impacted by changes in weather and the effects of conservation due to increased customer awareness. Third, pre-tax operating income for American States Utility Services declined by $4.8 million or $0.16 per share during the six months ended June 30, 2008 due primarily to the significant wastewater construction project in 2007 at Fort Bliss. ASUS recognized pre-tax operating income of $4.3 million for this wastewater expansion project during the six months ended June 30, 2007. There was no similar large special project in 2008. Higher operating maintenance and administrative and general expenses also contributed to the decrease in American States Utility Services pre-tax operating income. Fourth, Golden State Water Company recorded a net gain on the sale of property of $605,000 or $0.02 per share during the six months ended June 30, 2007. There was no similar gain in the same period of 2008. Fifth, Golden State Water Company recorded $480,000 of interest income or $0.02 per share during the second quarter of 2008 in connection with the IRS’ examination of the 2002 income tax return. Lastly, higher other expenses at Golden State Water Company partially offset by a lower effective income tax rate on a company-wide basis contributed to an overall net decrease of $0.07 per share to the results of operations for the year to date 2008. The $0.07 per share net decrease is due to an increase in other operating maintenance and administrative and general expenses at Golden State Water Company due to higher labor and benefit costs and an increase in depreciation and amortization expense reflecting among other things the effects of closing approximately $55.2 million of additions to utility plants during 2007. Partially offsetting these increases was a lower effective income tax rate of 40.8% for the six months ended June 30, 2008 compared to 41.7% for the same period of 2007. As I mentioned in the quarter, the decrease in the effective income tax rate is principally due to differences between booked and taxable income that are treated as flow-through adjustments. Before I turn the call over to Floyd, I would now like to take some time to discuss the contracted services business at American States Utility Services or ASUS. Contracted services operating revenues are composed of construction revenues and management fees for operating and maintaining the water and/or wastewater systems at military basis. The primary service is being conducted by ASUS. Such revenues decreased by $8.5 million during the six months ended June 30, 2008 primarily due to revenues in 2007 related to the significant wastewater expansion project at Fort Bliss which generated $19.5 million of construction revenues in the first six months of 2007. You may recall that in December of 2006 ASUS finalized an agreement with the US Government for the construction of certain improvements to the existing wastewater infrastructure located at Fort Bliss in El Paso, Texas. The agreement totaling $20.6 million was a firm fixed price contract. The project generated approximately $4.9 million of pre-tax income or $0.17 per share in 2007. Out of the $4.9 million of pre-tax income from this project in 2007 $2.2 million of pre-tax income or $0.08 per share was in the first quarter of 2007, $2.1 million of pre-tax income or $0.07 per share was in the second quarter of 2007, and the remaining $600,000 or $0.02 per share was generated in the third quarter of 2007. The project was completed in August 2007 and there were no further construction revenues associated with this special project after that. There was no singular significant project in the first and second quarters of 2008 and we don’t anticipate similar sized projects in the third and fourth quarters in 2008. As such we may continue to experience decreases in ASUS’ 2008 earnings as a comparison to its 2007 earnings because of this project. The point here is that earnings and cash flows from these military special projects are intermittent and may or may not continue into other periods. When modeling projections, we recommend normalizing the earnings by excluding such special projects on military bases with the US Government. However, the reduction in 2008 construction revenues compared to 2007 as a result of the wastewater project at Fort Bliss was partially offset by increased construction revenues at Andrews Air Force Base pursuant to its 50-year fixed price contract and the commencement of the water and wastewater systems at military bases in North Carolina and South Carolina in the first quarter of 2008. The timely receipt of price redeterminations is critical in order to cover ASUS’ increasing costs for operating and maintaining the water and wastewater systems at the military bases. The contract price for each of these military contracts is subject to price redetermination two years after commencement of operations and then every three years thereafter. Redeterminations have been submitted and are under review by the US Government for ASUS’ operations in Virginia and Maryland. Resolution of these price redeterminations is expected later in 2008 and to date ASUS has received interim increases to the management fees received for operating and maintaining the water and wastewater systems at Fort Eustace, Fort Story, and Fort Monroe in Virginia and the wastewater system at Fort Lee also in Virginia. ASUS has experienced delays in the redetermination of prices at Fort Bliss following the completion of the first two years of operations in October 2006. However, ASUS is also preparing the price redetermination for Fort Bliss and expects to file it in the third quarter of 2008. I will now turn the call over to Floyd.

