Greetings, welcome to the Pinnacle West Capital Corporation 2018 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, Stefanie 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 first quarter earnings, recent developments, and operating performance. Our speakers today will be our Chairman and CEO, Don Brandt, our CFO, Jim Hatfield. Jeff Guldner, APS's Executive Vice President of Public Policy, 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 our current expectations. 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 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&A section, 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 9th. I will now turn the call over to Don.
Thanks, Stefanie. Thank you all for joining us today. In the first quarter of 2018, we executed on our priorities and remained 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. The installation of selective catalytic reduction, or SCR, emission control equipment at the Four Corners Power Plant was completed on April 24th, on time and under budget. This project provides substantial environmental benefits, including a 90% reduction in nitrogen oxide emissions at the plant. On April 27th, we filed for a $67.5 million step increase to recover our investment in these improvements. The step increase is an effective tool that eliminates the need to file a full rate review immediately after the conclusion of our last rate review and provides rate gradualism for our customers.
The commission previously approved the use of a step increase for the SCR installation. We've calculated that the step increase request would result in approximately a 2% customer bill increase, which will likely be offset by a reduction in customer bills from other adjuster mechanism decreases. We've requested the commission approve the rate increase effective January 1, 2019. Turning to our operations, Palo Verde Generating Station had another successful quarter operating at full capacity. A planned refueling outage for Palo Verde Unit 3 began on April 7th and is proceeding very well. Additionally, construction activity is on track for our Ocotillo modernization project. The units at Ocotillo are expected to come online in the fall of 2018 and the spring of 2019 to meet our 2019 summer capacity needs. Technology continues to play an important role in the efficiency of our operations.
In 2012, APS became one of the first utilities in the nation to receive approval from the Federal Aviation Administration to fly drones in shared airspace. Since then, the use of drones for inspecting lines, building substations, monitoring solar fields, siting new power lines, inspecting storm damage, and accessing hard-to-reach areas has produced significant savings for our customers. Looking to the future, our resource plan is designed to achieve a cleaner, sustainable energy mix that is anchored by Palo Verde, the largest carbon-free electric resource in the United States. In fact, we've already reached a significant milestone in this effort. At the end of 2017, over 50% of our energy mix was carbon-free.
Our next integrated resource plan filing, scheduled for April 2020, will continue to support the goal of achieving a cleaner, sustainable energy mix and will incorporate updates as the commission's discussion around a possible energy modernization plan progresses. We recently announced our plan to issue multiple resource RFPs this year. On April 26th, we issued an RFP for 4 megawatts-800 megawatts of peaking capacity with an in-service date of 2021. The peak period is between June and September, and from 3:00 P.M. to 9:00 P.M. We also plan to seek competitive proposals that utilize Arizona Forest Bioenergy solutions and that provide battery retrofit opportunities for APS-owned solar facilities. These RFPs are part of a comprehensive effort to meet our resource needs beginning in the early 2020s. More specific information about these solicitations will be released in the coming weeks.
As you may be aware, an out-of-state group, primarily funded by California billionaire Tom Steyer, has filed a ballot initiative that would require some Arizona utilities to obtain 50% of their energy from renewable sources by 2030. The sponsors must gather approximately 226,000 ballot signatures by July 5th to place the proposal on the November 2018 ballot. This initiative is overly prescriptive and irresponsible. Pinnacle West is actively opposing this ballot proposal. The initiative seeks to impair Arizona's oversight and regulation of utilities, which has provided Arizona residents with some of the safest, cleanest, and most reliable and affordable energy in the country over 100 years. It would enshrine in the state constitution a regulatory mandate that is bad for customers, potentially doubling the average customer's electricity bill by 2030.
At least 13 chambers of commerce, including the Greater Phoenix Chamber of Commerce and the Arizona Chamber of Commerce and Industry, in addition to numerous other local organizations, have voiced opposition to the ballot initiative. The sponsors' campaign contains inaccurate information about clean energy, its economic impacts to the state, and the cost to customers. We believe it's important for customers to have accurate information to make an informed decision if this proposal is on the November ballot. As a company that's dedicated to not only providing safe, reliable, and affordable electricity, but also to maintaining and improving the communities we serve, we will continue to actively oppose this proposal. Lastly, I would like to share with you that crews from Arizona Public Service were part of a nationwide mutual assistance effort coordinated by the Edison Electric Institute to assist Puerto Rico with power restoration following Hurricane Maria.
