Pinnacle West Capital Corporation
Q3 2012 Earnings Call Transcript

Published: 2 Nov 2012

[Operator:]

Greetings, and welcome to the Pinnacle West Capital Corporation 2012 third quarter earnings conference call. (Operator Instructions) It is now my please to introduce your host, Becky Hickman, Director of Investor Relations.

[Rebecca Hickman:]

I'd like to thank everyone for participating in this conference call and webcast to review our third quarter earnings, recent developments and operating performance. Our speakers today will be our Chairman and CEO, Don Brandt; and our CFO, Jim Hatfield. Jeff Guldner, who is APS Senior Vice President of Customers and Regulations is also here with us. Before I turn the call over to our speakers, I need to cover a few details with you. First, the slides to which we refer are available on our Investor Relations website along with our earnings release and related information. Please note that the slides contain reconciliations of certain non-GAAP financial information. Also, all of our references to per-share amounts will be after income taxes and based on diluted shares outstanding. It is my responsibility to advice you that this call and our slides contains forward-looking statements based on current expectations and the company assumes no obligation to update these statements. Because actual results may differ materially from expectations, we caution you not to place undue reliance on these statements. Our third quarter 2012 Form 10-Q was filed this morning. Please refer to that document for forward-looking statements cautionary language as well as the MDNA section, which identifies risks and uncertainties that could cause actual results to differ materially from those contained in our forward-looking statements. A replay of this call will be available on our website for the next 30 days. It will also be available by telephone through November 9. At this point, I'll turn the call over to Don.

[Donald Brandt:]