[Floyd E. Wicks:]

Good morning Ladies and Gentlemen. Before we start on the status of key regulatory filings, I would like to take this opportunity to congratulate Bob Sprowls on his appointment to succeed me as Chief Executive Officer and President of the company effective January 1, 2009 as identified in a news release earlier this week. I will continue as a director of the company and effective January 09 as well as the Vice Chair of the Board of Directors. It is gratifying to me personally that an insider so-called was selected as my successor. Bob and I are already working on a transition plan which will include a company-wide tour to meet with all employees and keep business leaders as well. Now let’s discuss the status of key regulatory filings and important actions and those still pending. As Bob mentioned earlier the PUC approved rate increases subsequent to June 30 of 07 including the seven rate making areas in Region 1 customer service areas effective January 1 of 08. The authorized rate increases are anticipated to provide Golden State Water with additional annual revenues of approximately $6.4 million in 2008 based on authorized return on equity of $10.2% rate increases for Regions 2 and 3 customer service areas also effective January 1 of this year. The authorized rate increases will provide Golden State Water with additional annual revenues of approximately $3.6 million for Region 2 which represents the second year of a three-year rate case approved in 07, an increase of $3 million for Region 3 which is the third year of a three-year rate increase approved in 2006. The combined rate increases for all three regions, 1, 2 and 3, are designed to generate approximately $13 million in additional annual revenues effective January this year based upon normalized sales levels approved by the PUC. According to the PUC’s new water rate case plan which was adopted in May of last year, Golden State Water will migrate to a rate-case schedule that brings all three regions of Golden State Water within a single rate case. Golden State filed its general rate case for Regions 2 and 3 and the corporate office this year, actually last month, using the most recently adopted return on equity of 10.2%. New rates if approved as scheduled will be effective in January of 2010. Because the Region 1 rate case was just approved in January of this year, the rate case plan calls for a separate Region 1 general case filing in the year 2010. That case will have a two-year cycle for 2011 and 2012 and then will be combined into our next rate case cycle with the other two regions which will then all be reviewed in a single case filed in July of 2011 for a three-year rate case cycle beginning 2013. Also under the new rate case plan three of the large water utilities, Golden State Water, Cal Water Service Company, and California American Water Company, were required to each file a separate application on May 1 of this year to review the cost of capital. Golden State Water filed its first cost of capital application under the new rate case plan on May 1 of this year. The application requests the Commission adopt a return on equity of 12.1% for calendar years 2009, 2010 and 2011. According to the rate case plan the Commission intends to process the cost of capital proceeding in six months time at which time the rate of return authorized by the Commission will be implemented into rates on a company-wide basis in 2009. We anticipate having revenue adjustments in all water service regions for 2009 based on the difference between the then-approved rate of return in the pending cost of capital proceedings and the currently adopted returns. In February of 07 the PUC opened an order instituting investigation OII to consider policies to achieve conservation objectives known as the Conservation OII. Golden State Water is in phase 2 of this proceeding in which PUC will primarily consider the following

[Operator:]

(Operator Instructions) Our first question comes from [Hikee Door] – Janney Montgomery Scott, LLC.

[[Hikee Door]:]

Can we start with the regulatory matters in California? When will Golden State be implementing the RAM?

[Floyd E. Wicks:]

We’re hopeful it will be implemented this year. Whether it is going to be during this quarter or the fourth quarter, we’re hoping before the end of the third quarter but it’s not certain yet.

[[Hikee Door]:]

Had it always been that you were planned to go after Cal Water? I know that they have implemented theirs either last month or the month before. I thought that you would both be implementing around the same time.

[Floyd E. Wicks:]

No, just as we’re on different schedules for filing rate cases, the PUC has really categorized each of the Class A companies on a very strict schedule and we’re following Cal Water and I think Cal American was the other one that was ahead of us. I’m not sure of that.

[Robert J. Sprowls:]

Yes, they divided up the companies in to two phases and we got in to the second phase.

[[Hikee Door]:]

But the way it gets implemented is similar, right? The accounting doesn’t change from company-to-company?

[Robert J. Sprowls:]

That’s right.

[[Hikee Door]:]

I believe this is the first that I’m hearing of the rate case last month, perhaps I’m out of the loop. Can we have some numbers around the Region 2, Region 3 request that you recently made?

[Floyd E. Wicks:]

Yes, I believe that’s going to be in the Q tomorrow.

[[Hikee Door]:]

If it’s not handy I can wait until tomorrow, no big deal.

[Robert J. Sprowls:]

For Region 2, $20.3 million is the increase effective 2010 and then it’s $2.6 million in 2011 and $4.2 million in 2012. For Region 3 it’s $30 million in 2010, $1.17 million in 2011 and $3.7 million in 2012.

[[Hikee Door]:]

And now do those numbers assume the let’s call it 10.25 ROE that you’ve been getting currently? Or, how does that work?

[Robert J. Sprowls:]

Yes, the 10.2. Now, the 10.2 that we’re currently getting is really on just Region I.

[[Hikee Door]:]

Right but that get’s applied to future rate cases until the cost of capital proceedings get completed, right? Although in theory the cost of capital should be completed before this decision comes out.