We sent 83 line workers and support staff, as well as 42 vehicles to Puerto Rico in mid-January. When our crews returned on March 31st, restoration on the island had reached 95%. Crew members who took this special assignment are proud to have helped. Throughout their deployment, they did more than just restore power. On their own time and their days off, they immersed themselves in the community, helping to clean up storm damage, rebuilding homes, and providing household essentials to families in need. One of our crew members even bought a bicycle for a child so that he could ride with other neighborhood children. I'm extremely proud of how each and every one of these individuals represented our company and the state of Arizona. 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 2018, which were in line with our expectations. As shown on slide three of the materials, for the first quarter of 2018, we earned $0.03 per share compared to $0.21 per share in the first quarter of 2017. Slide three also outlines the variances that drove the change in our quarterly ongoing earnings per share. I'll highlight a few of the key drivers. Adjusted gross margin was up $0.13 per share compared with the prior year first quarter period, supported by the rate increase, higher transmission revenues, and higher sales-related revenues. These positive factors were partially offset by the effect of the federal tax rate change and unfavorable weather.
Specific to tax reform, the financial impact decreased gross margin by $0.20 per share in the first quarter of 2018, including a reduction in customer rates passed through our tax expense adjuster mechanism, our TEAM, an estimated reduction resulting from income tax changes in our wholesale transmission rates. You will notice there is not an offsetting effective tax rate driver in this year's first quarter. The refund to customers through the 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. As a result, there will be a timing difference throughout the year.
Looking now to operating expenses, higher adjusted operations and maintenance expense decreased earnings by $0.18 per share, primarily due to higher planned outage costs related to the SCR installation at Four Corners Power Plant Unit 4. Depreciation and amortization expenses were higher in the first quarter of 2018 compared to the first quarter of 2017, reducing earnings by $0.09 per share. The increase was primarily related to the higher D&A rates approved in the 2017 rate review order and plan additions. Also on slide three, you will see a new quarterly driver related to pension and other post-retirement benefits, non-service credits. We adopted the new pension accounting standard in January, resulting in the presentation of non-service credit component and other income. In addition, we are no longer capitalizing a portion of the non-service credits.
In 2018, the change in capitalization, combined with the increased returns, increased pre-tax income by approximately $7 million in the first quarter. As a reminder, in the 2017 rate review order, we were granted accounting deferral related to Four Corners Power Plant SCRs installation and the Apache County modernization project. The drivers I discussed account for the deferral associated with the Four Corners Power Plant SCRs, as there was no net impact on the first quarter 2018 results. Turning now to the Arizona economy, as it continues to be an integral part of our business story. Arizona and Metro Phoenix continues to be an attractive place to live and do business. Arizona's population surpassed 7 million in 2017, and Maricopa County has been ranked as the fastest-growing county in the nation for the past two years. The Metro Phoenix area continues to show job growth above the national average.
Through February, employment in Metro Phoenix increased 2.8% compared to 1.5% for the entire U.S. The Metro Phoenix unemployment rate of 4.4% also reflects the strength of the job market. The solid job growth continues to have a positive effect on the Metro Phoenix area's commercial and residential real estate markets. As seen in the upper panel of slide four, vacancy rates in the commercial markets continue to fall and are at levels last seen in 2008 or earlier. As a result of the increase in activity and low vacancy rates, about 6 million square feet of new industrial space was under construction at the end of Q1. Additionally, about 4 million square feet of new office and retail space was under construction at the end of the quarter as well.
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 four, housing construction is expected to continue the upward post-recession trend. In 2018, housing permits are expected to increase by about 4,000 compared to 2017, driven by single-family permits. Reflecting the steady improvement in economic conditions, APS's retail customer base grew 1.7% in the first quarter of 2018. We expect that this growth rate will continue to gradually accelerate in response to the economic growth trends I just discussed. In closing, I will 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, our adjustment mechanism, and sales growth will remain important gross margin drivers, which we expect will be partly offset by higher fossil plant outage costs and higher other operating expenses related to more plant and service, including higher D&A and property tax. As a reminder, we have higher fossil plant outage costs in the first half of 2018. A complete list of key factors and assumptions underlying our guidance is included in the appendix to our slides, which have been revised to reflect the changes to guidance related to the adoption of the new pension and other post-retirement benefits accounting standard I discussed earlier. We continue to expect to issue up to $600 million of long-term debt at APS this year, and overall liquidity remains very strong. Our rate base growth outlook remains at 6%-7% on average through 2020.
