Southwest Gas Holdings, Inc.
Q3 2014 Earnings Call Transcript

Published: 6 Nov 2014

[Operator:]

Good day, ladies and gentlemen, and welcome to the Southwest Gas 2014 Third Quarter Earnings Conference Call. My name is Tony, and I will be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to Mr. Ken Kenny, Vice President of Finance and Treasurer. Please proceed.

[Kenneth J. Kenny:]

Thank you, Tony. Welcome to the Southwest Gas Corporation 2014 third quarter conference call. As Tony mentioned, my name is Ken Kenny, I am the Vice President of 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 have slides on the Internet, which can be accessed to follow our presentation. Today, we have

[Jeffrey W. Shaw:]

Thanks, Ken, and welcome on the call, everyone. First, to Slide 3. Third quarter highlights. We realized $5 million in margin from rate relief in our most recent California rate case. We'll speak to that a little bit later. We have reached a settlement in principle during September 2014 for the Paiute Pipeline general rate case and the settlement rates were effective September 1 this year. A little more about that later as well. NPL recorded a quarterly contribution of $13.4 million on the bottom line in the third quarter. And we'll speak to that. We're very encouraged that the work that needed to get done, and we were unable to do as a result of weather in the first quarter, the management was able to make that happen in the third quarter. So I would say, I think we've mentioned that we expected to be able to do that, and it's good that we were able to deliver on that promise. Or at least, that expectation. NPL completed, as you are probably aware, the acquisition of the Link-Line group of companies in October 2014. And we were very encouraged by the platform that gives us to grow the business, especially in Canada. We remain focused on executing our strategy to build long-term shareholder value. It's pretty basic, pretty focused and it's work. And so, we are optimistic for the prospects for the duration of 2014. I will say this, that with respect to 2015, comments regarding '15 will more be appropriate for our call at the end of the year, when we have full year-end results. So we'll speak mostly to the expectations for '14 in the call today. Slide 4, the call outline. First of all, we will report on consolidated earnings for periods ended September 30, 2014. We'll speak to the natural gas segment earnings as well as NPL Construction Co. earnings. We'll speak to natural gas regulation. John will cover that as he has typically done on these calls. I will speak to customer growth, what we're seeing, unemployment rates, employment growth rates, so forth. I'll speak to rate base growth. Roy is going to talk about the NPL acquisition of the Link-Line group of companies. I will mention to you that in connection with that acquisition, that due to the amount of earnings we will arrive from the nonregulated portion of the business, S&P did downgrade us from a, A- to a BBB+. We do not, however, at this time, based on our continuous discussions with the rating agencies, expect any further downgrades based on where we're at presently and what we expect going forward. I will touch upon dividend growth a little later in the call, what our expectations are going forward. And we'll talk a little bit about an outlook for the remainder of the year, just to summarize the call, to bring it to conclusion, both for NPL and the natural gas segment of the business. So with that, what I'd like do is turn the time over to Roy, so he can talk about summarization of the operating results for the periods ended September 30 this year.

[Roy R. Centrella:]

