Good day, ladies and gentlemen, and welcome to the Black Hills Corporation First Quarter 2018 Earnings Conference Call. My name is Brian, and I will be your As a reminder, this conference call is being recorded for replay purposes. I would now like to turn the presentation over to Mr. David Soudouquist, Investor Relations and Analysis of Black Hills Corporation. Please proceed, sir.
Good morning. Welcome to Black Hills Corporation's Q1 2018 18 Earnings Conference Call. Leading our quarterly earnings discussion today are David Emery, Chairman and Chief Executive Officer and Rich Kinsley, Senior Vice President and Chief Financial Officer. Before we begin today, we would like to note that Black Hills will be attending the American Gas Association Financial Forum starting May 20 in Phoenix, Arizona. Our presentation materials and webcast information will be posted on our website atwww.blackhillscorp.com under the Investor Relations heading.
During our earnings discussion today, some of the comments we make may contain forward looking statements as defined by the Securities and Exchange Commission, and there are a number of uncertainties inherent in such comments. Although we believe that our expectations and beliefs are based on reasonable assumptions, actual results may differ materially. We direct you to our earnings release, Slide 2 of the investor presentation on our website and our most recent Form 10 ks and Form 10 Q filed with the Securities and Exchange Commission for a list of some of the factors that could cause future results to differ materially from our expectations. I will now turn the call over to David Emory.
Thank you, Dave. Good morning, everyone. I will be starting my comments on Slide 3 of the webcast deck for those of you following along. We'll have a format similar to past quarters. I will give a quick update on the quarter.
Rich Kinsley, our CFO, will give the financial update for the quarter. I'll cover forward strategy and then we'll address questions. You may have noticed or will notice as we go through the process this morning that we've made a few changes to our presentation format. Notably, we've added some more detail to our forecasted capital spending, which should improve some visibility into our future earnings growth. We expect to further enhance those disclosures as the year progresses.
Moving on to Slide 5, Q1 2018 highlights for our utilities. On the 25th April, our Colorado Electric utility received approval from the PUC in Colorado to contract with our own IPP subsidiary Black Hills Generation to purchase 60 megawatts of wind energy through a 25 year power purchase agreement. That agreement will provide the final amount of renewable resource we need to meet the state's renewable energy standard of 30% by the year 2020. On April 26, Rocky Mountain Natural Gas, which is our intra state gas pipeline in Colorado, received a recommended decision from the Colorado Administrative Law Judge approving a settlement for the rate review it filed in October of last year. That settlement, which is subject to final approval from the Colorado PUC includes a $1,100,000 increase in annual revenue and importantly, an extension of our safety system and integrity rider to cover investments that will be made this year through 2021.
It includes an authorized return on equity of 9.9% and a capital structure that's 46.6 percent equity. We expect new rates to be effective June 1, again pending final approvals from the commission. Moving on to Slide 6, continuing with utilities highlights. During the quarter, our South Dakota electric utility commenced construction on a $70,000,000 175 mile transmission line from Rapid City, South Dakota to Stegall, Nebraska. That project will be constructed in 2 segments.
The first should be placed in service by the end of this year and the second segment by the end of 2019. Also during the quarter, we continued our efforts to simplify our utility organizational structure by restructuring several of the legal entities that we acquired in 2016 through the Source Gas acquisition. That restructuring resulted in a $49,000,000 tax benefit associated with goodwill that is now amortizable for tax purposes. Highlights for our power generation segment for the quarter, I already noted on April 25, our electric generation subsidiary was selected to provide 60 megawatts of wind to our Colorado electric utility. That $71,000,000 Bush Ranch 2 wind project should be constructed and in service prior to the end of 2019.