Thanks, Becky, and thank you all for joining us today. This year we've made progress in a number of key areas as we focus on our core electric utility business. This progress includes demonstrating sustained improvement in the regulatory environment in Arizona, making selective capital investments, maintaining operational excellence, strengthening our financial profile and positioning ourselves to benefit from economic recovery. Jim and I will provide more information on each of these areas throughout our remarks today. APS's retail rate settlement, which was approved earlier this year became effective on July 1. Details of the agreement as well as the key underlying assumptions are outlined in the appendix to our slides. The settlement demonstrates significant collaboration and cooperation among APS peers on a Corporation Commission and other stakeholders as well as a proven commitment to expedite the retail rate case process. The settlement contains a number of benefits for our customers, the communities we serve and our shareholders. Among other things, first, it provides a financial support APS needs to meet our customers' energy needs and to help achieve Arizona's energy goals. Second, the settlement provides measure of regulatory certainty for both customers and shareholders through at least mid-2016. Third, it provides rate gradualism through the use of a number of rate adjustment mechanisms. This process will void the need for base rate increases every several years, while allowing reasonable recovery that APS has prudently incurred expenditures in the interim. And fourth, it allows APS the opportunity to earn a reasonable return on equity. That said, we believe a number of factors will allow us to achieve competitive financial performance during this out-period. Aspects related to the settlement include, first, APS's rate adjustment mechanisms, which will continue to function throughout the stay-out period. Among others, these mechanism include preferred formula rates and the related retail transmission costs adjuster, which passes annual changes in the formula rate through their APS retail customers. The renewable energy surcharge, which allows for recovery of AZ Sun plant additions, and other renewable resourced program costs, the new loss fixed cost recovery mechanism, which was adopted in the settlement to mitigate the loss of certain fixed cost related to energy efficiency programs and distributed generation. And an enhanced environment improvement surcharge, which will allow APS to collect up to $5 million annually for certain carrying cost on government-mandated environmental capital projects. Second, a rate rider carve out for the proposed Four Corners acquisition, and this provision will allow APS to seek rate adjustments as early as mid-2013, after the acquisition is consummated. I will review the status of the Four Corners plan momentarily. Third, provisions to mitigate certain cost increases. These features include deferrals of portions of higher property taxes attributable to tax rate increases as well as full pass-through of fuel costs through the power supply adjuster. And finally, without a time-intensive rate case litigation process in the next few years, we can focus fully on operational excellence, efficiency and disciplined cost management. In a related manner, on August 1, APS implemented an ACC approved increase in the retail transmission cost adjuster. The rate change reflected APS's increased investment in transmission lines and will increase annual formula-based revenues by $18 million. Beginning next year, the settlement allows future transmission cost adjuster changes to go into effect June 1 of each year without requiring the expressed Commission action. This change will synchronize wholesale and retail transmission cost recovery. Turning into next week selections, three of the five ACC Commission seats are on the ballot. Incumbent Commissioners, Sandra Kennedy, Paul Newman and Bob Stump are running for reelection. In addition, three challengers are also running for the seats. Republican, Susan Bitter Smith and Bob Burns; and Democrat, Marcia Busching. Regardless of the party affiliation, the three candidates who receive the highest number of votes will win the election and begin four-year terms in January. Whatever the results of the elections, we will continue working with the Corporation Commission and the various stakeholders to continue our collaborative focus on the states energy future. Our capital investments position us well to reliably serve the needs of APS's electricity customers, while meeting goals for Arizona's sustainable energy future and environmental compliance. Today I'll update you on two major components of our capital expenditures program, the AZ Sun program and the planned Four Corners acquisition. Our renewable energy initiatives, particularly the AZ Sun program are important, measured steps toward advancing Arizona's sustainable energy future. Through AZ Sun, APS plans to develop and own up to 200 megawatts of utility scale, photoable take solar plants in Arizona within service dates from 2011 through 2015. This program is progressing on target. To date, we have commitments in place for a total of 118 megawatts with a projected capital investment of $504 million. A summary of the program is included in the appendix to our slides. To date, we have placed three plants in commercial operation with a total capacity of 50 megawatts. Construction and other development activities are currently underway at three sites for another 68 megawatts. Of this amount, we plan to place 19 megawatts at the Chino Valley site in Northern Arizona into service later this year. We expect the reminder will go into operation in 2013. Additional planning and procurement activities are in various stages for the balance of the AZ Sun program. We are continuing with our plan to acquire Southern California Edison's interest in the Four Corners coal-fired plant in Northwestern New Mexico. A summary of the plant is included in the appendix to our slides. The plant has substantial merits, economically, environmentally and socially. The acquisition requires approvals by Arizona, California and federal regulators as we as other government agencies, most of which have already been obtained. Noteworthy conditions still must be met prior to closing the transaction, including approval by the Federal Energy Regulatory Commission and negotiation of a new coal supply contract. We expect to hear from them first by the end of this month, and coal contract negotiations are continuing. We intend to close the acquisition following satisfactory completion of these conditions. Excellence in day-to-day operations remains our top priority and our third quarter results reflect this focus. Throughout the summer, our generating fleet turned in solid performance, and our employees provided high-quality service, all of them meeting and demands of our peak season. During the third quarter, our Palo Verde nuclear plant operated as a 98% capacity factor. Currently, Unit 2 is in a planned refueling outage, which we've expected to be completed early this month, reflecting a schedule of approximately 30 days. Our fossil plants also operated well. When appropriate, we took advantage of low near-term natural gas prices by reducing output by our coal plants and increasing gas plant production. In September, we were again recognized for our sustainable business practices as Pinnacle West was name to the Dow Jones Sustainability North America Index. Our company has been included in the index for eight consecutive years. Every year since the index was established and is one on only nine North American electric utilities included in the current index listing. Over the past several years, we have achieved a number of needed improvements to strengthen the company's balance sheet and other aspects of our financial profile, while focusing on continuous improvement in operations to regulatory framework and cost management. Continuous improvement is essential to maintaining operational excellence and they are achieving our current and future financial goals. Last month we achieved another milestone, when our Board of Directors improved the cash component of return for our shareholders by increasing the common dividend by about 4% effective with this year's December payment. The board's decision to increase our dividend demonstrates the confidence we have in the fundamental strength of our business, the Arizona communities we serve and our future growth prospects. We are focused on delivering sustainable long-term growth and strong cash returns to shareholders. To close my remarks, I am very pleased with where our company is today and very optimistic about our future. With the retail rate settlement behind us, we will continue to achieve top-tier performance through our day-to-day focus on excellence in execution and continuous improvement, areas in which our talented leadership team and workforce performed exceptionally well. Now, Jim will review our third quarter results, the outlook for the Arizona economy and our guidance for 2012 earnings.

