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Pinnacle West Capital (NYSE:PNW)
Q2 2018 Earnings Conference Call
Aug. 3, 2018 12:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings and welcome to the Pinnacle West Capital Corporation's 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. [Operator instructions].

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.

Stefanie Layton -- Director of Investor Relations

Thank you, Christine. I would like to thank everyone for participating in this conference call and webcast to review our second-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' executive vice president of public policy, is also here with us.

First, I need to review 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 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 second-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 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.

Don Brandt -- Chairman and Chief Executive Officer

Thank you, Stefanie, 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 second-quarter 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 million 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 one of our best outages ever.

Looking at our capital investment program, nearly 200 miles of transmission lines and 15 new substations supporting the additional capacity have been added in the past three 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 to Morgan, was commissioned. Notably, the Sun Valley to Morgan project has garnered national attention for its innovative design and permitting process and collaborative work with the Bureau of Land Management.

The four 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 the wildfire season. To reduce fire risk, our teams performed vegetation management activities, held wildfire prevention training, and continued to expand our clearance-around-poles 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 a request for proposals regarding peaking capacity and forest bio-energy solutions. Proposals for the peaking capacity solicitation were due by July 20 and we are in the process of evaluating those proposals. The submission deadline for the forest bio-energy 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 project selected as part of the battery storage RFP. We expect to make final selections for each of these solicitations during the fourth quarter 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 2G to 4G. Over the next 18 months, we will replace roughly 2,000 2G devices with about 1,500 4G 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 2030 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 a 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 Steyer-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 2030. This would equate to over $10 billion in incremental capital investment by 2030.

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 and other costs associated with the early shutdown for Palo Verde Generating Station and the Four Corners Power Plant could be $1.9 billion and $1.3 billion respectively. While we expect the Steyer-funded ballot initiative would significantly increase our rate base estimates, customer bills in 2030 would likely be double today's bills.

We are not opposing this ballot initiative because we are opposed to cleaner renewable energy. We're opposing it because the 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 nine 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 amount of 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 2050 is a bold vision for the future.

While we are 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.

Jim Hatfield -- Chief Financial Officer

Thank you, Don, and thank you again, everyone, for joining us today. This morning we reported our financial results for the second quarter of 2018. As shown on Slide 3 of the materials, for the second quarter of 2018 we earned $1.48 per share, compared to $1.49 per share in the second quarter 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.

The adjusted gross margin was up $0.12 per share compared with the second quarter in 2017, 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, refund to customers due to a 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 Adjustor Mechanism, or TEAM, is based on a per kilowatt-hour sales credit and will generally follow our seasonal kilowatt-hour sales pattern. The impact on 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 impacts 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 cost 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 customers' service costs at APS, and at the parent company level, public outreach costs primarily associated with the Steyer-funded ballot initiative.

Depreciation and amortization expenses were higher in the second quarter of 2018 compared to the second quarter of 2017, reducing earnings by $0.13 per share. The increase primarily related to higher D&A rates approved in the 2017 Rate Review Order and plant additions.

Also on Slide 3, pension and other postretirement benefits non-service credits increased pre-tax income by approximately $5 million, or $0.03 per share, in the second 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 for the deferral associated with the Four Corners SCRs, as there was no net impact on second-quarter 2018 results.

Turning now to Arizona's economy, customer growth, and sales growth, the metro Phoenix area continued 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 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 second quarter of 2018. We expect that this growth rate will continue to gradually accelerate in response to the economic growth trends I just discussed. Importantly, the long-term fundamentals supporting future population, job growth, and the economic development in Arizona, appear to be in place.

As I mentioned earlier, our weather-adjusted gross sales, excluding 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 in regards 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 grandfathered distributed generation systems as well for net metering [Inaudible] full 2 percentage points out of residential growth rate this quarter. As the 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' off-peak demand reductions to better align the benefits for customers with realized 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 cost and higher than other operating expenses related to more plant service including higher D&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 million 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.

Questions and Answers:

Operator

[Operator instructions]. Our first question comes from the line of Michael Weinstein with Credit Suisse. Please proceed with your question.

Michael Weinstein -- Credit Suisse -- Analyst

So, you indicated that if the initiative passes that it would require over $10 billion of incremental capital investment by 2030 and that that can lead to a substantial increase in customer bills. It is why you are 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 is 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?

Jim Hatfield -- Chief Financial Officer

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 2050 incremental to what we currently have today.