Moving on to Slide 7, corporate highlights for the quarter. On April 23, our Board declared a quarterly dividend of 0.475 dollars a share, which is equivalent to an annual dividend rate of $1.90 per share. That $1.90 per share equivalent rate represents our 48th consecutive annual dividend increase. On March 8, S and P affirmed its corporate credit rating for Black Hills Corporation at BBB Flat, but revised its outlook to positive from stable, which we found encouraging. Finally, related to discontinued operations, which is our oil and gas segment, as of yesterday, we'd executed agreements to sell or had closed on sales transactions for about 96% of our oil and gas properties as measured by gross well count.
We expect to sell the remaining assets prior to the end of the quarter. Slide 8 provides a reconciliation of 1st quarter net income from continuing operations as adjusted compared to the Q1 of 2017. The most notable change being improved performance at our gas utilities. Rich will provide more detail on his financial update, which I'll turn it over to Rich to cover financials.
Very good. Thanks, Dave, and good morning, everyone. As Dave touched on, we delivered solid Q1 financial performance. With help from favorable weather, year over year, our natural gas utilities delivered strong financial results in Q1, demonstrating the benefits of our diversified utility portfolio and the 2016 SourceGas acquisition. I'll jump in on slide 10, where we reconcile GAAP earnings to earnings as adjusted to non GAAP measure.
We do this to isolate special items and communicate earnings to better represent our ongoing performance. This slide displays the last 5 quarters and trailing 12 months as of March 31, 2018 2017. As detailed on the slide, we experienced special items not reflective of our ongoing performance in each of the past 5 quarters. The first special item is acquisition related expense associated with the Source Gas acquisition and integration. We completed our integration work in 2017 and don't have that adjustment in 2018 or forward.
The second special item relates to income taxes and is predominantly the result of federal income tax reform. The corporate tax rate change from 35% to 21% beginning in 2018 required a revaluation of our deferred tax assets and liabilities on December 31, 2017, resulting in a $0.21 EPS benefit in the Q4 of 2017. Given additional information in Q1, certain estimates impacting the revaluation have been updated resulting in a Q1 charge of 2,300,000 or $0.04 of EPS. The largest special item in Q1 2018 also related to income taxes. As Dave noted, as part of our effort to simplify our legal organization, in Q1, we restructured certain entities as part of the 2016 Source Gas acquisition.
The restructuring increased goodwill that is amortizable for tax purposes resulting in an associated deferred tax benefit of $49,000,000 or $0.91 of EPS. These items are not indicative of our ongoing performance and accordingly we reflect them on an as adjusted basis. Our Q1 as adjusted EPS was $1.63 compared to $1.44 for the Q1 last year. The earnings uplift compared Q1 this year to Q1 last year was primarily driven by a colder winter heating season at our gas and electric utilities compared to a mild winter last year. We estimate mild weather last year as compared to normal negatively impacted Q1 2017 EPS by $0.09 This year we estimate that colder weather compared to normal positively impacted Q1 2018 EPS by 0 point 0 $5 Slide 11 is a new slide we've added to our investor materials to provide additional transparency related to year over year comparisons.
The waterfall chart illustrates major drivers that comprise the differences from Q1 2017 to Q1 2018. All amounts on the chart are net of Again, you'll note weather was a large positive driver year over year, especially at the gas utilities. We recorded a revenue reserve in Q1 2018 at the gas and electric utilities due to tax reform as we expect to pass the benefit of the lower corporate tax rate on to customers through reduced bills. However, this has no impact on net earnings due to the lower income tax rate as a result of tax reform. Dave will touch on this more in a bit, in short, we continue to work with our regulators in each of our states to pass the tax benefit from tax reform to our utility customers.
You can also see we did a good job managing O and M on a consolidated basis with limited O and M increases year over year. Slide 12 displays our Q1 income statement. Gross margin was flat year over year despite the revenue reduction related to tax reform that I noted a moment ago. Operating expenses and DD and A increased modestly comparing Q1 2018 to Q1 2017, primarily due to typical operating expense increases and incremental plant investments. Operating income was down for the quarter compared to the prior year, again mainly due to revenue reserves related to tax reform, which is offset by reduced income tax expense below the operating income line.