[James Hatfield:]

Thank you, Don. As Don said, we continue making progress, strengthening our financial profile. Today I'll discuss the following topics

[Operator:]

(Operator Instructions) Our first question is coming from Greg Gordon with ISI Group.

[Greg Gordon:]

Don, can I ask you to maybe articulate a little bit what the mindset is of the board around the dividends, the $0.02 increase was much appreciated by your shareholders, but I've heard from, maybe a few of them that they had hoped for at least a modestly higher increase. So what was the mindset of the board around that decision? And then second question on that front is the board going to be addressing the dividend annually in December or would you plan on sort of moving that date prospectively and ask them to think about the dividend increases on a different timetable?

[Donald Brandt:]

I'll answer the last one first, probably we've continue to address it as the October board meeting. There is no reason that couldn't change but that's traditionally been the time, if there was a reason. But I don't think we've changed it just to change it. So that's about as best answer. I think I'd focus on October for future years following some other changes. Relative to how the management team and the board focused on the dividend, one is focus on what would we do to create the most long term value for shareholders. And in that regard, our philosophy was a change in the dividend that would appear to be the least risky, meaning, I believe and our board, the more secure that dividend of peers going forward, the more shareholder value will create with the absence of uncertainty around it. That certainly doesn't mean we're locked into this kind of an increase in the future. But I'm also not telegraphing there is any change. But as you know we've heard the stock over the last couple of years about our cost control initiatives and the projects that Jim Hatfield, Mark Schiavoni, our team helped for us over the stay-out period, and the fact that we have 200 to 300 employees retiring each year and we're going to try to take as much advantage of those potential cost savings as possible. And our forecast of sales is essentially flat. And it's still very early stages. There is some activity in the housing market. And as you know, we've got more than 25,000 empty homes in our service territory. And when the market starts to return to normal, whatever normal might it look like in future years, that would be potential upside to earnings, and obviously both the management team and board would take those potential positive developments in the consideration in future years.

[Greg Gordon:]

On that front, Don, in talking to my housing analysts here, we've seen what you're seeing in Phoenix and if you could collaborate it or not? That would be helpful, as that there's been a slowdown in new home sales, because there is simply a lack of supply. And so do you think that that's true, have you seen the front end of permitting activity that might cause sort of a year down the line. A lot of the new homes to come on the market, and do you also think that that might lead to a quicker absorption of the 25,000 existing homes, because there's such lack of supply of new homes.

[Donald Brandt:]

Yes. It's a broad question. I'll probably give you a broad answer too. I know from our folks who deal with developers, there is still continuing activity. One thing we have heard is there is a labor shortage right now, relative to what the severe downturn or basically the housing industry, all that's shutdown, the carpenters, masons, roofers, et cetera. But that's not the kind of thing, and people in the housing business I've talked to that takes a year to develop, that's where you recruit folks from other parts of the country and you might be talking a matter of months to solve some of the labor issues. But with that said, I guess we've got the 25,000 plus, I think it's 27,000 of empty homes that are ready, willing and able to be occupied at a very short notice. And the local print paper, you find online at azcentral.com, there has been a number of almost every other day another story about changing in house prices and while there is some volatility, the trend seems to be on the uptick.

[Operator:]

Our next question is coming from Neil Mehta from Goldman Sachs.

[Neil Mehta:]

Jim, I think last time when I was out there we were talking about O&M trends. And I got the sense that you're looking to keep O&M flat in 2013 and 2014, as you think about the expense pie, where are those costs reductions coming from?

