Good day, everyone, and welcome to the ONE Gas First Quarter Earnings Conference Call. Today's conference is being recorded. And at this time, I'd like to turn the conference over to Mr. Brandon Lohse. Please go ahead.
Good morning, and thank you for joining us on our Q1 2018 earnings conference call. My name is Brandon Lozzi. I am pleased to have just joined the ONE Gas team as the new Director of Investor Relations. This call is being webcast live and a replay will be made available. After our prepared remarks, we will be happy to take your questions.
A reminder that statements made during this call that might include ONE Gas expectations or predictions should be considered forward looking and are covered by the Safe Harbor provision of the Securities Acts of 1933 34. Actual results could differ materially from those projected in any forward looking statements. For a discussion of factors that could cause actual results to differ, please refer to our SEC filings. Our first speaker this morning is Curtis Dinan, Senior Vice President, Chief Financial Officer and Treasurer of ONE Gas. Curtis?
Thanks, Brandon, and welcome to the ONE Gas team. Good morning, everyone, and thank you for joining us. Beginning with our financial results, net income was $90,800,000 or $1.72 per diluted share compared with $76,500,000 or $1.44 per diluted share for the same period last year. The strong quarterly results reflect increases from new rates in Texas and Kansas that were approved in 2017. Weather normalization mechanism effects in Kansas and Oklahoma and higher volumes from transportation customers.
It's important to note that while weather in the Q1 was 1% warmer than normal, it was 31% colder than the same period last year, resulting in our net margin being positively affected by $2,500,000 or $0.05 on an earnings per share basis compared with the prior year. Due to the new accounting standard for share based compensation that we adopted prospectively on January 1, 2017, we recorded a $2,800,000 tax benefit and income tax expense, which resulted in a $0.05 per share positive impact to net income in the Q1 of 2018, slightly higher than the $0.04 per share indicated in our guidance in January but below the $0.10 impact we recorded in the Q1 of 2017. As we previously indicated, the impact of this new accounting standard will depend on future share performance. Operating costs for the Q1 were lower by $1,900,000 compared with the same period last year, and capital expenditures increased $16,000,000 compared with the same period last year as our mix of projects was more heavily weighted to capital spending versus operational spending. We continue to invest in technology and infrastructure, which translates into improved efficiencies and reduced operating costs.
One such example is our investment in AMR or automated meter reading. At the end of 2013, AMR penetration was around 65% of our meter assets. And as of the end of Q1, we were over 85%. This technology reduces our labor, equipment and other operating costs, helping achieve our goal of reducing expenses to sustainable levels. This investment has been beneficial, and we will continue to make additional investments to improve efficiencies and reduce operating costs over the next several years.
Regarding tax reform. In compliance with the accounting authority orders in each of our regulatory jurisdictions, we have established a regulatory liability for the difference in federal taxes included in our rates that have been calculated based on a 35% statutory income tax rate and the new 21% statutory income tax rate. The establishment of this regulatory liability resulted in a $12,300,000 reduction to our revenues in the Q1 2018 or $9,300,000 net of tax, offset by a $16,200,000 reduction in our income tax expense. This timing difference between the revenue deferral and the reduction in our income tax expense created a $0.13 positive impact in our results this quarter, but the impact is expected to reverse by year end. While the long term effect of tax reform is negligible, in the near term, it will impact the timing and distribution of our quarterly earnings profile.
Our earnings profile has some seasonality to it. So in quarters where seasonal earnings are higher, the impact of tax reform will be positively accentuated and vice versa. Moving on from tax reform. Yesterday, the ONE Gas Board of Directors declared a dividend of $0.46 per share, the same as the previous quarter. This dividend is consistent with the company's guidance for 2018.