The company also continues to expect to achieve an annual consolidated earnings return on average common equity of more than 9.5% through 2019. 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. Our first question comes from the line of Julien Dumoulin-Smith with Bank of America.
Hey, good morning, good afternoon.
Hey, Julien.
I just wanted to understand a little bit more about the O&M situation. As you roll forward into 2019 and 2020, because I know that you've talked about before some of the other outages and upgrades that are going on, can you just elaborate a little bit and perhaps give us a little bit of a preview on how you're thinking about the cadence of the O&M normalizing off this higher figure, if you will?
Go for it.
We'll be done with major work at Four Corners. We've gone through really two to three years here where we've had increased outages preparing for the SCRs as well as the combined cycle. As we get beyond 2018, we would expect With Navajo closing for one thing next year and just more normal run rate on the coal units, you're going to see that more normalized outage O&M be in that, $40 million, $45 million range, which we had prior to 2016.
Got it. Right. The normalized level being more of the 13-15 range rather than the 16, 17, 18, as you said?
Yes. Correct.
Okay. Got it. Actually, you brought up another dynamic in your last remark. Can you comment a little bit on the dynamic to keep Navajo open? There were some recent media indications that there was some potential hope there, but can you elaborate on that? Obviously, it seems like a small detail to you, but is there any interest in maintaining any megawatts on a contracted basis or otherwise, and/or would you receive proceeds if this were actually to happen?
Hey, Julien, it's Jeff. The Navajo situation is obviously being led by SRP since they're the operator of the power plant. There's been a lot of activity over the last year on that. I don't think the current situation has changed. I think there's an effort going to see if they could continue to operate that plant after the other owners have left. We're just watching that continue to develop. It's really in SRP's hands.
I'll leave it there. Thank you very much.
Our next question comes from the line of Michael Lapides with Goldman Sachs. Please proceed with your question.
Hey, guys. Just curious, Don, some of the comments about the ballot initiative. I don't really want to go into the ballot initiative. I want to go into the economics of renewables, which is, do you see the addition of incremental renewables to your system using the costs that folks either bid into PPAs as raising or lowering the all-in cost to customers right now? Then if you could think about where you think this is going over the next few years, kind of give your view on how you think that plays out.
Well, Michael, it's dependent on how one approaches it. If one does it in a constructive, deliberate fashion, working with the company obviously, the commission towards a goal that's good for our customers and good for the environment, it can integrate quite well. In this case, 50% renewable by 2030 is relatively ridiculous. The costs are extreme. The impact on the rest of the company's operations would have a dramatically negative impact on cost.
Got it. Thank you. Can you all also talk about upcoming RFPs and supply needs? Can you remind us, there were some pieces of the last rate case settlement that kept Arizona Public Service from being able to self-supply, and then other aspects of that where you could actually be a supplier. I'm thinking both for renewables and for conventional generation.
Yeah, Michael, this is Jeff. We've got RFPs out. We can get you the language in the last settlement. There are exceptions and provisions to that. We continue to move forward with RFPs. The timing of that is in the 2020-
2021
2021 timeframe. To Don's point, one of the things we do when we do these RFPs is we're resource agnostic in some cases. When we go out for a peaking capacity RFP, we don't specify the resource. People have bid in. We saw a bid that came back in our last RFP for that was actually a combination of renewables and batteries. It came in as the most economic resource for the need that we were trying to fill. To that point, you can use these RFPs in a way to constructively build in the portfolio and to continue to develop renewables, but it's better to do it in that thoughtful way.
Got it. Then one for Jim. The increase in transmission revenues, does that drop to the bottom line? It looks like it does. Is that just due to higher transmission rate base year-over-year or some other factor?
