Earnings Call: Q2 2018

Aug 3, 2018

Greetings, and welcome to the Pinnacle West Capital Corporation 2018 Second 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. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Stephanie Layton, 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 Q2 earnings, recent developments and operating performance. Our speakers today will be our Chairman and CEO, Don Brandt and our CFO, Jim Hatfield. Jeff Goldner, APS' Executive Vice President of Public Policy is also here with us. First, I need to cover a few of the 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 on 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 Q2 2018 Form 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 and A sections, which identify risks and uncertainties that could cause actual results to materially differ 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 August 10. I will now turn the call over to Don. Thank you, Stephanie, and thank you all for joining us today. 2018 continues to be in line with our expectations, and we remain well positioned to meet our financial commitments this year. Before Jim discusses the details of our Q2 results, I'll provide a few updates on our recent regulatory and operational developments. The step increase request for the selective catalytic reduction equipment at the Four Corners power plant is progressing. The Arizona Corporation Commission hearing is scheduled to begin on September 5 and we continue to expect a decision around the end of the year. As required by the 2017 rate review order, all residential customers except grandfathered solar customers were migrated to new rates. We successfully transitioned nearly 1,000,000 residential customers to new rates in a few short months. Turning to our operations. On May 5, Palo Verde Generating Station completed its scheduled Unit 3 spring maintenance and refueling outage in a plant record 28 days and 13 hours. The team's collective performance resulted in the one of our best outages ever. Looking to our capital investment program, nearly 200 miles of transmission lines and 15 new substations supporting the additional capacity have been added in the past 3 years. In May, the last 110 mile section of a 500 kV loop around the northern part of the valley here known as Sun Valley De Morgan was commissioned. Notably, the Sun Valley De Morgan project has garnered national attention for its innovative design and permitting process and collaborative work with the Bureau of Land Management. The 4 500 kV projects commissioned since 2015, including completion of this loop, provide added reliability, increased economic development opportunities and enhanced import and export capabilities with neighboring states. It should come as no surprise that each year we go through extensive preparation and planning to maintain reliability throughout Arizona's intense summer heat. This year in addition to expanding and strengthening our transmission system, we implemented new strategies to lower fire risk during wildfire season. To reduce fire risk, our teams performed vegetation management activities, held a wildfire prevention training and continued to expand our clearance around polls program. Implementing these strategies is the right thing to do for customers, the environment and the health of our company during increasingly dry conditions. For future resource needs, we recently issued requests for proposals regarding peaking capacity and forest bioenergy solutions. Proposals for the peaking capacity solicitation were due by July 20 and we're in the process of evaluating those proposals. The submission deadline for the Forest Bioenergy RFP is August 17. In addition, we issued a battery storage RFP for up to 106 Megawatts located on APS solar facilities with an in service date no later than June 2020. We intend to own any projects selected as part of the battery storage RFP. We expect to make final selections for each of these solicitations during the Q4 of 2018. As the utility industry continues to evolve, so does the grid technology landscape. As part of an ongoing process to modernize the grid, we are upgrading the cellular communication technology for our meters from 2 gs to 4 gs. Over the next 18 months, we will replace roughly 2,000 2 gs devices with about 1500 4 gs devices providing improved real time outage information to system operators. Devices that have already been installed are transmitting information more quickly and efficiently than the old system, which means added reliability and quicker outage response for our customers. This investment is just one of many that aim to make the grid more advanced and more reliable for our customers. Turning to the ballot initiative. On July 5, the Tom Steyer funded California campaign turned in signatures in an attempt to place a constitutional mandate for 50% renewable energy by 2,030 on the Arizona ballot for the election this November. On July 19, a lawsuit was filed arguing that fraud as well as other systemic errors disqualifies the majority of the signatures collected. The trial is set to begin on August 20 and we anticipate that the judge will issue a decision in August. Barring action by the judge by late August or early September, the Arizona Secretary of State will make an official statement announcing whether the Steyer funded initiative will be on the Arizona ballot. It is clear the impacts from the Steyer funded ballot