As we have indicated previously, we expect the average annual dividend increase to be 7% to 9% between 2017 2022 with a targeted dividend payout ratio of 55% to 65% of net income. We also affirmed our 2018 earnings per share guidance of $2.96 to $3.20 per share. However, with the strong first quarter, we believe that the more likely scenario puts us in the upper half of that range. At March 31, 2018, our current authorized rate base, defined as the rate base established in our latest regulatory proceedings, including full rate cases and interim rate filings, was approximately $3,000,000,000 With additional investments in our system and other changes in the components of our rate base that have occurred since those regulatory filings, we project that our rate base in 2018 will average approximately $3,400,000,000 with 42% of that being our rate base in Oklahoma, 32% in Kansas and 27% in Texas. And now I'll turn it over to Pierce Norton, ONE Gas President and Chief Executive Officer.
Pierce? Thanks, Curtis, and good morning, everyone. I'd like to give you an update on recent regulatory activity in our service areas. So let's begin in Oklahoma. In March, we filed our 2nd annual performance based rate change application since the general rate case that was approved in January of 2016.
We identified a $5,600,000 credit to our base rates associated with the impact of tax reform. Our procedural schedule has not yet been approved, but we do anticipate an order in the Q3 of 2018. Now on to Kansas. In April, the legislative bill expanding the scope of the gas system reliability surcharge mechanism was approved. Beginning January 1, 2019, the scope of safety related capital investments that qualify under the GSRS statute will be expanded to include expenditures to replace, upgrade or modernize obsolete facilities as well as projects that enhance the integrity of the pipeline system components or extend the useful life of such assets.
Safety related investments will also include expenditures for physical and cybersecurity. In addition, the capital or the cap on the surcharge will be increased to $0.80 per residential customer per month from $0.40 This legislation allows us to begin earning on eligible capital sooner with the expanded definition through GSRS filings instead of having to wait for the general rate case. While the updated scope of GSRS will assist in the timing of recovery for capital spending, we are already spending at accelerated paces in Kansas to support our long term plan. We have only 17 miles of cast iron pipe remaining in Kansas and our own pace to have all cast iron out of our system by the end of next year. After all the cast iron is removed, those capital dollars will be shifted to remove more bare steel pipe.
We are expecting to file our next general rate case in Kansas before July 2018 based on a 2017 test year. The impacts of tax reform will be reflected through our filed cost of service. And in Texas, we've made the filings under the Gas System Reliability Infrastructure Program for all customers in the West Texas service area requesting an increase of $3,500,000 This increase is offset by $4,700,000 request for a decrease to rates due to the reduction in the federal income tax rate. A onetime refund of $2,400,000 is also being requested for changes to the tax rate for the period between January 1, 2018, to the date when the new rates are implemented. If approved, both filings for West Texas are expected to become effective July 2018.
Similar to West Texas, we've also made GRIP filings for all customers in the Central Texas service area requesting a $3,300,000 decrease I'm sorry, increase, which is offset by a $4,900,000 request for decrease to rates due to the reduction in the federal income tax rate. A one time refund for $2,500,000 is also being requested for changes to the tax rate for the period between January 1, 2018, to the date when the new rates are implemented. If approved, both filings for Central Texas are expected to become effective in July 2018. Billings to incorporate tax reform into rates were also made in the Rio Grande Valley service area but are not material to earnings. ONE Gas is focused on leading the industry in a safe, reliable provider of natural gas to our customers, an important component of our strategy and why we reinvest in our natural gas distribution systems and facilities.
In 2018, we expect to spend $375,000,000 on capital expenditures, and we expect to spend approximately 2,000,000,000 dollars through 2022, more than 70%, which will be spent on system integrity and pipe replacement projects. We continue to take a risk based approach to analyzing and upgrading our distribution systems, which creates the safest and most reliable system that our customers and regulators expect. To close, I would like to thank all of our 3,500 employees for their engagement, dedication and commitment to safely and reliably delivering our product and for focusing on continuous improvements that benefit all of our stakeholders. Operator, we're now ready to answer any questions.