So that would be positive but it keeps Palo Verde as well, which is the largest source of clean energy in the U.S.

Michael Weinstein -- Credit Suisse -- Analyst

OK. And just to confirm, 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 three-year growth forecast did not change.

Jim Hatfield -- Chief Financial Officer

Probably. We're getting toward the end of the installations of the applications from the September 1 grandfathered deadline. You have to remember that once the deadline passed, some of the national sellers pulled away from Arizona. So the installations are slower than they had been in the past but we should see that in the second half of the year.

Michael Weinstein -- Credit Suisse -- Analyst

And also one last question, what are your latest thoughts on the next rate case filing in terms of timing and around the next election cycle?

Jim Hatfield -- Chief Financial Officer

We are still looking at that. As I've said, our desire would be pushing out a year. So we file in 2020 and the rate is effective 2021. So, we'll make a decision on that as we get through the next month or so.

We are really looking at sales patterns based on the rate design and migration to new rates and we need to make sure we understand that profile.

Michael Weinstein -- Credit Suisse -- Analyst

OK, great. Thank you.

Operator

Our next question comes from the line of Julien Dumoulin-Smith with Bank of America. Please proceed with your question.

Julien Dumoulin-Smith -- Bank of America Merrill Lynch -- Analyst

So, just wanted to follow up on the last question a little bit more. Can you clarify just for us the timeline here? So the secretary of state is going to come out on the Tom initiative, then what else? And then separately and perhaps more importantly, can you comment quickly on recourse, if it does actually succeed in terms of any appeals process or implementation? And especially even within that, to the extent we have both proposals move forward, how would you reconcile between the two? I mean, basically would the more stringent of the two basically apply, and if Tobin were to get his proposal going forward, would that basically be moot given the success of the ballot initiative?

Don Brandt -- Chairman and Chief Executive Officer

Julien, I'm going to ask Jeff Guldner to kind of walk through the key dates well up to the litigation and what would happen with the secretary of state. You might want to clarify your question but I rather not, won't go into a lot of detail about what ifs. Right now we are focused on the litigation that's pending in the courts and we'll take it one step at a time. With that, Jeff?

Jeff Guldner -- APS Executive Vice President of Public Policy

Julien, right now the signature review is in its normal process, so the secretary of state sent them to the counties. The county's doing their review. The lawsuit that was filed in superior court is proceeding kind of parallel with that. There has been motion practice, some 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 is a pre-hearing, pre-trial conference on August 17 and then the trial would begin on August 20, will 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.

Julien Dumoulin-Smith -- Bank of America Merrill Lynch -- Analyst

Got it, all night, excellent. And then just coming back to the parallel path 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?

Don Brandt -- Chairman and Chief Executive Officer

Julien, I wouldn't characterize them as competing proposals. There are two 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 a year-by-year, whatever frequency they wanted to do, as opposed to a constitutional amendment that would lock something into the Arizona constitution forevermore.

Julien Dumoulin-Smith -- Bank of America Merrill Lynch -- Analyst

Got it. Actually maybe is there any mechanism to put in place to address [Inaudible] cost that you could see here just to kind of de-risk the whole effort? I mean, is there something else?

Don Brandt -- Chairman and Chief Executive Officer

Again, right now we are focused on observing what's happening in the courts with the litigation on the signatures that have been filed.

Julien Dumoulin-Smith -- Bank of America Merrill Lynch -- Analyst

Understood. All right, we'll leave it there. Thank you very much.

Operator

Our next question comes from the line of Ali Agha with SunTrust. Please proceed with your question.

Ali Agha -- SunTrust Humphrey Robinson -- Analyst

First, I wanted to just clarify from your opening remarks, as you mentioned, if this initiative is happening, there could be premature retirement with two of your plants. I just wanted to be clear. So, 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?

Jeff Guldner -- APS Executive Vice President of Public Policy

This is Jeff. So, that would have to be addressed at the commission. So, there are various ways. We've had stranded cost issues before.

And so those would be addressed at the commission at the time.

Ali Agha -- SunTrust Humphrey Robinson -- Analyst

So it's not formulaic if you would have to go through a proceeding?

Jeff Guldner -- APS Executive Vice President of Public Policy

That's right.

Ali Agha -- SunTrust Humphrey Robinson -- Analyst

I see. OK. And then, Jim, I wanted to clarify your point, looking at 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 three 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 three consecutive negative declines we have seen here?

Jim Hatfield -- Chief Financial Officer

You had grandfathering 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.

