PINNACLE WEST CAPITAL CORP quarterly report, Q1 FY2014

Business context and reporting period

Pinnacle West Capital Corporation’s unaudited Form 10-Q covers the three months ended March 31, 2014, compared with the first quarter of 2013. Pinnacle West owns Arizona Public Service Company (APS), a vertically integrated Arizona electric utility that generates essentially all of the parent company’s revenue and earnings. Interim results are subject to seasonal weather effects and may not indicate full-year performance.

Financial performance and position

Revenue was nearly flat year over year, but operating income and common-shareholder earnings declined. Fuel and purchased-power expense rose $19.1 million to $249.8 million; operations and maintenance expense fell $10.4 million to $212.9 million, while taxes other than income taxes increased $5.8 million to $45.8 million. Interest expense also increased. The filing attributes the earnings decline primarily to weather and higher property taxes, partly offset by lower employee-benefit costs and income taxes.

Operating cash flow increased by $37 million, primarily reflecting a $135 million IRS refund for 2008–2009 tax years, partly offset by higher pension contributions, changes in collateral and working capital. Thus, the cash-flow improvement includes a substantial one-time tax receipt. Investing cash use increased, chiefly because capital expenditures were higher. Financing cash flow benefited from debt issuance; the company paid $62.5 million in common dividends.

At March 31, Pinnacle West reported $3.586 billion of long-term debt including current maturities, plus $9.5 million of short-term borrowings. APS had $3.461 billion of debt including current maturities. APS reported a 56% common-equity ratio under the ACC’s definition, above its 40% minimum requirement. Pinnacle West and APS were within their 65% maximum debt-to-capitalization covenant, at approximately 47% and 46%, respectively. Pinnacle West had $200 million of revolving credit capacity and APS had $1 billion; neither had revolving-facility borrowings outstanding. APS had no commercial paper outstanding, while Pinnacle West had $10 million.

Material changes and developments

• APS issued $250 million of 4.70% unsecured senior notes due 2044. Proceeds repaid commercial paper used to finance the Four Corners acquisition and replenish cash used to reacquire tax-exempt debt.
• APS acquired SCE’s 48% interests in Four Corners Units 4 and 5 for approximately $182 million in December 2013 and retired Units 1–3. The associated cost-deferral balance was $47 million at March 31, 2014.
• APS’s 2014 annual Lost Fixed Cost Recovery adjustment of $25.3 million was approved and took effect April 1, 2014. The ACC also approved $68.9 million budgets for each of APS’s 2013 and 2014 demand-side management plans.
• APS’s 2014 renewable-energy budget of approximately $143 million was approved. A new charge for customers installing rooftop solar after December 31, 2013 took effect January 1, 2014; the filing estimates about $4.90 per month for a typical affected customer. The charge is credited to the LFCR and does not increase APS revenue.

Outlook, management commentary, and risks

Management expects average annual customer growth of about 2.5% and weather-adjusted retail electricity sales growth of about 1% for 2014–2016. These are operating estimates, not earnings guidance; the filing provides no explicit full-year earnings-per-share guidance. Estimated APS capital expenditures are $973 million in 2014, $1.026 billion in 2015, and $1.263 billion in 2016, funded through operating cash flow and external financing as needed. The board declared a $0.5675-per-share dividend payable June 2, 2014.

• Regulatory and recovery risk: APS’s requested Four Corners rate adjustment could raise an average residential bill about 2% if approved; a hearing was scheduled for August 2014. The outcome and timing were uncertain. FERC denied recovery of $40 million associated with the Four Corners transmission termination arrangement; rehearing requests were pending, with negotiation or arbitration possible.
• Environmental and plant risks: Estimated APS shares of potential or required pollution-control costs include approximately $350 million for Four Corners, up to $200 million for Navajo under EPA’s proposal, and about $200 million for Cholla if its challenge fails. Further environmental rules could increase costs, affect coal-plant economics, or lead to impairment or early retirement; rate recovery is not assured.
• Legal and contingency risks: APS faced preliminary FERC allegations concerning seven reliability-standard requirements related to the 2011 Southwest power outage; possible penalties and other impacts were uncertain. Superfund litigation, a New Mexico coal-tax dispute, and Clean Air Act litigation also remained unresolved, with potential losses not clearly estimable in the filing.
• Operating and market risks: Results remain exposed to weather, electricity demand, fuel and purchased-power prices, plant and transmission performance, water and fuel availability, regulation, and the cost and availability of capital. Management noted that typical weather or economic sales variations could change annual net income by up to $10 million; extreme weather has historically produced larger effects.
• Pension and liquidity considerations: Management expected voluntary pension contributions totaling $175 million in 2014, including $105 million already contributed early in the year. Derivative and energy-related contracts could require additional collateral following a credit downgrade.

Important facts for investors to verify

1. Whether the $15.8 million of Q1 common-shareholder earnings reflects the ongoing run rate, given weather impacts and the year-over-year decline.
2. How much of the $249.2 million operating cash flow is repeatable without the $135 million IRS refund, and how capital spending and pension contributions affect future cash needs.
3. The ACC’s decision on Four Corners rate recovery and the outcome of the related FERC transmission proceedings, including potential exposure to the disputed $40 million.
4. Actual environmental compliance costs, project timing, and the prospects for recovery through customer rates.
5. Whether customer and sales growth, renewable and energy-efficiency requirements, and net-metering policy develop in line with management’s estimates.
6. APS’s ongoing compliance with capitalization and debt covenants, and the availability of liquidity if credit ratings weaken or collateral requirements rise.