Thank you, Jeff, and let me also welcome those of you joining us today. I plan to provide a comparative summary of third quarter and rolling 12 month operating results for both operating segments and identify those factors, which we expect will impact full year 2014 results. Well, starting on Slide 5. During the third quarter of 2014, we reported net income of $0.04 per share versus a loss of $0.06 per share during the third quarter of 2013. The improved results were attributed to NPL, which reflected income of $13.4 million compared to $9.1 million in the prior period. The gas segment experienced a loss of $11.5 million in the quarter, a slight improvement from last year's third quarter loss of $11.9 million. For the 12-month period, we earned $140 million or $3.01 per basic share versus $150 million or $3.25 per basic share during the prior period. We were very pleased with NPL's strong quarter as they have now fully recovered from the poor weather impacts earlier in the year. Next, we'll look at results by segment. Starting with the gas operations on Slide 6. The gas segment operating loss during the quarter improved from $8.3 million last year to $2.7 million this year. Operating margin grew by nearly $6 million, whereas operating expenses were relatively flat between periods. Unfavorable between period variances and interest expense resulting from a 2013 $250 million debt offering, and other income, due mainly to company-owned life insurance, or COLI, returns, largely offset the operating loss improvement. Please note that due to the seasonal nature of our business, losses during the third quarter for the gas operations segment are normal. Next, on Slide 7. Let me talk just for a minute about operating margin, which increased $6 million between periods. You'll note that rate relief contributed $5 million. This resulted from the California rate case, and coupled with the second quarter amounts received, means the full $7 million granted has now been substantially recognized. On Slide 8, you'll see that operating expenses overall were pretty flat between periods, with an O&M decrease of $2.6 million, being largely offset by higher depreciation and amortization expense. The O&M reduction was primarily due to reduced employee-related costs, mainly pension expense. Despite the flat quarter, we still expect total operating expenses to increase by about 3% for the year. Moving to Slide 9. We break down other income and deductions, which declined by $2.2 million between quarterly periods. Investments underlying our COLI policies declined by $300,000 in the most recent quarter, whereas they increased $2.5 million last year. Next, starting on Slide 10. We'll review the 12-month periods. The gas segment contribution to net income decreased to $118 million from $121 million. There was a $4 million decline in operating income as operating cost increases exceeded the growth in operating margin. In addition, interest cost increased $7.4 million between periods. Slide 11 provides a breakdown of the $18 million growth in operating margin between 12 month periods. Rate reliefs, principally from California, contributed $9 million. And we also recognized about $8 million in new margin from customer growth as the company added 29,000 net new customers, a growth rate of 1.5%. Moving to Slide 12. Operating costs between periods decreased by $26 million -- I'm sorry, increased by $26 (sic) [$22.6] million or 3.8%. O&M costs were up $10.7 million or 3% due to higher general cost as well as a $5 million legal accrual, partially offset by lower pension costs. Depreciation and general taxes increased by 6% and 2%, respectively, due mainly to plant additions. Slide 13 provides a summary of other income and deductions, which increased from $8 million to $9 million between 12-month periods. Of note here is that both periods reflected much higher COLI income in our expected range of $3 million to $5 million. And lastly, with regards to the gas segment, Slide 14, identifies net financing costs, which increased $7.4 million between periods. This resulted from the 2013 debt offering previously mentioned, partially offset by debt refinancings and lower interest expense associated with deferred gas cost balancing accounts. Let's turn our attention to NPL now. Slide 15 provides a summary income statement for the quarterly and 12-month periods for NPL. The third quarter is traditionally NPL's strongest earnings period of the year as construction activities are at their peak levels in most of their operating areas. Now as Jeff mentioned earlier, NPL achieved record revenue and net income during the most recent quarter, substantially exceeding prior year results. And for the 12-month period, revenue increased $42 million. However, net income declined from $29 million to $22 million. Both 12-month periods contained unusual activity, which we have previously disclosed, that skewed results. I will reiterate those items in just a minute. Moving to Slide 16. Third quarter revenue of $206 million was $14 million or 7% greater than last year at this time, due to increased replacement construction with a number of existing customers. NPL was able to substantially complete the work that was carried over from earlier in the year when poor weather got us off to a slow start. Construction expenses increased $6.4 million or 4% between periods as a result of this incremental work. G&A costs, which are a component of construction expenses, included $1.2 million of cost related to the recent business acquisition completed in early October. With this quarter behind us, on a year-to-date basis, NPL revenues were $510 million, up 5% year-over-year and their contribution to the net income was up 4% from $18.7 million to $19.4 million. Based on this, we now expect NPL's full year 2014 net income to modestly exceed 2013 results. And lastly, Slide 17 summarizes the 12-month results and highlights the unusual items which affected both periods. There were 3 noteworthy items

[John P. Hester:]