[James Hatfield:]

Well, I think we've been flat since '08, so I think any sort of non-essential expense has been eliminated. I think Don alluded to this in his text, which is we're going to have significant retirements over the next few years, to consider that two-thirds of our people related costs that as we continue to improve our business processes in labor technology, our ability not to replace each individual that leaves will be where we'll have to drop them.

[Neil Mehta:]

And then on AZ Sun, that's been a big success here and do you think that appetite to upsize the AZ Sun program?

[James Hatfield:]

At this point, I don't think so for a couple of reasons. This thing runs through '15, so we'll have to see. But from a capacity perspective we're in pretty good shape capacity-wise. We'll be doubled at 2015 renewable energy standard, so probably not near term and appetite to do anything more with utility scale.

[Operator:]

Your next question is coming from Kevin Cole from Credit Suisse.

[Kevin Cole:]

I guess, more on Greg's question on the dividend, is it your view, I guess, should I review that the 4% increase is a one-time up year-over-year or should I consider it to be stable through the stay-out or is it a stable longer term than that.

[Donald Brandt:]

Well, it's something we'll look at each year. But I think our aspirations are to continue to grow the dividend. We feel very confident and we'll talking more about the future earnings in connection with EEI in the next week or so. And I think that would give you more insight into it.

[Kevin Cole:]

Then I guess, this 4% dividend growth imply a similar annual EPS growth rate through the stay-out or is that's a point that's coming at your Analyst Day?

[Donald Brandt:]

Yes, Kevin, we'll address that at the next Friday.

[Kevin Cole:]

And then last question on leverage to an economic recovery, I guess under the current rates and the LFCR, what is your EPS leverage for every 1% move and in a lower order customer count?

[Donald Brandt:]

1% move is about $10 million in net income, so probably $0.09 or so.

[Operator:]

Your next question is coming from Paul Ridzon from KeyBanc.

[Paul Ridzon:]

Jim, you had mentioned, one federal tax credit that expired and might it ticking up again, would that apply retroactively?

[James Hatfield:]

Well, if it came back in or was extended in 2012 before the end of the year, it would be applied retroactively to the year. They could also extended in '13 and make a retroactive. We'll have to wait and see what happens with that. Our tax people feel like it's something that will be extended at some point.

[Paul Ridzon:]

And can you give more color on where the $0.09 from retail transmission came from that, it seems awful big?

[James Hatfield:]

Well, I think there were a couple of things in there, Paul. First you had to switch gear at annual increase, which was $0.02. We also had about $0.04 to a catch-up adjustment last year which went against us. So we didn't have that this year, and that's another $0.04. And then, we begin booking in the third quarter, now, that we have a set schedule of June 1 every year through the 2012 settlement that we're sort of accruing next year's increase as we earn it throughout the year. It's a same concept we're doing with LFCR which will apply for our filing on application next year, but we're actually earning it this year.

[Operator:]

Our next question is coming from Ali Agha from SunTrust.

[Ali Agha:]

In the appendix and the slides, et cetera, you guys talked about '12 through '15 a 6% annual growth in rate base. Does that bake in all the expenditures that will be spent at that time or is there a scenario that growth could be stronger than that?

[James Hatfield:]

That's our current plan, Ali. At this point absent something unforeseen like a quick recovery and growth next year sometime. I don't see that we would have a rate base growth that's greater than 6%.

[Ali Agha:]

And, Jim, to your point earlier apart from some equity issuance that will come into play maybe sometimes in '14, is that the biggest disconnect we should think about between the 6% rate base growth and what an EPS growth commensurate with that should look like, it's really some dilution at some point from equity, is that a fair way to think about it?

[James Hatfield:]

I think we have a couple of things, Ali, to think about. And again, we'll cover this more specifically Friday. But you don't have perfect regulation, so you're not going to get a dollar for dollar in that regard. And then, yes, at some point we'll have some dilution as we calibrate the capital structure assuming we are on a next rate case.

