Greetings, and welcome to the Pinnacle West Capital Corporation 2019 first quarter earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Stephanie Leighton, Director of Investor Relations. Thank you. You may begin.
Thank you, Christine. I would like to thank everyone for participating in this conference call and webcast to review our first 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, APS's President, and Daniel Froetscher, APS's Executive Vice President of Operations, are also here with us. First, I need to cover a few details with you. The slides that we will be using are available on our investor relations website, along with our earnings release and related information. Note that the slides contain reconciliations of certain non-GAAP financial information. Today's comments and our slides contain 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 first quarter 2019 10-Q was filed this morning. Please refer to that document for forward-looking statements, cautionary language, as well as the Risk Factors and MD&A sections, which identify risks and uncertainties that could cause actual results to differ materially from those contained in our disclosures. A replay of this call will be available shortly on our website for the next 30 days. It will also be available by telephone through May 8th. I will now turn the call over to Don.
Thank you, Stephanie, and thank you all for joining us today. 2019 has started off in line with our expectations, and we remain well-positioned for a solid year. Before Jim discusses the details of our first quarter results, I'll provide a few updates on our recent regulatory and operational developments. On April 9th, Chief Administrative Law Judge Jane Rodda issued a Recommended Opinion and Order, or ROO as we call it, in the customer complaint docket. The ROO states that the customer complaint should be dismissed. The ROO also recommends that in the next rate review, APS, commission staff, and other stakeholders collaborate on better ways to communicate the bill impacts to residential customers. The ROO suggests that any further issues concerning the reasonableness of APS's rates or the adequacy of its customer education and outreach program be considered in the current rate review docket.
The current rate review docket was opened by the commission in January to review APS's 2018 books and records and determine whether APS has earned more than its allowed return. As we've mentioned on our fourth quarter 2018 earnings call, our 2018 ACC jurisdictional return on equity was 9.5%, which is less than the authorized 10% ROE. Commission staff is in the process of reviewing our 2018 financial information, and I'll provide the commissioners with a report at the conclusion of their review. While the commission staff had originally been targeting a May 3rd deadline for their report, the staff indicated during the open meeting on April 23rd and 24th that they may need some additional time. Lastly, the commission approved our second refund to customers from federal tax reform. Starting April 1st, we began passing an additional $86 million back to customers.
Together with the first $119 million in savings approved in 2018, customers will receive more than a $200 million rate decrease. The third and final tax refund request was filed with the commission on April 10th and is currently awaiting approval. If approved, TEAM phase three will return an additional $34 million to customers annually for the first three years. The tax reform reductions, combined with additional savings from lower fuel costs, are expected to lower bills $14 per month, or $168 a year, for the average residential customer compared to one year ago. Turning to our operations, Palo Verde Generating Station had another successful quarter operating above a 100% capacity factor. A planned refueling and maintenance outage for Palo Verde Unit 1 began on April 6th. Additionally, the Ocotillo Modernization Project is on budget and scheduled to have all five units in service by this summer.
On August 1st, we plan to file our preliminary integrated resource plan, which includes a 15-year forecast of electricity demand and the resources needed to serve our customers reliably in the future. We're currently engaging with a wide variety of stakeholders to gather input and ideas prior to our preliminary filing. The final IRP will be filed with the commission in April of 2020. An important part of our forecast will be increasing the integration of clean energy resources and technology in an economically responsible manner. Clean energy resources not only reduce our carbon intensity, they also reduce O&M and fuel costs for customers. Similar to the bill savings from tax reform, these reductions will allow us to continue investing in technology and grid enhancements necessary to support additional clean energy while maintaining customer bills at an affordable level.
As you know, in February, we announced the addition of nearly a gigawatt of new clean energy projects. Consistent with this plan, in April, we issued a request for proposal for 59 megawatts of storage that will be added to our existing Chino Valley and Red Rock solar plants. Both projects are expected to be in service in 2021. We also issued a request for proposal for a new 100-megawatt solar facility paired with 100 megawatts of battery storage to be in service in 2021. Lastly, I'd like to provide an update on the equipment failure that occurred on April 19th at our McMicken Substation battery storage facility. During the response to this incident, firefighters from Surprise and Peoria, Arizona, were injured. Our hearts go out to the injured firefighters. We greatly appreciate their hard work and bravery in responding to this event.