Thanks, Roy. Turning to Slide 18. We have the summary of the results of our California rate case proceeding. This case concluded with the CPUC decision issued in June of this year. As we noted in our August earnings call, in addition to the $7.1 million in annual margin authorized by the CPUC, we'll have 2.75% increases in margin each year for the period of 2015 to 2018. We are on a 5-year rate case cycle in California, so our next rate case application is scheduled to be filed in late 2017, with new rates requested effective January 1, 2019. As Roy indicated, given the mid-year implementation of new California rates this year and the realization of $5 million in the third quarter, fourth quarter incremental California rate case margin should total only a few hundred thousand dollars. Moving to Slide 19. As Jeff mentioned earlier, we're very happy to report that we've reached a settlement in our previously pending Paiute Pipeline rate case that was filed in February this year. Recall that this rate case filing was required to be submitted per Paiute's last rate case settlement in 2009. Paiute had originally filed for a $9 million increase earlier this year. And in September, reached an agreement with shippers for a $2.4 million margin increase, along with a $1.3 million depreciation decrease. The new rates are effective September 1. An official settlement document is expected to be filed for next week, with final approval expected in January. In addition to the increase in operating income from this resolution, Paiute also secured 5-year contract extensions from its largest customers. Finally, under the terms of the settlement, Paiute is required to file its next rate case application no earlier than May of 2016 and no later than May of 2019. On Slide 20, we have summarized the parameters under which our next Arizona rate case filing will be submitted. Recall that our last rate case decision in Arizona provided for new rates effective January 1, 2012. That decision was the result of a settlement that provide for a $52.6 million in incremental margin in the decoupled rate structure. The settlement also incorporated a stay out provision that allowed the company to submit its next rate case filing no sooner than April 30, 2016, using a test period ended no sooner than November 30, 2015. These filing dates would permit new rates to be effective no earlier than May 1, 2017. Our settlement agreement also contemplates the filing of the depreciation study with the rate case filing. Turning to Slide 21. We continue to see our Nevada regulators to be supportive of safety oriented accelerated pipe replacement activities. The Commission approved the company request to establish regulatory assets to account for the depreciation carry cost of $15.6 million of accelerated pipe replacement in 2013 and $18.9 million of replacement in 2014. Last month, under new gas infrastructure recovery mechanism rules that were established in January, the Commission authorized Southwest to pursue $14.4 million of early vintage plastic pipe replacement in 2015. In a separate filing last month, Southwest requested the Commission to authorize a surcharge to recover cumulative replacement deferrals through August 2014. The surcharge is proposed to become effective January 1, 2015, and is expected to generate $2.1 million of cost recovery in calendar year 2015. On Slide 22, we note some of our other regulatory initiatives beyond rate case filings. First, our Arizona Customer-owned yard line program is finishing up its 3rd year of operation. 2013 capital expenditures in this program totaled $6 million, and we expect a comparable amount of replacement to be completed in 2014. The future of these expenditures may trend up as a result of the ACC's expansion of the program earlier this year, but now permits replacement of customer lines that are not yet leaking. Also in Arizona, we're currently awaiting an ACC staff report on the LNG storage facility application we submitted earlier in this year. This project is estimated to cost approximately $55 million. We're hopeful that a staff recommendation will be issued in the next few weeks with the final Commission decision by year end. With respect to Paiute Pipeline, we continue to pursue our proposal to build a 35-mile, $35 million lateral interconnecting pipeline. FERC staff has been reviewing the proposal and we anticipate that the FERC will issue its environmental assessment in January. The final decision is expected in April. If approved, construction would take place this coming summer, with an in-service date of November 1, 2015. Moving to Slide 23. Our deferred gas cost balances returned from a payable to a receivable over the past year. Southwest under-collected balance as of September 30 was $78.3 million. While we have regularly changing rate mechanisms in each of our jurisdictions, I will note that we submitted a request to implement a $0.06 surcharge in Arizona in May of this year, and that request was approved by the Arizona Commission in July. Given the relatively low volumes we've experienced in the summer, however, we won't realize meaningful incremental collections until this winter. The current gas price level is accumulative under-collected balance should be substantially recovered next year. With that, I'll turn the call back to Jeff.