Moving below the operating income line, interest expense increased slightly year over year due to higher interest rates on our variable rate short term The most significant change comparing Q1 2018 to Q1 2017 is on the income tax line. You'll note the $26,000,000 income tax benefit recorded in Q1 2018 despite $113,000,000 of pre tax income. This resulted from the legal reorganization we mentioned already. The effective tax rate after adjusting out the special items I noted on slide 10 is 18.9% in Q1 2018 compared to 29.6% in Q1 2017. The lower effective rate this year was driven by tax reforms corporate rate reduction.
Moving to the as adjusted income from continuing operations line, we generated $88,000,000 for the quarter compared to $79,000,000 for the same quarter last year, a 12% increase. You'll note our Q1 2018 diluted share count decreased to Q1 2017. This was due to the application of the treasury stock method related to the unit mandatory securities we issued in late 2015 to help fund the SourceGas acquisition. Until the securities convert to equity in November of this year, we're required to apply the treasury method of accounting whereby we include a portion of the shares in our diluted share count. The number of shares we include is based on the average daily closing price of our stock during the reporting period.
Our average share price was lower in Q1 2018 compared to Q1 2017. So in Q1 2018, we added approximately 700,000 shares to our diluted share count compared to approximately 1,600,000 additional shares in Q1, 2017. As I noted in our year end earnings call on February 2nd, we're assuming approximately 56,000,000 weighted average shares in our full year 2018 guidance as we will have approximately 60,000,000 diluted shares beginning November 1 after the conversion occurs. Considering the increase in as adjusted net income and the reduced share count as adjusted EPS grew $0.19 or 13% from the same quarter last year. I'll now discuss each business segment.
Slide 13 compares our electric and gas utility segments Q1 2018 gross margin and operating income compared to Q1 2017. Our electric utilities operating income decreased 7,300,000 dollars Q1 2018 compared to Q1 2017. Electric utilities gross margin decreased $1,400,000 quarter over quarter, driven by a $6,100,000 revenue reserve related to tax reform, partially offset by higher margins from in transmission, favorable weather and higher non energy revenues. Operating expenses including depreciation were $5,900,000 higher for the Q1 in 2018 compared to the Q1 of 2017 as a result of increased vegetation management and outage related expenses as well as increased property taxes and depreciation associated with rate based investments. Moving to the right slide of Slide 13, our gas utilities reported an increase of $3,400,000 in operating income comparing Q1 2018 to Q1 20 27.
Gross margins were favorable by $4,200,000 quarter over quarter as cold weather added $9,000,000 of incremental margin year over year. Heating degree days were 2% higher than normal in Q1 2018 compared to 13% below normal for Q1 2017. Customer growth and capital recovery rider mechanisms added approximately $4,000,000 to margins year over year. These increases were partially offset by tax reform related revenue reserves of $9,000,000 Operating expenses were nominally higher compared to the prior year reflecting strong cost management of the gas utilities. As I noted earlier, the unfavorable impact of operating income to operating income from tax reform at both the electric and gas utilities is offset by lower income tax expense and is earnings neutral.
On Slide 14, you see that power generation operating income $400,000 comparing Q1 2018 to Q1 2017, primarily from reduced sales volume under our power purchase agreements. The Power Generation segment continued to realize strong contract availability from its generating units and continued its strong earnings and cash flow contributions. Also on Slide 14, you'll see in the Q1 of 2018, our mining segment had a $1,000,000 operating income increase compared to Q1 2017. For the quarter, revenue was $600,000 higher primarily from higher tons sold in 2018. On the O and M side, we decreased cost by $400,000 Our mine continues to perform at a high level with sales almost entirely to on site mine mouth plants and roughly half our sales based on a cost plus pricing methodology.