Ali Agha -- SunTrust Humphrey Robinson -- Analyst

I see, OK. 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&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. I mean, 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?

Jim Hatfield -- Chief Financial Officer

I mean, those are two impacts to the financials in isolation. There's much other impacts as well. We'll come out with 2019 guidance later this year.

Ali Agha -- SunTrust Humphrey Robinson -- Analyst

But both of those are accurate, right, in terms of helping your earned ROE next year?

Jim Hatfield -- Chief Financial Officer

In isolation, yes.

Ali Agha -- SunTrust Humphrey Robinson -- Analyst

Thank you.

Operator

Our next question comes from the line of Andrew Levi with ExodusPoint. Please proceed with your question.

Andrew Levi -- ExodusPoint -- Analyst

Just back on the ballot initiative, I don't know, I just feel there is like some investor confusion because kind of since this whole thing has come out the stock has on a relative basis hasn't done so well, and I understand the effects on the rate there if this were to go through and obviously it would be a several-year process, if it actually got on the ballot, it was approved, right, there would be some type of legal challenge to it? And then I have a follow-up. Is that correct?

Don Brandt -- Chairman and Chief Executive Officer

I think we have missed your question, Andy.

Andrew Levi -- ExodusPoint -- Analyst

I'm sorry, you didn't hear me, OK. So basically, if it were to pass, it would 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.

Don Brandt -- Chairman and Chief Executive Officer

We are not to that point yet. We are, as I said earlier, we are 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.

Andrew Levi -- ExodusPoint -- Analyst

OK 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 the stranded costs potential longer-term, though that rate base as you kind of outlined would be replaced by renewable rate base and the Company is kind of surrounding that, isn't that correct?

Don Brandt -- Chairman and Chief Executive Officer

Again, I'll use Jim's words, in isolation that's correct but there are so many variables to this situation. Until there is clarity around the results of this litigation, it's really hard to start predicting things that far out.

Andrew Levi -- ExodusPoint -- Analyst

OK, that's fair. I get it. Just that your stock has suffered quite a bit, again, on a relative basis, because group has been going up since this initiative has been initiated, but I just feel there is kind of a misperception of the end result, but thank you very much.

Operator

Our next question comes from the line of Paul Patterson with Glenrock Associates. Please proceed with your question.

Paul Patterson -- Glenrock Associates -- Analyst

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?

Jeff Guldner -- APS Executive Vice President of Public Policy

There was a statute that was passed to address what you would do in a compliance situation of a statute 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.

Paul Patterson -- Glenrock Associates -- Analyst

OK 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 old scheme of things?

Jeff Guldner -- APS Executive Vice President of Public Policy

That's correct.

Paul Patterson -- Glenrock Associates -- Analyst

From a cost-benefit perspective, is that correct? I mean, you know what I'm saying, I mean, in other words, if this initiative was going to cost ratepayers a whole bunch of money, etc.? The cost of non-compliance would seem to be considerably lower. Am I wrong?

Jeff Guldner -- APS Executive Vice President of Public Policy

Based on the reading of that, you're exactly correct on the reading of that legislation.

Paul Patterson -- Glenrock Associates -- Analyst

OK. I guess the message today that was before we get down to all these hypotheticals of what may or may not happen, you'd rather just see what actually happens in the courts and [Inaudible]. Is that how I should think about it as opposed to pursuing a bunch of questions about what may or may not happen? Is that what you're basically suggesting we do?

Don Brandt -- Chairman and Chief Executive Officer

Yes, exactly. We have a strategy. It's tied up in the courts right now and we are watching that very closely and we'll respond when the time comes.

Paul Patterson -- Glenrock Associates -- Analyst

OK. My other questions were answered and I won't take any more of your time. Thanks so much.

Operator

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.

Stefanie Layton -- Director of Investor Relations

Thank you and this concludes our call.

Operator

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.

Duration: 36 minutes

Call Participants:

Stefanie Layton -- Director of Investor Relations

Don Brandt -- Chairman and Chief Executive Officer

Jim Hatfield -- Chief Financial Officer

Michael Weinstein -- Credit Suisse -- Analyst

Julien Dumoulin-Smith -- Bank of America Merrill Lynch -- Analyst

Jeff Guldner -- APS Executive Vice President of Public Policy

Ali Agha -- SunTrust Humphrey Robinson -- Analyst

Andrew Levi -- ExodusPoint -- Analyst

Paul Patterson -- Glenrock Associates -- Analyst

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