[Jeffrey W. Shaw:]

Thanks, John. Let's look -- turn to Slide 24, speak to customer growth briefly. First of all, for the 12 months ended September, we had 20,000 first-time meter sets. We also added 9,000 additional meters that were the previously termed excess inactive meters. That number now is down below 20,000. It was at the worst, time period, 55,000, throughout our service areas, but it's down now below 20,000. We're happy to report that those meters are coming back on. So 29,000 net additional customers, about 1.5% growth rate. We expect for 2014 that, that growth rate of 1.5% will hold through the remainder of the year. Slide 25. If you look at our -- two rates here, the unemployment rate and the growth rate. You can see that in every one of our geographical areas, the unemployment rate has declined year-over-year, which is a good development. It's not dramatic, but it's definitely directionally positive. And then if you look at unemployment growth -- or excuse me, the employment growth numbers, they have all improved in every jurisdiction. So again, everything that you see on this chart is directionally positive. We're not seeing dramatic growth, but it's consistent, and it leads us to the conclusion that, that 1.5% number that we're giving you is a reasonable number to rely on. Slide 26, capital -- excuse me, construction expenditures. The total -- either expected for 2014 to total approximately $375 million. Franchise work and other replacements will account for about $182 million of that pie chart that you see on the slide, about 49%; growth will account for about $107 million or 29%; general plant, $47 million; replacement under trackers, $31 million, which is about 8%. And as you might have surmised, we are making efforts to try to increase that number and to make that a bigger percentage of the pie chart; and other was about $8 million, so that gives you a sense. Our 2014 through 2016 estimate that we included in our annual report to shareholders was an estimate of $1.1 billion in capital expenditures. We update that number each year after we put out the annual report, so you can expect to see an updated number then. Let's move then to Slide 27 and speak to dividends -- excuse me, net plant growth. I'm sorry, I'm getting ahead of myself. We expect about 4.5% net utility plant compound annual growth rate by the end of the year. That's been fairly consistent. We expect that operating cash flows were about $290 million, accounting for approximately 70% of Construction expenditures and dividend requirements for the 12-month period ended September 30, 2014. We expect, going forward, roughly 85% of funds required for Construction expenditures and dividends will be generated internally. Our rate base growth is highly correlated to our compound annual growth rate of net capital expenditure increases. However, bonus depreciation remains a wildcard. And it if it's up to me, and to the other CEOs in the industry, we would have Washington put the brakes on, because we -- it does have a tendency to foul up your rate base growth, so we're not fans of bonus depreciation beyond what we've already experienced, but we will obviously, do whatever the law requires. With that, let's go to Slide 28, and I'll turn it over to Roy to talk a little bit about the acquisition of Link-Line group of companies.

[Roy R. Centrella:]

Thanks, Jeff. On October 1, the company completed its acquisition of the Link-Line group of companies for $171 million plus $14 million of assumed debt. This acquisition expands our Construction Services footprint into Canada, making NPL one of the largest LDC service providers in North America. The deal was financed by NPL using a new 5-year $300 million secure revolving credit and term loan facility. Slide 29 provides some details about the 3 acquired entities. Link-Line Contractors is the single largest LDC contractor in Canada, operating in the Ontario province with about 700 employees. They serve 2 of the largest LDCs in Canada, as Ontario is the most populous province with over 13 million people. W.S. Nicholls provides fabrication and multi-trade operations for industrial projects in a number of varied industries in Ontario and Western Canada. They've been in business since 1996. And Brigadier Pipelines performs midstream Construction in Pennsylvania, providing NPL an entry point in a fast growing market segment. The next slide provides a map of the NPL and Link-Line companies' operating areas. The takeaway here is that there are no overlapping service territories in the Distribution and Construction businesses. And finally, Slide 31 shows the Link-Line company's revenue, operating income and EBITDA levels for 2013. Much like the U.S., Ontario has significant pipe replacement needs for pre-1960s steel mains, early vintage plastic pipe and aged mechanical fittings. They're also experiencing strong population expansion, which is translating into new housing growth. As such, we are very excited with this acquisition, and expect earnings accretion in the first full year of operations. With that, I'll turn the time back to Jeff for a few closing slides and comments.