initiative are bad for our customers and the State of Arizona. We estimate that the Steyr funded ballot initiative would require APS to add over 5,500 megawatts of new resources above and beyond our 2017 Integrated Resource Plan estimates by 2,030. This would equate to over $10,000,000,000 in incremental capital investment by 2,030. Further, customers would bear the brunt of our recovery of the costs associated with the forced early retirement of existing facilities. At the time of a possible early retirement, the remaining book value Generating Station and the Four Corners power plant could be $1,900,000,000 $1,300,000,000 respectively. While we expect the Steyr funded ballot initiative would significantly increase our rate base estimates, customer bills in 2,030 would likely be double today's bills. We are not opposing this ballot initiative because we are opposed to clean or renewable energy. We're opposing it because a constitutional amendment is an irresponsible way to set energy policy and it will harm our customers. We know clean energy is important to our customers and it's important to our company. At the end of 2017, over 50% of our diverse energy mix was carbon free. Our renewable resources, including 9 large solar farms across the state and 80,000 rooftop solar installations provide about 14% of that total. APS is in the top tier of all utilities in terms of solar power nationwide. Paired with our nuclear fleet and other clean sources, we have a long proven track record of advancing both clean and renewable energy. As a long term leader in integrating sustainable clean energy resources, we continue to invite further thoughtful discussion about increasing the immoder renewables and other technologies that support clean energy in our state. In fact, this week we filed a letter encouraging the Arizona Corporation Commission to continue to move the energy modernization plan forward. As we have stated since the concept was first introduced, APS believes this proposal to achieve 80% clean energy by 2,050 is a bold vision for the future. While we're proud of our accomplishments, we recognize that we need to continue to do more to achieve the best energy future for Arizona in a way that is right for our state. We believe the energy modernization plan is important to designing the energy future. We look forward to working with the Arizona Corporation Commission and stakeholders to further develop and implement this vision. I'll now turn the call over to Jim. Thank you, Don, and thank you again everyone for joining us today. This morning, we reported our financial results for the Q2 of 2018. As shown on Slide 3 of the materials, for the Q2 of 2018, we earned $1.48 per share compared to $1.49 per share in the Q2 of 2017. Slide 3 also outlines the variances that drove the change in our quarterly earnings per share. I'll highlight a few of the key drivers. Adjusted gross margin was up $0.12 per share compared with the Q2 in 2,007 supported primarily by the rate increase, offset by the federal tax rate change, unfavorable weather and lower retail sales. Although retail sales were lower this quarter versus the prior year quarter, weather adjusted gross sales excluding the impacts of energy efficiency and distributed generation were up 1.2% in the quarter. I will discuss our sales trends in more detail in a moment. Continuing with the key drivers, refunds to customers due to the lower federal corporate income tax rate decreased gross margin by $0.20 per share, but were positively offset by the lower effective tax rate. The net impact of tax reform in the quarter was a $0.10 per share benefit to net income. As a reminder, the refund to customers through the tax expense adjuster mechanism or team is based on a per kilowatt hour sales credit and will generally follow our seasonal kilowatt hour sales pattern. The impact of the lower federal income tax rate is based on pre tax earnings and will more closely align with our quarterly pre tax earnings pattern. Please see Slide 8 for more information related to the timing and facts of tax reform. Now looking now to operating expense, higher adjusted operations and maintenance expense decreased earnings by $0.23 per share, primarily due to the higher planned outage costs related to the select catalytic reduction equipment installed at Four Corners. As you may recall, our guidance for 2018 outage spend was concentrated in the first half of the year as compared to the 2017 outage schedule, which was concentrated in the second half of the year. Additional drivers to higher operations and maintenance expense were transmission, distribution and customer service costs at APS and at the parent company level, public outreach costs primarily associated with the sire funded ballot initiative. Depreciation and amortization expenses were higher in the Q2 of 2018 compared to the Q2 of 2017, reducing earnings by $0.13 per share. The increase was primarily rated to higher D and A rates approved in the 2017 rate review order and plan additions. Also on Slide 3, pension and other post retirement benefits non service credits increased pretax income by approximately $5,000,000 or $0.03 per share in the 2nd quarter. The increase was primarily related to higher market returns and the adoption of a new pension and OPEB accounting guidance for 2018. As a reminder, in the 2017 rate review order, we were granted accounting deferrals related to the Four Corners