An investigation with APS first responder representatives and third-party engineering and safety experts is underway. A thorough investigation will help us determine the cause of the failure. We have no reason to believe there are any safety issues with similar energy storage facilities. However, we will use the findings from the investigation to ensure all our facilities are safe moving forward. In addition, we will continue with our plans to add clean energy projects to our system, including pairing storage with solar resources. Energy storage is a breakthrough technology helping to solve challenges and create new opportunities for additional clean energy resources. In closing, we are delivering on our commitments and continue to be well-positioned for long-term growth. We're focused on operational excellence while solidifying Pinnacle West as a sustainable leader through strategic clean energy investments. I'll now turn the call over to Jim.
Thank you, Don. Thank you again, everyone, for joining us today. This morning, we reported our financial results for the first quarter of 2019. As shown on slide three of the materials, for the first quarter of 2019, we earned $0.16 per share compared to $0.03 per share in the first quarter of 2018. Higher adjusted gross margin and lower adjusted operating and maintenance expenses were the key positive drivers during the quarter. Adjusted gross margin was up $0.14 per share compared to the prior year first quarter period. Favorable weather was a positive $0.14 gross margin impact during the quarter, driven by the second coldest February in the last 40 years. Higher adjusted gross margin was also supported by a shift in the seasonality of revenue. The positive drivers were partially offset by lower transmission revenue and lower other gross margin.
As Don mentioned, TEAM Phase 2 was approved by the Commission and was implemented beginning on April 1st. The impact of the TEAM Phase 2 is expected to be earnings neutral as both the timing of the refund and the offsetting income tax benefit will be recognized based on our seasonal sales pattern. Sales, net of energy efficiency and distributed generation, were up 1% in the quarter compared to the prior year first quarter period. As we mentioned last year, we expect to see the headwinds from energy efficiency and distributed generation decline, which will likely narrow the difference between customer growth and retail sales growth going forward. Continuing with the drivers, lower adjusted operations and maintenance expenses increased earnings $0.09 per share, primarily due to lower planned outage costs.
Partially offsetting the positive earnings drivers were higher depreciation and amortization expenses due to plant additions and lower pension and other post-retirement non-service credits due to lower market returns. As we look ahead to the remainder of 2019, we remain focused on achieving long-term benefits for customers and investors. We have a track record of cost management discipline, and we are taking the next steps in becoming a lean-principled organization. We are committed to identifying new ways of working and strengthening our lean and digital capabilities in order to create cost reduction opportunities and to keep customer rates affordable over the long term. Turning now to the Arizona economy, Metro Phoenix continues to show strong job growth and has consistently been among the national average. Through February of 2019, employment in Metro Phoenix increased 3.1% over 2018, compared to 1.8% for the entire U.S.
Job growth remained strong in the construction and manufacturing sectors, a sign of strength in the regional economy. Construction employment increased by 10.3%, and manufacturing employment increased by 4.3%. We expect a continuation of business expansion and the related job growth to continue to support commercial and economic development. In particular, we have had several recent announcements of companies moving to the west side of the Metro Phoenix area. Red Bull announced they will build a 700-1,000 sq ft facility in Glendale, and milk distributor fairlife plans to build a 300,000 sq ft distribution facility in Goodyear. After announcements from Stream Data Centers and Vantage Data Centers regarding plans to build in the West Valley, Microsoft recently confirmed their plans to build world-class data center facilities on two new sites in Goodyear.
Phoenix was also ranked the second most active market in data center leasing in 2018, according to CBRE's latest U.S. Data Center Trends report. The Metro Phoenix residential real estate market has also continued its upward post-recession trend. In 2019, we expect a total of 30,000 housing permits, an increase of about 2,800 compared to 2018, driven by single-family permits. We believe that solid job and income growth and relatively low mortgage rates should allow the Phoenix Metro housing market, and the economy more generally, to continue to expand faster than the national average. Reflecting the steady improvement in economic conditions, APS's retail customer base grew 1.9% in the first quarter of 2019. We expect that this growth rate will continue to accelerate in response to the economic growth trends I just discussed.
Importantly, long-term fundamentals supporting future population, job growth, and economic development in Arizona appear to be in place. According to the U.S. Census data, Maricopa County ranked number one in the U.S. for population growth for the third straight year, and we believe Phoenix should remain one of the country's fastest-growing large metropolitan areas. Switching to our financing activities, on February 26th, APS entered into a $200 million unsecured term loan facility that matures on August 26th, 2020. On February 28th, APS issued $300 million of 30-year four-and-a-quarter senior unsecured notes. The proceeds were used to repay the $500 million of eight-and-three-quarter senior notes at maturity. We continue to expect to issue up to $450 million of long-term debt at APS during the remainder of 2019. Overall, liquidity remains strong.