[Jeffrey W. Shaw:]

Okay, thank you. Slide 32, now is the time I'll speak to dividends. Over the last 5 years, our annual growth rate has been approximately 9%, just under. In the last 3 years, we've exceeded a 10% increase of the dividend in each of those years. Over time, the Board tends to increase the dividend, such that our payout ratio approaches our local distribution company peer group average of around 55% to 65%, while maintaining our strong credit ratings on our ability to effectively fund the future rate base rate growth. Our payout ratio for the 12 months ended September 30, 2014, the dividends per share were $1.46; EPS $3.01; out ratio, 48.5%. The timing and amount of any increases will be based on the Board's continuing review of our dividend rate in the context of the company's 2 operating segments and their future growth prospects. If you look historically, the Board's addressed dividend policy in February of next year for the last several years. Finally, 2014 outlook update. For the Construction Services portion of our business, we remain cautiously optimistic that earnings for the full year 2014 net of acquisition-related costs will be consistent with or exceed 2013 results. We believe Link-Line fourth quarter earnings, expect to substantially offset acquisition costs. We've also believe the current low interest rate environment and the regulatory environment, which occurs in the natural gas industry to replace aging pipeline infrastructure will continue to positively influence revenues. And the management team is charged and enthusiastically pursuing growing revenues by 5% to 8% on average over the long-term, and that would include the combined entities of NPL and Link-Line. For the natural gas operations segment on Slide 34, operating margin for 2014 is expected to be favorably influenced by customer growth, again, approximately -- approximating 1.5%. The infrastructure mechanisms, both in Nevada and Arizona should contribute modestly to 2014 results. The rate relief we previously mentioned from the recent California rate case decision has been largely recognized in the current year. And incremental margin for the fourth quarter will not -- above 2013 levels for the fourth quarter will not be significant. And a proportion share of Paiute's recent settlement rate increase is anticipated to be realized during the fourth quarter. Finally, Slide 35, operating costs increases, we expect approximately 3% for the current full year. Now that includes a net pension and expense decrease of $5 million and a legal accrual expense of around $5 million net out. Net financing cost will also increase this year by about $6 million in total, primarily due to the October 2013 issuance of $250 million of 4.875% senior notes, partially offset by our November 14 redemption of $65 million of 5.25% Series A fixed rate IDRBs. With that, I will return the time back to Ken, prior to our -- taking any of your questions.

[Kenneth J. Kenny:]

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

[Operator:]

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

[Matthew P. Tucker:]

First question on the Link-Line acquisition. I appreciate that you gave us some 2013 financials. Would you be willing to talk at all about how those numbers have trended so far in 2014, year-to-date?

[Roy R. Centrella:]

The results, at this point in time, have been pretty solid. I mean, I don't think -- given that we've only had them starting in October 1, it's difficult to provide much color on that, but we're very pleased with the first 9 months of the year as reported back to us. Obviously, we didn't have the keys then, but -- we think their -- that the fourth quarter will be good, and our full year for next year will be good.

[Matthew P. Tucker:]

And you talked in the past about the $1 billion revenue as kind of a threshold that you need to reach before it even makes sense to consider kind of strategic options for NPL. Based on the 2013 numbers you provided for Link-Line, and kind of your long-term growth expectations for the business, it looks like you could be approaching that number next year. Can you just talk a little bit about how now you're thinking about the longer-term strategy with the Construction segment?