selective catalytic reduction equipment installations and the Ocotillo modernization project. The drivers I discussed above account from the deferral associated with the Four Corners SCRs as there was no net impact on Q2 2018 results. Turning now to the Arizona's economy, customer growth and sales growth, the Metro Phoenix area continues to show job growth above the national average. Through May, employment in Metro Phoenix increased 3% compared to 1.6% for the entire United States. The solid job growth continues to have a positive effect on the Metro Phoenix area's commercial and residential real estate markets. We expect a continuation of business expansion and related job growth in the Phoenix market, which will in turn support continued commercial development. Metro Phoenix has also had growth in the residential real estate market. As you can see in the lower panel of Slide 4, housing construction is expected to continue the upward post recession trend. In 2018, housing permits are expected to increase by about 4,200 compared to 2017, driven by single family permits. We believe that solid job and income growth and low mortgage rates should allow the Phoenix Metro housing market and the economy more generally to continue to expand. Reflecting the steady improvement in economic conditions, APS' retail customer base grew 1.6% in the Q2 of 2018. We expect that this growth rate will continue to gradually accelerate the response to the economic growth trends I just discussed. Importantly, the long term fundamentals supporting future population job growth and economic development in Arizona appear to be in place. As I mentioned earlier, our weather adjusted gross sales, including the impact of energy efficiency and distributed generation, were up 1.2% in the quarter. This solid sales growth was led by healthy growth in the residential sector of 2.2%, mixed with about flat growth in the commercial and industrial sector. In terms of commercial and industrial sales growth, the results were somewhat disappointing and at odds with the positive economic growth trends we have seen, but we believe this divergence will likely be short lived. We also expect to see the other headwinds to sales growth declining in magnitude. Notably, the installation of grandfather distributed generation systems eligible for net metering took practice a full 2 percentage points of the residential growth rate this quarter. As a grandfathering deadline has now passed, we expect this sales reduction from new installations going forward will be less than half of this quarter's rate. It is also worth noting that the 2018 demand side management plan currently awaiting approval from the Arizona Corporation Commission, focuses energy efficiency programs on peak demand reduction, better aligning the benefits for customers with Relay system benefits. In closing, I'll review our earnings guidance and financial outlook. We continue to expect Pinnacle West consolidated earnings for 2018 will be in the range of $4.35 to $4.55 per share. The rate increase and our adjustment mechanism remain important gross margin drivers, which we expect to be partly offset by higher fossil plant outage costs and higher than other operating expenses related to more plant service including higher D and A and property tax. A complete list of factors and assumptions underlying our guidance is included in the appendix to our slides. We continue to expect to issue up to $300,000,000 of debt at APS this year, but overall liquidity remains strong. Our rate base growth outlook remains at 6% to 7% on average through 2020 supported by robust capital investment needs. We also continue to expect to achieve an annual consolidated return on average common equity of more than 9.5% through 2019. This concludes our prepared remarks. Now I'll turn the call over to the operator for questions. Thank you. We will now be conducting a question and answer session. Thank you. Our first question comes from the line of Michael Weinstein with Credit Suisse. Please proceed with your question. Hi, guys. Hi, Michael. Hi. So you indicated that if the initiative passes that it would require over $10,000,000,000 of incremental capital investment by 2,030 and that could lead to substantial increase in customer bills, which is why you're opposing this method of getting to those kinds of goals. But I'm wondering, even if let's say the initiative doesn't pass and Commissioner Tobin's energy plan goes through and there's a more measured pace of renewable expansion for the next decade. How much incremental capital do you think would be possible for you to absorb or you to win as part of the rate base growth profile for the next decade? That's a great question, Michael. We haven't really looked at it in terms of rate base growth. We know we're going to have to add over 3 gigawatts of gas in addition to additional renewables. So, our rate base outlook would have Commissioner Tobin's 80 by 50 incremental to what we currently have today. So that would be positive, but it keeps Calaverde as well, which is the largest source of clean energy in the U. S. Okay. And just to confirm that the I guess with the grandfathering period now expired, that you should be seeing maybe the benefits of higher customer growth starting next year? I mean, I noticed the 3 year growth forecast has not changed. Probably, we're getting toward the end of the installations of the applications from the September 