Turning to guidance, we continue to expect Pinnacle West's consolidated earnings for 2019 will be in the range of $4.75-$4.95 per share. A complete list of the key factors and assumptions underlying our guidance is included on slides six and seven of the materials. This concludes our prepared remarks. I'll now turn the call back over to the operator for questions.
Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please, while we poll for questions. Thank you. Our first question comes from the line of Greg Gordon with Evercore. Please proceed with your question.
Hey, gentlemen. Good afternoon.
Hey, Greg.
I see all of the underlying short, medium, and long-term guidance drivers are the same as Q4. I did notice that you've extended the planned outage schedule for Cholla on page 10 of the presentation. Can you explain what's going on there, and why that's not having an impact on your O&M or moving you around in the guidance range in any material way, I would hope?
Yeah, Greg, it's Daniel Froetscher. Thanks for the question. When we opened up the generator at Cholla, the outset of our planned outage, we discovered some rubbing and erosion elements that affected rotor vibrations, and in essence, had to remove that rotor, ship it offsite, get it recalibrated and balanced, and it's due to be back on site later this week. The outage was originally scheduled for 46 days. It'll go to approximately 79 days. The reality is, at this time of year, based on its anticipated running profile anyway, there will not be an increase to overall fossil O&M.
Great, thanks. Second question. I know that we fought the war to end all wars on rooftop solar several years ago in terms of getting a balanced decision on net metering. I saw news yesterday that Tesla, the artist formerly known as SolarCity, is significantly cutting the cost of its rooftop solar installations. I know it's only been a day, but do you have any sense of whether or not that might allow them to increase or slow the deceleration of their penetration under the current rate structure in Arizona?
Sunrun has probably been the leader in our service territory over the last 18 months or so. It's hard to say what that will do at this point in time.
Okay. Thank you, guys. I won't take up any more time. I'll go to the back of the queue if I have more. Have a great day.
Thanks, Greg.
Our next question comes from the line of Insoo Kim with Goldman Sachs. Please proceed with your question. Insoo Kim, your line is live.
Apologies, I was on mute. Just going back to the Cholla plant. I know you guys are potentially looking into the conversion of one of the units to biomass. Any detail you could provide on timing or scale of such a conversion? My second related question is, why are you only considering the conversion of one of the units as opposed to the remaining couple?
Yeah. Thanks for the question. Again, it's Daniel Froetscher. We have just taken an exploratory look at converting potentially Cholla One to biomass. We've engaged the services of a third-party engineering and design firm, invested in that exploratory look over the last 60 to 75 days, and in relatively short order should be coming forth with a summary of that analysis and a discussion at the Arizona Corporation Commission then about whether that appears to be the right approach to take for our customers and our company. Ask you to be patient a little bit longer. In terms of only the one unit versus unit one and three, frankly, there is an existing biomass plant within which APS is the offtaker in northern Arizona. There is some level of uncertainty about long-term contracts for harvesting the biomass and slash from the northern Arizona forest to support multiple biomass plants.
We're taking a conservative approach. Additionally, there are some gas pipeline issues that would prevent Cholla from being converted to anything larger than a unit 1 conversion of about 60 to 70 megawatts.
Got it. Thanks. Maybe switching to guidance a little bit. In your 2019 guidance, do you incorporate the Four Corners SCR investment recovery and return to go into effect sometime in this year, potentially mid-2019?
Yeah. Our guidance considered an earlier 2019 implementation date. We'll continue to look at guidance throughout the year. I don't believe that guidance will change as we continue the deferral that offsets most of the cost of the SCR. We should be good within our original guidance.
Understood. Thank you very much.
Our next question comes from the line of Michael Weinstein with Credit Suisse. Please proceed with your question.
Hi, guys.
Michael.
I see that in the CapEx forecast, there's a little bit more of clean generation of CapEx plan for 2020. It looks like some of the buckets have changed a little bit. Maybe you could just talk about what that's from and what's happening since the fourth quarter report.
Nothing has really changed. We've just trued up the cash flows over those years as we got a better understanding of how all the cash flows would work.
Okay. After, I guess, once we get the staff report, the ROO, eventually, assuming it's, I guess it might be delayed, but I guess officially right now it's still May third. Is that correct?
