American States Water Company (AWR) and Golden State Water Company (GSWC) — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018; interim financial statements are unaudited. This is a combined filing for AWR and its regulated utility subsidiary GSWC. Unless identified otherwise, consolidated results below are for AWR.
Business context
AWR operates through GSWC, a California water and electric utility, and American States Utility Services (ASUS), which operates and maintains water and wastewater systems at U.S. military bases under long-term contracts. GSWC serves approximately 260,000 water customers and 24,000 electric customers. AWR’s 2018 contracted-services results include the start of operations at Fort Riley in July.
Financial performance
| AWR consolidated | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Operating revenue | $124.2 million | $124.4 million | $325.8 million | $336.4 million |
| Operating income | $34.0 million | $38.5 million | $78.2 million | $105.1 million |
| Net income | $23.0 million | $21.0 million | $50.1 million | $56.5 million |
| Diluted EPS | $0.62 | $0.57 | $1.35 | $1.53 |
| Operating margin | 27.4% | 31.0% | 24.0% | 31.2% |
Q3 revenue was nearly flat, but operating income declined 11.8%; lower income tax expense helped net income rise 9.3%. Nine-month revenue fell 3.2%, operating income fell 25.6%, and net income fell 11.4%. The comparison is affected by the $8.3 million pretax gain on the Ojai water-system sale in 2017; 2017 also included a $1.5 million pretax recovery of drought-related costs that did not recur.
- Utility gross margins: Water gross margin was $62.3 million in Q3, down 8.1%, and $167.0 million for nine months, down 7.9%. Electric gross margin was $4.8 million in Q3, down 2.6%, and $15.7 million for nine months, down 2.5%. These are company-defined, non-GAAP measures.
- Cash flow and investment: Nine-month operating cash flow was $108.4 million, compared with $120.2 million. Capital expenditures were $87.3 million, versus $77.9 million. Investing activities used $88.8 million; 2017 included $34.3 million of Ojai sale proceeds. Cash at September 30 was $2.0 million.
- Debt and liquidity: AWR reported $281.0 million of long-term debt, $40.3 million of current debt and $70.0 million of bank borrowings. Its $150 million revolving facility had $79.1 million available and $0.94 million of letters of credit outstanding. GSWC’s $40 million, 6.70% note is due in March 2019; management expects to fund repayment through intercompany borrowing and/or new long-term debt. AWR and GSWC had S&P ratings of A+ with stable outlook; Moody’s affirmed GSWC at A2 with a positive outlook.
- Dividends: AWR declared $0.275 per share for Q3, up from $0.255 in 2017. The board approved another $0.275 per share for Q4, payable December 3, 2018.
Material changes and management commentary
- Water revenue decreased, reflecting lower rates associated with the Tax Act and the CPUC cost-of-capital decision, expired customer surcharges, and the Ojai system sale; third-year rate increases partly offset those factors. Nine-month billed water consumption rose approximately 6%, but WRAM mechanisms generally limit the earnings effect of usage changes.
- Water supply costs increased, in part because several wells were out of service and the share of purchased water exceeded adopted levels. The company recorded additional WRAM/MCBA net under-collections of $12.2 million in the first nine months, primarily due to higher supply costs.
- The Tax Act reduced the federal corporate tax rate from 35% to 21%. AWR’s effective tax rate fell to 21.7% for the nine months from 37.3%; GSWC’s fell to 22.5% from 38.6%. Lower utility revenues were largely offset by lower income tax expense, with no material earnings impact reported. Management expects lower operating cash flow and potentially greater debt or equity funding needs.
- GSWC’s authorized water return on equity declined to 8.90% from 9.43%, and return on rate base to 7.91% from 8.34%. The decision, together with Tax Act effects, was expected to reduce the 2018 adopted annual revenue requirement by approximately $3.6 million.
- The water general-rate-case settlement filed with the CPUC proposes approximately $334.5 million of infrastructure investment over 2019–2021. If approved, the filing estimates 2019 water gross margin would increase approximately $6.0 million over the 2018 adopted level; potential increases of $10 million in 2020 and $12 million in 2021 are subject to conditions. CPUC approval remained pending.
- The electric general rate case had a tentative settlement, with a conference scheduled for November 2018. 2018 billed electric revenue was based on 2017 adopted rates pending a final decision; new rates, if approved, would be retroactive to January 1, 2018.
- ASUS reported $3.2 billion in remaining contracted-services performance obligations, to be recognized over the remaining 36-to-50-year contract terms. U.S. government contracts may be terminated in whole or part for convenience.
Outlook, risks and contingencies
- GSWC estimated 2018 company-funded capital expenditures of $110–$120 million. Management said capital spending may be reduced temporarily if access to financing is constrained.
- Key risks include CPUC rate-case timing and outcomes, water availability and drought, supply costs, aging infrastructure, wildfire and severe-weather exposure, environmental requirements, financing costs, and ASUS contract adjustments, government payment timing, audits and possible contract termination.
- California’s permanent water-use standards are expected to apply beginning in 2022; management said the company’s ability to comply and recovery of associated costs cannot yet be predicted. As of October 30, 2018, the U.S. Drought Monitor classified about 3% of California as in extreme drought, 19% severe and 48% moderate drought. GSWC reported no water sources exceeding the cited PFOA/PFOS advisory or notification levels.
- GSWC had completed lead sampling at approximately 42% of schools in its service areas as of September 2018; required testing is due before July 1, 2019, and management noted that school cooperation may affect completion.
- Estimated remaining cleanup costs at a former gasoline-storage site were $1.3 million, recorded as a regulatory asset and accrued liability; management considered recovery through rates probable. Management did not expect other routine litigation to materially affect results, financial position or cash flows. The filing reported no significant changes to 2017 risk factors.
Most important facts for investors to verify
- Final CPUC decisions and effective rates for the water and electric general rate cases, including the proposed water infrastructure program and its earnings implications.
- Whether water supply constraints, wells out of service and higher purchased-water costs persist, and how quickly regulatory balances are recovered from or refunded to customers.
- Cash conversion and funding needs: operating cash flow declined while capital expenditures increased; confirm financing plans for the March 2019 $40 million note and ongoing investment.
- Whether ASUS achieves expected contract price adjustments and construction activity, and monitor government payment, audit and termination risks.
- Progress toward school lead-testing requirements and developments in drought, water-use regulation, wildfire exposure and related cost recovery.