Thank you. And we'll go first to Sarah Akers at Wells Fargo. Hey, good morning.
Good morning, Sarah.
Can you give us a sense in Kansas, what percentage of CapEx there will now qualify for the GSRS recovery beginning next year versus the percentage that qualifies now?
Hey, Sarah, this is Curtis. And about 70% of our capital will qualify into that program.
Got it. And is that a pretty significant increase to the current levels?
Yes. Historically, we've been closer to 30% or 35%.
Got it. Great. And then in Oklahoma, the $5,600,000 proposed rate reduction, is that solely related to tax reform? Or is there also a base rate change embedded in there?
Yes. Sarah, that's a net number. So there's a base rate change from going through the PBR mechanism and then that gets more than offset by the tax reform. So overall, it's a net reduction in rates.
Okay. So but the ROE was low enough to actually trigger a requested base rate increase in Oklahoma?
That's correct.
Okay, great. Thanks a lot.
Thank you. Thank you, Sarah.
And we'll go next to Chris Sighinolfi at Jefferies.
Hey, good morning, guys.
Good morning, Chris.
I just want to follow-up maybe where Sarah left out. Just on the expanded definition in Kansas of the GSRS, I guess, applicability. In terms of the capital that will now qualify, I was also curious, you had in your slide presentations in the last couple of years, Pierce, a sort of estimation on your longer term modernization efforts, both the cast iron, the bare steel, the vintage plastic. I think you had defined it in the presentation based on sort of miles of pipe and this was system wide, not just Kansas specific. But just curious, did it expand or any of the changes in the definitions for that program expand the amount of likely work you have out there?
Was that a total number to begin with?
No, that was a total number to begin with, Chris. The thing I would point out to you though is before if you looked at the June 30, 2018 test year under the oil program, the capital expenditures were around $37,700,000 resulting in increased revenues of about $3,600,000 which was a customer impact of about $0.37 Under the new program, the capital expenditures are in the neighborhood of $68,000,000 $69,000,000 with an additional revenue associated with that. Instead of $3,600,000 it will be about $6,700,000 It raises the customer impact to about $0.68 We're still under that $0.80 So we don't expect to accelerate anything unless there's some sort of a comes out and says that we need to do some things in the past. We're already on an accelerated pace. So it really didn't expand what's there.
It just gives us quicker recoveries and you don't have it under the rate case. A big picture way to look at that is everything is going to be kind of reset in this year's annual rate case filing. So effectively, what this does is impacts our future earnings in that 2020 kind of time frame. So long term, it does have an impact on us. So hopefully that answers
your question.
No, it does, Pierce. That's helpful. So greater certainty of your recovery, a faster time profile for the recovery. But in terms of the absolute opportunity set, you'd identified it as is.
Right. That's correct.
Okay. That's very helpful. I guess following on some of what Curtis talked about in terms of the impact from tax reform and it making the profile of earnings a bit more pro seasonal. I'm just curious, if I look at the guidance and I look at the implications, even at the top end at $3.20 for EPS, thinking about the record Q1 you all just posted and what that maybe implies year on year for the back half. Are there other items that we should pay attention to?
I'm assuming based on your comments, Chris, there will be a disproportionately large negative tax impact in 2Q, 3Q given the low seasonality of the profits in those quarters. Are there other items we should pay attention to that might step up in the back half of the year that cause year on year earnings degradation?
Yes. So on the tax piece, you're exactly right that, that 0.13 dollars will reverse in the 2nd and third quarters and will probably reverse even a little bit more than the $0.13 before we get into the 4th quarter, which is a little bit stronger earnings quarter for us typically. So that's the first thing I would point to. The second thing is that the positive impact that we're having from rates or that we had from rates in the Q1, that was from rate cases that went into effect in the last half of twenty seventeen. And so we're getting the full annualized effects here in the 1st and second quarters.