No, Michael, this is Jeff. There was discussion at the last open meeting, and I think Don mentioned that there was discussion at the last open meeting where staff indicated that they were not likely to make that May third date. We expect, I don't have great visibility on when it's coming out, but I would expect it's probably coming out later in May.
Could you explain what are the possible choices that the commission has after that? What happens at the ACC level once that report comes out?
Well, they'll issue the report. One of the questions is what open meeting will it be synced to? There's an open meeting May twenty-first and twenty-second, given the time for exceptions and such. It'd be challenging to see it making that open meeting. There's an open meeting June eleventh and twelfth. When they issue the Recommended Opinion and Order, all the parties have an opportunity to file exceptions to that. Part of the discussion that had been in that process was what are the remedies? I think that would be, my opinion, more future-focused. Things to address in the next rate case. You got to see what the staff report says.
Gotcha. Okay. Thank you.
Our next question comes from the line of Julien Dumoulin-Smith with Bank of America Merrill Lynch. Please proceed with your question.
Good morning. How are you?
Hey, good, Julien. How are you?
Good. Excellent. Thanks for the time. Perhaps just to come back to where Michael just left it off, if you can. Can you talk a little bit more about the timeline here as you see it, more for the Four Corners step up? Then also, if I can go back to Insoo's question, how do you think about offsetting factors here for guidance, depending on the timeline for Four Corners to get done? Especially if it is pushed out from June into July or whenever. I am thinking here about O&M cost cuts or anything else that, again, as you think about affirming the 2019 outlook specifically here. I know a number of different questions there, so I will let you take it at this point.
Then on your last question, Julien, it is Jeff. Let me start with the sequencing. You have got the customer complaint case, Recommended Opinion and Order came out on that. I recommended dismissing the complaint. That was discussed but not voted on at the last open meeting. Then you have got the rate review, and so we would expect a ROO to come out next month or so. The timing of that, so I do not know whether the customer complaint is going to go on the May open meeting or whether that would get pushed to potentially coincide with the rate review at a subsequent open meeting. Again, all that will then drive what happens with the SCR decision, and will they all be on an open meeting, or will there be some sequencing between there? Just do not have visibility to that. From a timing standpoint, that is what I would look at.
Then on your last question, Julien, I look through the guidance through the course of the year. We will manage within the bandwidth of all the factors of guidance. Again, I do not expect a delay will cause us to rethink guidance, at least at this point.
Sorry, just to clarify that, when you say at least at this point, that is contemplating a delay potentially into this July timeframe. Or actually, how do you even think about the timeframe, and is there a relationship between this ROO and just getting this Four Corners step-up done at this point? I know a lot is going on.
I think we look at a range of timing of the SCR ROO. I'm still very comfortable with our guidance.
Okay. All right. Fair enough. Understood.
Our next question comes from the line of Ali Agha with SunTrust. Please proceed with your question.
Thank you. Good morning.
Morning.
Morning. Just clarifying a few of the points made already. First, on the staff audit on the returns calculation, are there certain adjustments that they make that may be different to the way you calculate that? If I heard you right, you guys have already run the math and you didn't see yourself over-earning. Is there a different math that staff likely goes through than the way you've done it?
Ali, it's Jeff. I don't know. They'll come out with the staff report. When we do rate cases, you do pro forma adjustments and things. We'll have to see in the staff report.
I see. Jim, coming back, just again to get a perspective on this Four Corners step up. You said there's deferred costs obviously currently that are out there as well. On a net basis, can you just give us a sense of what the impact is of this Four Corners step up, net of deferred costs?
All the costs are deferred. Your deferral balance gets bigger as you go through the year.
Right. When you do get the step up, in other words, what's kind of embedded in guidance in terms of the net EPS impact? How should we think about that?
I would think about it as the deferral covers your costs. Until the step goes into effect, you're just deferring all the costs and not a significant financial impact.
No, I get that. I'm saying, assuming this all plays out, is this a net $0.10 pickup, a $0.05 pickup? Just to get a sense of magnitude the way you're thinking about it.
It's in guidance.
Okay. My final question, can you just remind us again on your current thinking on when to file the next rate case and when at the earliest do you think you may need to issue external equity at this point?
Right now, our plans are June 1, 2020. As we've said in the past, we're considering issuing equity sometime this year. It'll be a modest amount.
Sometime this year, a modest amount?
Yeah. We're considering sometime this year. Whatever we issue will be a modest amount. It's really to top off the capital structure.
I got you. Thank you.
Our next question comes from the line of Steve Fleishman with Wolfe Research. Please proceed with your question.