That is really wheeling, third party wheeling or contract wheeling. These come off as a revenue credit when we do our next formula rate. It has the benefit of the year that it happens, but it is a bottom-line impact.
Got it. Thank you, guys. Much appreciated.
Our next question comes from the line of Insoo Kim with RBC. Please proceed with your question.
Hey, thank you. My first question is on the CapEx plan, especially in 2020. The current plan that you guys have in place, I assume, incorporates the replacement, I guess, generation that you guys were contemplating in the previous IRP. Given the potential changes that you may make with regards to renewables and the more cleaner resources, could that number, all else being equal, trend up in the next revision?
I mean, it could. It could trend up for several reasons. We, as you can see on the chart, we have no gas generation, which is really Ocotillo, finishing up in the first quarter of 2019, as Don alluded to, and then we don't have anything in 2020. Obviously things could change with battery storage and other things, but nothing currently contemplated.
Got it. Then in regards to weather-normalized sales growth, I think year-over-year on the drivers table, you guys had a pretty meaningful increase. I was just looking at the appendix in the back, and the weather-normalized retail sales seemed like it was down 0.4%, unless I'm reading something wrong. What's the discrepancy there?
Well, what you have is the same dynamic we really had in the fourth quarter last year, which is even though quantity is down slightly, you do have pricing or when people are using the power benefiting. Put those together, you do have sales. It's not quantity driven. It's more price driven.
Got it. Okay. The benefit was more price driven? Okay.
Yeah.
Thank you very much.
Our next question comes from the line of Ali Agha with SunTrust. Please proceed with your question.
Thank you. First question. As you pointed out, the rate base growth you have is 6% to 7%. Recently, you also raised your dividend growth target to around 6%. When we think about your earnings outlook from the 2018 base with O&M normalizing, et cetera, as you mentioned going forward, is it fair to say that EPS growth should pretty much be in line with how you're looking at rate base and dividend growth going forward?
Yeah. We don't give earnings growth targets, we've always talked about the earnings growth over the long term being bracketed by rate base, and obviously, the board looked at the earnings growth when they raised the dividend in October.
Yeah. Okay. Also, Jim, one of the other things you also talk about is, as you're thinking about 2018 through 2020 on a consolidated earned ROE basis, the plan is to earn 9.5% or higher. I know there's no sort of ceiling per se on consolidated earned ROE, but how should we think about that realistically? Can you theoretically earn more than 10% on a consolidated basis, or is that a good proxy to think about in terms of if things are going in your favor, et cetera, as we think about 9.5% being really the target to be the floor?
Well, we're allowed 10% at APS, and Pinnacle relies on APS for most of its earnings. They say, could we go above 10% at the consolidated level? We could, but that's not likely because APS is going to be on that slightly less than 10% ROE. I don't know mathematically how else you'd get there.
Got it. The delta between, say, consolidated and APS, is that a good rule of thumb to think about?
For what? I'm sorry, Ali.
For on ROE, when we think about APS and consolidated, is that a good rule of thumb to think about what the delta is?
Well, you have APS, and you're going to have holding company debt and some other things. Yeah. I think looking at APS as a starting point and then going from there is a fairly good way to construct that.
Yeah. Lastly, just reconfirming, you were talking about the timing differences on how tax reform is given back to customers impact. On an annual basis, just to be clear, it should net itself out, right? The annual impact should still be neutral. Is that right?
Yeah. It's just the timing between quarters. We have the slide in the appendix on slide eight that actually shows sort of a pre-tax earnings expected spread and a sales expected spread across a quarter. That gives a good look at sort of the mismatch.
Yeah. Got it. Thank you.
Our next question comes from the line of Michael Weinstein with Credit Suisse. Please proceed with your question.
Hi, guys.
Hi, Michael.
Can you talk about the energy efficiency and DSM filings that I think are still pending approval? My understanding is that the energy efficiency program, you were looking at trying to attack more peak load reductions to ease the duck curve ramping, and that might reduce some of the lag that you experience between customer growth and load growth.