1 grandfather deadline. You have to remember that once the deadline passed, some of the national installers pulled away from Arizona. So the installations are slower than they have been in the past, but we should see that in the second half of the year. And also one last question, what is your latest thoughts on the next rate case filing in terms of timing and around the next election cycle? We're still looking at that. As I've said, our desire would be push it out a year. So we file in 2020 and rates effective 2021. So we'll make a decision on that as we get through the next month or so. We're really looking at sales patterns based on the rate design and the migration and new rates and we need to make sure we understand that profile. Okay, great. Thank you. Our next question comes from the line of Julien Dumoulin Smith with Bank of America. Please proceed with your question. [SPEAKER JULIEN DUMOULIN SMITH:] Hey, good morning, good afternoon. Good morning, Julien. Hey. So just wanted to follow-up on the last question a little bit more. Can you clarify just first the timeline here so the Secretary of State is going to come out on the ballot initiative? Then what else? And then separately and perhaps more importantly, can you comment quickly on recourse if this does actually succeed in terms of any appeals process or implementation? And especially even within that, to the extent which said both proposals move forward, how would you reconcile between the 2? I mean, basically with the more stringent of the 2 basically apply and if Tobin were to get his proposal going forward, would that basically be moot given the success of the ballot initiative? Julian, I'm going to ask Jeff Gouldner to kind of walk through the key dates relative to the litigation and what would happen with the Secretary of State. You might want to clarify your question, but I'd rather not and won't go into a lot of detail about what ifs. Right now, we're focused on the litigation that's pending in the courts and we'll take it one step at a time. With that, Jeff? Yes. Julien, so right now the signature review is in its normal process. So the Secretary of State sent them to the counties. The county is doing their review. The lawsuit that was filed in superior court is proceeding kind of parallel with that. There's been motion practice, a motion practice out there. It's under a special procedure for elections cases. And so that involves expedited appeals from the superior court to the Supreme Court, including on issues that are decided before the actual trial begins. There's a pre hearing pre trial conference on August 17th and then the trial would begin on August 20th. We'll likely go through that week and the judge would likely come out with a ruling pretty quickly after that, would expect that to then go through some expedited appeals to the Supreme Court, and all that is likely to be wrapped up by the end of the month. And that's when the secretary would normally certify. Got it. All right. Excellent. And then just coming back to the parallel paths here. I mean, how would it work just in terms of the competing proposals here if both were to move forward? Just trying to understand, I mean, how much input does the commission have in ultimately implementing this? Again, Julien, I wouldn't characterize them as competing proposals. There are 2 different aspects. One is a constitutional amendment. The other is a plan or program that the Arizona Commission could implement and monitor and adjust accordingly on year by year or whatever frequency they wanted to do as opposed to a constitutional amendment that would lock something into the Arizona Constitution forevermore. Got it. Excellent. But is there any mechanism to put in place to address stranded costs that you could see here just to kind of derisk the whole effort? I mean, is that something else? Again, right now, we're focused on observing what's happening in the courts with the litigation on the signatures that have been filed. Understood. All right. We'll leave it there. Thank you very much. Our next question comes from the line of Ali Agha with SunTrust. Please proceed with your question. Thank you. Good morning. Good morning. Good morning. Don, first, I wanted to just clarify from your opening remarks, as you mentioned, if this initiative is happening, there could be a premature retirement for 2 of your plants. I just wanted to be clear, is there a mechanism right now in Arizona? I mean presumably there would be a mechanism if plants retire early for companies to recover those costs. Is there a set mechanism already in place? Holly, this is Jeff. So that would have to be addressed at the commission. So that would there's various ways. We've had stranded cost issues before. And so those would be addressed at the commission at the time. So it's not formulaic, you would have to go through a proceeding? That's right. I see. Okay. And then, Jim, I wanted to clarify your point, looking at the sort of the delta between customer growth and at least the weather normalized sales growth that we are getting from your data which is showing that we've had 3 consecutive negative weather normalized sales growth trends. And so again just to be clear, are you suggesting that the energy efficiency and demand response are having a much larger impact, which should mitigate? I just want to be clear I understand the trend. Should we now start to see those weather normalized