Hi. Yeah, thanks. Hey, Don, just a question on the battery fire, just I think in some of the articles I read that there's been some of these maybe overseas. I'm just kind of curious, of some of the ones that have occurred elsewhere, what have generally been the reason for it, and do you have any sense of what can be done differently to make sure these don't happen in the future?
Yeah. Thanks, Steve. I don't think we have a lot of data on the fires overseas. I think there've been a variety of different causes, it's just far too preliminary to even speculate on what happened. We're not quite sure if it was fire or explosion or both. Very early. I think it was just last Monday that the experts got into the field, so to speak, where it was secured and safe to begin the inspection, we think it's going to be at least a couple of weeks to do the postmortem on it.
Okay. Obviously, this is a big new sector, having something like this happen. It's kind of important. Are you seeing a lot of people take a look at this from well beyond just the company involved?
Yeah.
The supplier.
Yeah, I think the industry is taking a look at it. Obviously we're getting a lot of questions, what happened? The technology is not extremely complex. Identifying what the issues in this specific instance was and to make sure that doesn't recur. I don't think it's anything systemic relative to the design or the industry as a whole. We still have full confidence in going forward on our clean energy projects, including pairing batteries with solar resources. We don't have doubts there. Some glitch happened, we're going to run it to ground to make sure it's not any place else on our system. I think the industry will be looking to make sure it's not any place else.
Okay. Thank you.
All right.
Our next question comes from the line of Paul Patterson with Glenrock Associates. Please proceed with your question.
Hey, good morning.
Hey, Paul.
Just sort of back on the customer complaint case. When I was listening to one of the, I guess it was last week, the hearing, it seemed that there was some discussion of that. I think it was like 56% of customers were not on the economically optimal rate plan. I think it was Justin Olson. Seemed to suggest, the idea of placing customers sort of as a default on a plan that would be economically optimal for them, since the education seems to be sort of a challenge here. I was just wondering, do we have a sense as to what the potential revenue impact of that might be? Or just your general thoughts about that approach?
Yeah, Paul, this is Jeff. The complexity with that, I think this was talked about at the hearing, was that the settling parties in that underlying rate case agreed on a framework where the customer would move on to the most like rate. There was a lot of customer outreach to try to encourage customers to move on to the best rate. We're ahead of the rest of the country, I think, in residential rate design. A lot of the things that we're working through here are going to be important in how you do this in other places. That was one of them. The parties initially to the settlement said, we think we should move customers to the most like, most similar rate structure, not necessarily the one that is best for them.
What I think you'll see in this and the rate review case is a fair amount of attention on that. How do you focus on the customer education piece of this? How you factor that into revenue, you'd have to look at that in subsequent cases.
Okay. I guess what it sounded to me like when I listened to it was that just in general, because of the complexity of this and because of the sort of the response that we've seen, the fact that we've got this complaint case, et cetera. It seemed to me that they were looking sort of perhaps beyond the idea of educating customers to simply going for a default rate that would be economically optimal. Do you follow what I'm saying? I'm just wondering, if that did happen, do we have a sense what that would mean from a revenue impact? Do you follow what I'm saying? If they were to take that approach.
Yeah. No, I don't. Again, my guess is that would be in a subsequent case.
You don't think it would be as part of this complaint case?
I don't. I don't know. I don't think so.
Okay. That's it. The rest of my questions were asked and answered. Thanks so much, guys.
Thanks.
Our next question comes from the line of Charles Fishman with Morningstar. Please proceed with your question.
Thank you. Don, in your opening remarks, I believe you said as part of the next round of IRP process, you would forecast demand to 2035. If memory serves me, the last time you went through this, you were talking a 30% increase by 2030 in customer demand. I would think with what's going on over the last 5 years with respect to the Phoenix economy, with respect to the rate design that is now more balanced between utility scale renewables as well as rooftop. Is it fair to assume that that number is not going to be lower, and it could even go a little higher as far as a 15-year growth rate?
That's a good observation, Charles. I hate to front run our work on the IRP, even the preliminary IRP, the economy here in Arizona is really humming on all cylinders. You don't have to do a study. You can just drive around all the cranes and the excavation and the building going on, both commercial, industrial, residential. It wouldn't surprise me to see longer term growth rates higher than they were last time around.
Okay, great. Thank you. That's all I had, Don.
Thanks.
Thank you. We have reached the end of the question and answer session. I will now turn the floor back over to management for closing comments.
Thank you all for joining us today. This concludes our call.
Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.