Yeah, Michael, Jeff. It's really reflecting the change. Duck curve's part of it, but it's the idea that you've got situations where you want to encourage load and consumption in the middle of the day. Traditional programs like light bulbs that don't really look at the time difference aren't as effective in the environment that we're in. We have looked at trying to shift that more towards attacking the peak, which is really where you can grab more value out of the program. They're still being reviewed by the commission. Not sure when that's going to work its way out, but that's probably the trend that's going.
You have to assume some level of customer adoption for that to happen.
Right. I think you indicated that electric sales, weather normalized, are improving this quarter. How many quarters in a row do you think you'd need before they start to flow into long-term guidance?
I don't know that we would do much with guidance at this point. We have fairly modest sales growth in there of a half of 1%, to 1.5%, so a little upside would be good. Based on where we are, don't really see that happening right now. We would take that when we go to update guidance later this year if it happened.
Is there a certain number of quarters you'd like to see to make sure a trend is shaping up?
No.
No. All right. Thank you.
Our next question comes from the line of Paul Ridzon with KeyBank. Please proceed with your question.
In the first quarter, rate relief was basically offset by tax reform timing impacts. Is the right way to think about this still on an annual basis, the net's about $20 million?
There should be no impact from income tax because.
The way I see it is income tax is offsetting part of the rate increase, and that delta is about $20 million.
We had a rate increase of slightly less than $90 million, and the rate reduction for the tax impact is $119. The $119 doesn't really impact the bottom line over the course of the year.
Right. That flushes out. Okay.
Yeah.
What was weather relative to normal?
Weather relative to normal was off about $0.09 at $13 million. It really relates to heating degrees that the residential side was way down year-over-year.
Do you also have year-over-year down $0.09, last year was essentially normal? Is that correct?
Yes, that's correct.
Okay. Thank you very much.
Our next question comes from the line of Charles Fishman with Morningstar. Please proceed with your question.
Hi. I think that this question is for Jim. I just want to make sure I understand this. If I look at slide six, you've added this line, other income, excuse me, $45 million-$55 million.
Yeah.
That's primarily the new accounting for pension?
Correct.
Okay.
Well-
Your O&M. Go ahead.
It was embedded in O&M previously.
Oh, it was included in O&M?
Yes.
Oh, got it. Okay. Sort of that leads to another question. Now you have this other line to manage, although it was included in O&M, but the accounting is treated different, so you're going to have to manage that as part of your commitment, which I respect and a lot of other people do, that to hit that 9.5% ROE, now you have this other line to manage. Is that going to change the way you manage the pension fund at all?
No. We had to manage it before. We feel good about our pension funding, 95% funded on a GAAP basis. OPEB is actually overfunded, so we feel good about the line. All the accounting treatment did is separate your service from non-service pension and OPEB costs. That's all it did. No difference in how we would approach the business.
Okay, got it. Thank you. That's all I had.
Our next question comes from the line of Paul Patterson with Glenrock Associates. Please proceed with your question.
Hey, good morning. How are you?
Hey, good.
Just a few quick ones here. The Steyer initiative, do you guys, just any thoughts on how that might impact voter turnout in the upcoming election? Just any other thoughts about how you see some of the things that we might think about some of the local stuff down there that we should think about? I know it's a ways away, I apologize for that, but just any thoughts that we should have in terms of the upcoming election?
Yeah, Paul, November is, in political talk, a year away. A lot can happen between now and then. The most critical aspect on this ballot initiative is the big if, whether it qualifies for the ballot or not. We'll take it one step at a time going forward. We are actively opposing it and pretty much universally across the business community, people understand the implications that are all negative for Arizona, for our customers, and basically all the residents of Arizona.
Okay, fair enough. Just we've seen some M&A activity out there, and I'm sure you guys have been watching this as well. Just any thoughts about what you're seeing there in terms of what some of these companies are going for, and, I don't know, the leverage in some cases employed and just sort of your own balance sheet and how attractive you guys might be, and, I don't know, any thoughts that we might have or any thoughts you guys have, excuse me, in terms of what you're seeing out there and any insights you might have with respect to that?
Well, just as you do, we stay abreast of what's going on out there, and every transaction is unique to those companies involved in that particular transactions, and I'll just leave it at that.
Okay. Thanks so much.
Okay.
Thank you. We have reached the end of the question and answer session. I would now like to turn the floor back over to management for closing comments.
Thank you 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.