sales numbers start to turn positive or what's causing the 3 consecutive negative declines we've seen here? Well, you had grandfathering of the last of the net metering September 1, we saw applications skyrocket June, July, August as they were pulling things forward. All of those installations are now being installed and we believe the backlog is through us now and so we'll see less of an impact as we move forward as we continue to add residential customers. I see. Okay. And then my last question, if I look at some of the dynamics that you all have already talked about, I. E. That your O and M costs are unusually high this year given the outage schedule, so they should come down to a more normalized level next year. And then you have the step up in rates coming from the Four Corners SCR investment. Would that imply me at least to me that would imply that the earned ROE next year should be higher than this year. Is that a fair way to be thinking about this or am I missing some other dynamic there? Well, I mean those are 2 impacts to the financials in isolation. There's much other impacts as well and we'll come out with 20 19 guidance later this year. But both of those are accurate, right, in terms of helping your earned ROE next year? In isolation, yes. Thank you. Our next question comes from the line of Andrew Levi with ExodusPoint. Please proceed with your question. Hi. Good afternoon or morning for you guys. How are you doing? Good, Andy. How are you? I'm okay. So just back in the ballot initiative, I don't know, I just feel there's like some investor confusion because since this whole thing has come out, the stock is on a relative basis hasn't done so well. But just and I understand the effects on the ratepayer, if this were to go through and obviously it would be a several year process if it actually got on the ballot and was approved, right, there'd be some type of legal challenge to it? And then I have a follow-up. Is that correct? I think we missed your question. I'm sorry, you didn't hear me. Okay. So basically, if it were to pass, it'd be like a several year legal challenge to that. Is that correct? If it actually got on the ballot and passed? That's my first question. We're not to that point yet. We're as I said earlier, we're observing the pending litigation in the Arizona courts. So the question is whether it gets on the ballot or not. We'll kind of take it one step at a time. Okay. But I guess my point is even if it were to pass and over a several year process was able to survive various legal challenges, As far as your earnings and your long term kind of outlook, that would basically be unchanged because even with stranded costs potential longer term, That rate base as you kind of outlined would be replaced by renewable rate base and things kind of surrounding that. Isn't that correct? Well, again, I'll use Jim's words. In isolation, that's correct. But it's still there are so many variables to this situation until there's clarity around the results of this litigation. It's really hard to start predicting things that far out. Okay. That's fair. Again, it's just that your stock has suffered quite a bit, again, on a relative basis because group's been going up, since this initiative has been initiated. But I just feel there's kind of a misperception of the end result. But thank you very much. Thank you, Andy. Our next question comes from the line of Paul Patterson with Glenrock Associates. Please proceed with your question. Good morning. How are you doing? Hi, Paul. Could you just revisit, as I recall the legislature passed something regarding a fine that would happen if there was no compliance with the initiative. Could you elaborate a little bit on that again or just remind us what that was? Yes. There was a statute that was passed to address what you would do in the compliance situation of a statute or amendment like the Steyer initiative that's out there as something that the commission would probably consider moving forward, but that's also likely to get challenged. Okay. But the cost associated with that is quite low, correct? I mean, the fine associated with non compliance would be considered. As I recall that was pretty nominal in the whole scheme of things. That's correct. From a cost benefit perspective, is that correct? I mean, do you follow what I'm saying? I mean, in other words, if this initiative is going to cost ratepayers a whole bunch of money, etcetera, the cost of noncompliance would seem to be considerably lower, am I wrong? Based on the reading of that, you're exactly correct on reading of that legislation. Okay. I guess what the message today though is before we get down to all these hypotheticals of what may or may not happen, you'd rather just see what actually happens to the courts in the validation of now. Is that how I should think about as opposed to pursuing a bunch of questions about what may or may not happen? Is that what you're basically suggesting we do? Yes, exactly. We have a strategy. It's tied up in the courts right now and we'll we're watching that very closely and we'll respond when the time comes. Okay. My other questions were answered and I won't take any more of your time up. Thanks so much. Thanks, Paul. Thank you. We have reached the end of the question and answer session. I would now like turn the floor back over to management for closing comments. Thank you. Then 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