Slide 15 shows our capitalization. At March 31, our net debt to capitalization ratio was 64.1%, a decrease of 190 basis points from year end. This reduction was driven by the increase in retained earnings due to our solid first quarter earnings as well as by strong Q1 cash flows that allowed us to reduce our total debt from year end. Our $299,000,000 of unit mandatory securities are reflected as debt on our balance sheet until the units convert to equity on November 1 this year. After conversion, we expect our debt net debt capitalization ratio to decline below 60%.
While we may need to increase our short term borrowings from time to time over the course of 2018 2019 to fund our currently forecasted capital expenditures, we don't anticipate the need to issue any equity to fund these activities. If additional capital investment opportunities emerge, we have our at the market equity program available if the need to issue any equity arises. Slide 16 shows our debt maturity schedule. We're also evaluating options for the 2019 2020 maturities. Slide 17 shows our investment grade credit rating.
As Dave noted, during the Q1 S and P affirmed our BBB credit rating and upgraded the outlook positive. We're committed to maintaining our strong investment grade credit ratings and our forward forecasted metrics support those ratings. On Slide 18, we're reaffirming our 2018 earnings guidance of $3.30 to $3.50 per share based on the assumptions previously provided on February 2, 2018. I'll turn it back to Dave now for his strategic overview.
All right. Thank you, Rich. Moving on to Slide 20, we group our strategic goals into 4 major categories, profitable growth, valued service, better every day and great workplace with the overall objective of being an industry leader in all we do. On Slide 21, from a strategy execution perspective, we're focused on delivering strong long term total shareholder returns. We plan to accomplish that by achieving a long term EPS growth rate that's above the industry average, targeting a 50% to 60% dividend payout ratio, while still retaining the flexibility to increase that dividend during periods of slower EPS growth and continuing our track record of 48 consecutive annual dividend increases.
On Slide 20 2, we're currently in the process of transitioning our earnings growth drivers from a largely acquisition and integration focused strategy over the last year or so with the Source Gas acquisition back to a more traditional utility growth approach. In the near term, this year and next year, we expect slower earnings growth since we're entering test years in preparation for rate review filings or actually commencing those rate review filings in some of our jurisdictions. We do have 3 active rate review processes currently in process right now. Over the long term, starting in 2020 beyond, we expect higher earnings growth expectations, driven by strong capital investments to meet our customer needs, continued focus on standardization and efficiency improvements and back to more regular rate review filings. Slide 23, as we focus on delivering long term shareholder value, our fuel and service territory diversity reduces our business risk and drives more predictable earnings.
Slide 24, our utility acquisitions over the years have created a much larger transmission and distribution system network both on the electric and the gas side of the business. With that increase in size comes increased opportunity for investment to serve a much larger customer base. Moving on to Slide 25, strong capital spending has in the past and will continue to drive much of our earnings growth. We plan to invest almost $2,300,000,000 over the next 5 years to better serve our 1,250,000 utility customers and that level of investment far exceeds depreciation contributing to earnings growth. Slide 26, which is a new look provides a detailed capital spending forecast for our gas utilities, including breakouts by state investment type and recovery mechanisms for a full 5 years compared to the 3 years that we previously disclosed.
Slide 27 provides a similar capital spending detail for our electric utilities. Moving on to Slide 28, this slide provides a regulatory update for our utilities, highlighting the status of our active rate review filings and our federal income tax reform dockets by state. You'll notice that we've completed the process of determining customer benefits for federal income tax reform in both Iowa and Kansas and either have started to reflect those changes on customer bills as is the case in Iowa or are planning to beginning in Kansas, I'm sorry, and then planning to do that beginning in July for the State of Iowa. I've already noted the other key regulatory updates with one exception and that is on April 30, we received an order from the Denver District Court regarding our appeal of the Colorado Public Utility Commission's prior decision on our 2016 rate review for Colorado Electric. There are several issues addressed in the ruling, some positive and some negative for Black Hills.