And there's not a lot of activity replacing that in 2018 as we've been talking about over the past year. The last thing I would mention is in the Q1 a year ago, we were a little bit behind on our capital compared to this year. I think I made the comment that our mix of projects was more heavily weighted in the first half of last year to operating type projects as opposed to capital. This year, we're a little more evenly spread, which is why our capital is up in the Q1. So we'll still see the same mix of capital and operations type projects are just spread a little bit differently between the years.
And so it's really a combination of those three factors that are creating the situation that you're describing.
And so with regard to that capital deployment mix shift, we'll see that show up in your O and M lines? Is that where we most likely see it?
That's right.
Go ahead.
Sorry, Chris. We use a lot of internal labor in our capital projects. So that labor gets capitalized. When we have higher capital spending, we're therefore capitalizing more of that labor as opposed to expensing it for operating type projects.
Okay. I understand. I guess final question for me is on that front. You guys have done a fantastic job since certainly since the spin out from ONEOK back in 2014 of really holding a line on your operating costs. And I know it appears you offered the commentary on the automated meter readings and the improvement you've made there.
But I'm just curious what other I guess what work remains that you've identified that you communicate to us that we should pay attention to in terms of incremental improvement, either on things you've already done or whole new areas of cost improvement and technological adoption that might help hold the line on a go forward?
Well, the one thing that has surprised me, Chris, is the ability of our operating people to continually find ways to improve our efficiencies. And so we continue to deploy technology to allow our people to do things much quicker on the spot as opposed to having to bring in a lot of data and do a lot of data entry in the back office. So we get a lot of that stuff done kind of on-site. We continue to improve the way that we deliver service and efficiency in deploying our people. It's not any one particular thing.
It's just a multitude of continuous improvement in our processes and the technology that we deployed, I do think that that's going to continue into the future. We also have, as I mentioned, going from basically the 65% to 85% AMR, we did that basically over a 4 year period. So we still have many years left to continue to improve in AMR as well. We're also improving the stuff as it relates to safety as well. So just the combination of everything, Chris, is really what's leading to that, but we're laser focused in that area.
It's been impressive. And I think, I mean, you had outlined that in your plan upon the spin or in advance of the spin. And just I guess you admitted in the answer, Pierce, you found ways that have surprised you and they've surprised us too. So I'm just curious what the different avenues and channels are for that to continue. So anyway, the color is helpful.
I appreciate the time this morning guys. Thank you, Chris.
And we'll hear next from Tim Winter at Gabelli.
Good morning guys and congrats on another really good quarter. Thank you. I wanted to
ask a strategic question.
I know you've been pretty clear with the simple straightforward regulated strategy and it's working very well. But I was just wondering if there's any updated thinking with the MLP issues, whether that might lead you to find some opportunities in say like regulated like assets, storage assets or pipeline assets or if you're seeing anything there?
We're not seeing anything right now, Chris not Chris, but Tim. We would if you go back all the way in most of our history in this room, a lot of these assets started off in C Corps, then they morphed into the MLP structure. So that MLP structure kind of captures those earnings to be distributed through their distributions. And so it's hard to kind of get assets out of there. We don't see anything immediately on our radar screen, but probably overall, the things morph back to C Corps.
There could be long term some assets out there that might be bought and brought back into these distribution companies. But right now, I'm not seeing any of those opportunities in our territories.
Okay, very good. Thank you.
Thanks,
And it appears I have no additional questions at this time. Mr. Lohse, I'll turn the program back over to you, sir.
Thank you for joining us this morning. Our quiet period for the Q2 starts when we close our books in early July and extends until we release earnings in early August. We'll provide details on the conference call at a later date. We look forward to seeing many of you at the AGA Financial Forum in a few weeks, which hopefully will provide a chance for me to meet many of you in person. Have a great rest of your day.
And ladies and gentlemen, once again, that does conclude today's conference. And again, I'd like to thank everyone for joining us today.