[Jeffrey W. Shaw:]

This is Jeff. Let me go ahead and address that. Firstly, we're very, very excited to have this acquisition. We really like the management team that came with the acquisition. We think they have a great business. We think they have a lot of potential for growth in Canada. We're also very bullish on the management team that we've assembled, and that has continued to evolve at NPL. And we have talked about some of the additions that we made there. So we think we've positioned ourselves to take advantage of some opportunities that are before us. Most of the utilities, the LDCs throughout the country, and also in Canada, have announced multiple-year, large replacement type -- infrastructure replacement-type projects or work that needs to be accomplished. And we believe we have a -- 2 companies here, by bringing them together, that are very -- that carry very good reputations, that know how to bid, know how to proceed profitably. So when we did this acquisition, we wanted to make sure that we saw accretion in the future by making the acquisition as we've disclosed before, we expect it to be accretive in the year 2015. And as I mentioned earlier, we think that the performance in the fourth quarter will largely offset the transaction cost. So we're very bullish going forward. Now to your question, yes, we did mention $1 billion is sort of a threshold. And it's possible that next year, we reach that threshold. But I will say this, when you get the keys to a car, you want to drive it and make sure that you understand it and take full advantage. And I think we have some opportunity with that combined entity to take a little time, and not be too much in a hurry to jump to a conclusion. What we did say is we felt like we needed to get to $1 billion before it would even be an option for the Board to consider something different than just continuing to hold it. But let me also say that holding the business on a going forward basis is also an option for the Board. And if the business does well and we can continue to grow the utility, then there may be no impetus to cause us to want it to shed the company. So I think we have options that are evolving and developing before our Board, and that was the whole idea behind doing the acquisition.

[Matthew P. Tucker:]

That's great color. Just shifting gears to the utility side. I guess, could you just help me understand kind of the mechanics behind the $5 million benefit from California rate relief that you on the third quarter, and why you're not expecting much now in the fourth quarter? And then also, your comment about not seeing much additional rate relief going forward. Was that just for the fourth quarter? Or does that apply to 2015 as well?

[John P. Hester:]

Matt, this is John. With respect to the California margin, what we have in California is a decoupling mechanism subsidy amount of margins annually. And when we get a rate case decision, we spread that margin across the various months, the amounts of that margin by month are incorporated in our tariffs. So we wanted to see what that margin would be in a particular month, and I think that when you compare how that spreads with, in place for 2013 and then you compare that to 2014, that's where that differential comes from. So that the goal is to certainly recover the entire amount of margin over a 12-month period, but depending on the rate case, the cost of service, the value of the amount of the increase, et cetera, that spread over the various months can differ.

[Matthew P. Tucker:]

And then, just with respect to your interest expense guidance, and I guess, how will you finance the IDRB redemption, in I guess, later this month? And I assume the borrowings to finance the Link-Line acquisition are included in that guidance, is that interest rate just so low there, that doesn't have much of an impact?

[Roy R. Centrella:]

Yes, this is Roy. In terms of the IDRBs, we had capacity on our working credit -- working capital facility to take that out. And so at least in the short run, you would see some significant cost savings, but that's already -- that's been baked in for the rest of this year into our forecast of interest expense. But some of those savings would roll forward into 2015. At some point, given our capital requirements, we will have to go out and do another offering. It could be late '15 or early '16. We haven't decided on the timing yet, but at this point in time, our working capital facility was sufficient. The Link-Line acquisition that was on the books of NPL and -- so that being a 5-year note, the interest rates on that are, at this point, fairly modest. I'd say LIBOR plus a spread rate, 1.75%, or it's a Canadian equivalent, plus a spread, depending on which entity -- where the borrowings are, so we could borrow either in Canada or the U.S. So yes, I guess, -- so that -- those borrowings are not part of our debt forecast, so we say interest is up $6 million, that's the gas segment.

[Operator:]

There are no further questions in the queue.

[Jeffrey W. Shaw:]

Okay. Well, thank you, Tony. This concludes our conference call, and we appreciate your participation and interest in Southwest Gas Corporation. Thank you.

[Operator:]

Ladies and gentlemen, again, thank you for your participation. You may now disconnect, and everyone, have a great day.