[Ali Agha:]

And last question, coming back to the dividend for a second. So given where you are right now, at least from a payout ratio perspective, are you guys now comfortable that you are where you need to be relative to your benchmark peer group or do you have any thoughts on the payout ratio?

[James Hatfield:]

I think we are comfortable where we are, Ali.

[Operator:]

Our next question is coming from Charles Fishman from Morningstar.

[Charles Fishman:]

Don, you brought up the fact that the election could change the composition of the Commission. Is there anything that because of a stay-out there is really nothing that the new commissioners would have to hit the ground running on, I mean there is no immediate decisions that would face. I mean it's just really all you have to do is get them up to speed between now and when you file in 2014?

[Donald Brandt:]

Well, we have the ongoing riders in that, we'll continue communications. But to answer your question, Charles, directly, there aren't any big issues out there. But its continuing monthly, if not a weekly dialogue with the commissioners and their policy advisor's to keeping abreast to what's going on in the company, and just from a relationship standpoint.

[Charles Fishman:]

And then, can I ask a question on Slide 26, the RES cost, demand side management cost?

[Donald Brandt:]

Yes.

[Charles Fishman:]

Quarter-over-quarter there is step down in the RES, but that was due to the transfer of those cost to rate base with the settlement earlier this year, is that correct?

[Donald Brandt:]

Yes.

[Operator:]

Our next question is a follow-up from Greg Gordon with ISI Group.

[Greg Gordon:]

So just a sort of a follow-up on, I guess Ali's question. If I just look at your slides, and I know you'll probably be going to tell me, I'm front running your Analyst Day by asking you this. If I look at Slide 17, you say rate base is going to grow on average 6% annually. You're saying that you'll earn at least to 9.5% ROE over the forecast period. Jim, you've said, there's very little regulatory lag associated with your capital expenditures. So absent equity dilution, why wouldn't it be fair to presume that earning should grow in line with rate base growth?

[James Hatfield:]

Well, Greg, I think you'll need to come back Analyst Day to get that answer. How did that sound?

[Operator:]

Our next question is coming from Paul Patterson with Glenrock Associates.

[Paul Patterson:]

Just on the election is there any potential that there could be a change in policies like renewals or whatever that could impact to you. I know there's been sort of a back and forth between the Commission and the state legislature and what have you. I'm just wondering, if there is anything we should be thinking about in terms of what could happen there with respect to renewables or whether or not that could impact you guys?

[Donald Brandt:]

Well, most of the issues were a year ago in the media between a legislature and Commission, if fairly well died down. And both parties in the year of the existing commissioners have been supportive over our past on renewable. So I certainly can't and won't predict the outcome of any election much less the Corporation Commission. But I don't foresee the need or the likelihood of any significant change.

[Paul Patterson:]

And then, with respect to just a housekeeping I guess, I'm a little bit confused. When I read maybe I'm reading something incorrectly, but when I look at the press release on Page 2, it says that there was a decrease in retail sales, excluding the effects of weather variations, which reduced results by $0.02 a share?

[Donald Brandt:]

That's correct.

[Paul Patterson:]

And then, when I look at the statistical slides, and again, maybe I'm just misreading it. It looks like retail sales gigawatt hour weather normalized was actually up, on Page 4 and 5 in the statistical supplement? It does look like it's a lot. We're not talking about this, just sort of wondering about if I am reading it correctly, if there was something missing? I saw that, I just meant the total retail sales seem to, weather normally seem to go up, and if I was reading this it seemed like the effects of what you guys actually have seen it go down?

[James Hatfield:]

Yes, we did. I'll have to look into that.

[Rebecca Hickman:]

I'll get back to you Paul.

[Operator:]

Thank you. We have reached end of our question-and-answer session. I'll turn the floor back over to Ms. Hickman.

[Rebecca Hickman:]

We thank you all for being with us. We know that you have a number of calls today. And if there is anything else that you need, please contact me or one of us. Thank you.

[Operator:]

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time and have a wonderful day. We thank you for your participation today.