[Robert J. Sprowls:]

Yes, it should, that’s right.

[[Hikee Door]:]

Just as a final question, can you talk a little bit more about ASUF and the efforts to get price increases on these military contracts?

[Floyd E. Wicks:]

Yes, it’s been quite an extensive operation to get these filings made for price redeterminations as well as equitable adjustment filings. And, as you know, as we’ve mentioned before, these filings in many ways sort of emulate what we do in terms of filing a rate case. In the case of the military basis our regulator frankly is the US government and it’s new for them as well and I think that’s frankly why it’s taking a little longer than we would anticipate. But, we’re making progress. They have included – there have been some recent interim adjustments while we’re waiting for the final increase to be determined so I believe we’re on track for having better news by the end of the third quarter.

[[Hikee Door]:]

Is there additional information on this in the Q as well or is it kind of mum’s the word until a decision gets made from the government?

[Robert J. Sprowls:]

Well, at this point we have filed the redeterminations for an east coast bases, the Virginia and Maryland bases and so those are being considered. For Fort Bliss, we expect to file that price redetermination in the third quarter. And, there is more detail in the 10Q but that’s the process we’re going through. Fort Bliss has been a little bit of a problem in terms of this particular item but we’re working through it. It’s also the base where we had the significant waste water project so we look at it as a lot of opportunity there. But, it’s just a little tougher to work through the red tape I guess.

[Floyd E. Wicks:]

With regard to that, Bob makes a good point, if you could imagine moving in 30,000 people in to an already existing fairly good sized base within a short period of time, two to three years, it’s a very busy place and we believe there will be other opportunities there but we can’t forecast that at this point.

[Operator:]

Our next question comes from Allan Seymour – Columbia Management.

[Allan Seymour:]

I have two questions, the first one is your return on equity request of 12.5%, can you give me some sense of history of how that has worked out in the past? Then the second question has to do with when a developer in your area does a development and requests water, how do you handle that capital expenditure? And, are there accounts receivable associated with any developer that you may have to get reimbursement from?

[Robert J. Sprowls:]

The return we requested in the water rate case for Region 2 and 3 is 12.1% ROE and typically we’ll go in for a rate increase and request a ROE that we think is valid but seldom do we get what we ask for. In a number of cases we’ve been requesting between 11.5% and [inaudible] we come out in the neighborhood of 10%. So, I don’t want you to think that you can sort of scale 12.1% down that way because what happens typically in a rate case is a lot of cases you end up settling this particular issue with the Department with direct testimony, it doesn’t make it to the hearing in terms of putting your witnesses on the stand. With given the new ROE approach for the water companies, there will be cross examination given to rate of return witnesses because they basically bifurcated the return on equity component or the cost of capital component from the general rate case approach. It use to be that there would be a little bit of horse trading in terms of we’ll take a slightly lower return if we get this particular capital project in or this particular operating expense, or vice versa. Floyd do you want to handle the second question?

[Floyd E. Wicks:]

Regarding the developer projects where we deal frankly throughout the state of California, typically we follow the rules as set up through the California Public Utilities Commission where developers would put in all the infrastructure required to serve the development and then over a period of 40 years, that developer would get a payback pretty much pro rata on one fortieth each year at no interest. That’s what we affectionately call Rule 15. It’s been in place for quite a number of years in California but we do not put our own capital at risk in these developer related projects. I don’t know if that fully answers your question or not, I’d be happy to try again.

[Robert J. Sprowls:]

Well they basically contribute the dollars they spent on this infrastructure to the company?

[Floyd E. Wicks:]

Correct, that’s right.

[Robert J. Sprowls:]

If you look at the liability side of the company’s balance sheet you’ll see two lines there, customer advances for construction and contributions in aid of construction. That’s where this infrastructure has been sort of contributed. On the left hand side you’ll see the assets that have been contributed and on the right hand side you’ll see sort of these liabilities for the customer advances for construction we have to pay back to the customer over time and that’s what Floyd described. At some point some of this property turns in to contributions in aid of construction and those are dollars we don’t have to pay back.

[Floyd E. Wicks:]

The dollars we pay back under the so called advance, the developer advances the dollars and we pay them back, those dollars over time find their way in to rate base so that does build rate base over time but at a much slower pace than if we paid for that capital up front and imposed it in the rate base.

[Operator:]

There are no further questions at this time. I will now turn the call back to management for any closing remarks.

[Floyd E. Wicks:]

Thank you all again. We really appreciate your participation today and for your continued interest in the company and we thank you for following our news releases here this week and congratulations again to Bob Sprowls.

[Robert J. Sprowls:]

Thank you.

[Floyd E. Wicks:]

Thank you all.

[Robert J. Sprowls:]

Thank you.

[Operator:]

This concludes today’s American States Water Company conference call. As a reminder, the call will be available for replay beginning at approximately 2