Most notably, we're very disappointed that the court affirmed the commission's decision related to the rate treatment of the new gas turbine generator we constructed in Colorado. The PUC in that 20 16 rate decision assigned a lower return on investment for that turbine than for any of our other utility assets in Colorado. The turbine was built in response to the Colorado Clean Air Clean Jobs Act, a law passed in Colorado that was intended to provide an incentive to utilities to retire their coal fired generation before the end of its useful life and replace it with cleaner, more modern generation. For the commission to assign a lower return on investment for the new generation after we built it in good faith and in compliance with the Clean Air and Clean Jobs Act is very troubling. And the fact that the court upheld that is even more troubling.
And frankly, we feel it's contrary to the intent of the Colorado Clean Air Clean Jobs Act. We're currently evaluating the impacts of the court order on our business and considering our next steps in the legal process. Moving on to Slide 29, we're extremely proud of our track record of annual dividend increases that I mentioned earlier, including stronger increases the past several years, reflecting our confidence in strong future earnings growth and cash flows. As I noted earlier, we have the flexibility to use larger dividend increases during periods of slower earnings growth to help deliver solid total shareholder returns. Even after relatively strong dividend increases during the past few years, we're still well within our targeted 50% to 60% dividend payout ratio range.
Moving on to Slide 30, we focus every day on operational excellence. We continue to make great progress improving our safety performance and also continue to consistently demonstrate our power plant availabilities, which are among some of the best in the industry. On Slide 31, we note that we've created a new corporate responsibility report, which is available on our website. We encourage you to check that out. And finally, on Slide 32, this is our scorecard for 2018.
This is our way of holding ourselves accountable to you, our shareholders, for our accomplishments and our key strategic objectives. Now that concludes our remarks. We'd be happy to entertain any questions.
Thank you, sir. Ladies and gentlemen, we are ready to open the lines for your questions. And our first question will come from the line of Julien Dumoulin Smith with Bank of America Merrill Lynch. Your line is now open. [SPEAKER JULIEN
DUMOULIN SMITH:] Hey, congratulations.
[SPEAKER JULIEN DUMOULIN SMITH:]
Good morning. So perhaps just to come back to a few things you said. First off, on the wind award, just curious, how do you think about the earnings profile of that asset, specifically on the latest one? But more broadly, do you anticipate participating perhaps even outside of your service territory for these kinds of projects more strategically, right, I. E.
More contracted? I suppose this is the latest example. So I'd just be curious.
Yes. I would categorize this one. Obviously, this is an investment from our IPP subsidiary. I would categorize the earnings from that as probably consistent with how you would look at an IPP project. That is it's financed with a little more debt than you would expect from a utility capital structure and then also the returns would be consistent the I would say the answer is yes, but on a limited basis.
I think there would have to be a very compelling strategic reason for us to do so, whether that's a relationship with an existing wholesale customer or something like that. We don't have any aspirations of running out and being a full blown competitor in the IPP business. That's not our strength. But I do think there are certain circumstances where it may make sense for us to do this for others. They would be fairly few and far between, however.
Got it. And just on in terms of like the net income profile of the latest wind investment, would you characterize this as a premium or discount to the traditional utility returns?
Well, I think the return would be probably comparable, but the capital structure is significantly different with less equity, right. And then as consistent with wind projects and other renewable projects, a lot of the earnings are really driven by production tax credits. So they show up below the operating income line.
And I'd add one thing to that, Julian. That was a competitive process and there were a lot of bids. It was vigorously competitive. So we did have to be aggressive to win that bid.
Got it. All right. Understood. And actually, let me turn back to you real quickly here, Rich. In terms of the comments you made on the call around capital spend and the potential need for equity, just can you frame that a little bit in terms of of under what circumstances you would see that at this point in time?
And then secondly, I suppose related to that, you provided a little bit more of an extensive view on your CapEx here out to 'twenty two. Can you talk about some of the other big puts and takes that might materialize here in your forecast, now that we've got the win win out?
Yes. From Q1 to Q2, you can see the difference in our CapEx schedule is the addition of the wind project. We added $11,000,000 to this year's capital and $60,000,000 to next year. We're still comfortable that after the convert, we're going to be well below 60%. When that converts, that will get our debt to total cap down below 60%.
And our cash flow should keep us there through the end of 2019. And then if you look post 2019 at that CapEx schedule, we should remain comfortably there. If additional large projects come up, we may need to issue some equity. That's where I'd leave that, Julian.
Yes. And I'd say that story is consistent with what we've talked about in the past, Julian. We've said we have fairly aggressive capital spending outlook going forward, but we expect to finance that with internal cash flows and debt absent any big special projects that might get added. And that is why we've kept our at the market equity issuance program active, just in case we may have one of those projects, but we would only use that in the event that we'd have some additional CapEx that is not on our current schedule.
But is there any other large capital project whether in procurement now or bidding etcetera that we should be paying attention to? It doesn't sound like it.
Well, there's several that are in the works, but not mature enough to the point that we're ready to talk about specific projects. I mean, we're always looking at some renewable projects for our electric utilities, pipelines for our gas utilities, transmission lines we've talked about, things like that. And we have several of those that we're looking at and studying and potentially would integrate into our forward plans, just not mature enough to actually file a certificate of public convenience and necessity or something that would say we're really ready to propose yet.
Got it. Excellent. Well, thank you very much.
Thank you.
Thank you. And our next question will come from the line of Michael Weinstein with Credit Suisse. Your line is now open.
Hi, guys. Good morning, Mike.
Hey, I may have missed this, but in light of the court decision now, I mean, can you still file for rehearing? I think you can, right? I mean, they should I think they from my understanding that the commission had suspended the rehearing or canceled it waiting for the court decision, right? So is it possible that they might take it back up again anyway?
Yes. We've got several options. We're evaluating all those. One is of course another level of appeal, which we certainly could do. The other one is we could basically elect to either go back and ask the
commission to rehear that or
All those options are on the table. And frankly, having just received that ruling earlier this week, we're still in the process of discussing what those options are and which ones would be the best to pursue at this point in time. But they're all on the table.
Yes. I guess, I mean, my other interest there is that in light of the approval for Busch Ranch and also the Rocky Mountain Gas Pipeline ALGM recommendation, those decisions, do you think they bode well for a possible rehearing despite the court decision?
It's really hard to say and hard to speculate. I think we've been pleased with our working relationship with the commission recently, and we hope that continues.
Okay. Can you give any color on the other discussions on the pass back of tax savings beyond Iowa and Kansas?
Well, they're all in various states of process. So the Colorado Rocky Mountain Natural Gas Pipeline that settlement includes the impacts of tax reform. Our active rate reviews in Northwest Wyoming and in Arkansas, when they get completed, will include the results of tax reform. And then all of the others are at various stages in the process from very early to well underway. Our tact in most of those and it's going to be a commission dependent decision state by state, but we've taken the position that we think it's best for customers to go back to the most recent rate case and just compute the difference in the tax rate and start collecting or stop collecting that difference from customers going forward and of course refund it back to the effect of date of the tax rate change.
That's not going to happen in every state. We don't think some of them are asking us to look at what's the current impact rather than the impact back to the most previous rate case. But all are progressing and we're comfortable and happy frankly with the progress we're making. Some will be a little slower though.
Got you. All right. Thanks a lot.
You bet. Thank you, Mike.
Thank And I'm showing no further questions over the phone lines. Mr. David Emory, please proceed with closing remarks.
All right. Thank you. Well, thanks for your time and attention this morning, everyone. We appreciate you attending our Q1 earnings call. And for those of you who are going to be at the AGA Financial Forum, we look forward to visiting with you there.
Have a great day and a great weekend. Thank you.
Ladies and gentlemen, thank you for your participation on today's conference. This concludes the presentation. You may now disconnect. Good day.