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ONE Gas Inc  (NYSE:OGS)
Q3 2018 Earnings Conference Call
Oct. 30, 2018, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day and welcome to the ONE Gas Third Quarter Earnings Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Mr. Brandon Lohse. Sir, please go ahead.

Brandon Lohse -- Investor Relations

Good morning and thank you for joining third quarter 2018 earnings conference call. This call is being webcast live and a replay will be made available. After our prepared remarks, we would be happy to take your questions. A reminder that statements made during this call that might include ONE Gas expectations or predictions should be considered forward-looking statements and are covered by the safe harbor provision of the Securities Acts of 1933 and '34. Actual results could differ materially from those projected in any forward-looking statements. For a discussion of factors that could cause actual results to differ, please refer to our SEC filings.

Our first speaker this morning is Curtis Dinan, Senior Vice President and Chief Financial Officer of ONE Gas. Curtis?

Curtis Dinan -- Senior Vice President & Chief Financial Officer

Thanks, Brandon. Good morning everyone, and thank you for joining us today. Beginning with our third quarter results, net income for the third quarter 2018 was $16.3 million or $0.31 per diluted share, compared with $18.8 million or $0.36 per diluted share for the same period last year. The largest impact to our results was the timing of income tax deferrals and related rate adjustments which was partially offset by increases from new rates in Texas and Kansas, and residential customer growth in Oklahoma and Texas. I will comment more as to the ongoing effects of tax reform in a minute.

Operating costs for the third quarter were $110.5 million compared with $104.8 million in the same period last year, due to an increase in employee related costs and bad debt expense. Capital expenditures for the third quarter increased $9 million to $103.5 million, compared with $94.4 million for the same period last year. We are still expecting full year capital expenditures to be in the range of $375 million to $390 million, with approximately 70% targeted toward system integrity and replacement projects.

Now for a quick update on tax reform. In compliance with the accounting authority orders in each of our jurisdictions, we have established a regulatory liability for the difference in federal taxes resulting from the recent drop in statutory income tax rates. The establishment of this regulatory liability and related rate adjustments from completed filings resulted in a $6 million reduction to our revenues in the third quarter of 2018 or $4.6 million net of tax. This was partially offset by $2.6 million reduction in our income tax expense.

Recall from our two previous earnings calls that this timing difference between the revenue deferral and the reduction in our income tax expense created a positive $0.13 impact on earnings in the first quarter and a negative $0.06 impact in the second quarter. We saw another $0.04 reversal in the third quarter and expect the remaining $0.03 to reverse in the fourth quarter. The effect from the change in tax rate has now been reflected in regulatory filings across all of our jurisdictions, including our pending filings in Oklahoma and Kansas. The timing and process for returning excess accumulated deferred income taxes to our customers in most of our jurisdictions is still to be determined.

Yesterday, the ONE Gas Board of Directors declared a dividend of $0.46 per share unchanged from the previous quarter. This dividend is consistent with the company's guidance for 2018. As we have indicated previously, we expect the average annual dividend increase to be 7% to 9% between 2017 and 2022, with a targeted dividend payout ratio of 55% to 65% of net income.

We affirmed our 2018 net income guidance range of $167 million to $178 million or $3.15 to $3.35 per diluted share. Historically, during our earnings calls, we have provided two different rate base calculations. The first is authorized rate base, defined as the rate base reflected in our latest regulatory proceedings, including full rate cases and interim rate filings. At September 30, 2018, authorized rate base was approximately $3 billion.

The second is estimated average rate base which is defined as authorized rate base plus additional investments in our system, and the other changes in the components of our rate base that are not yet reflected in approved regulatory filings. We project that for year-end 2018, our estimated average rate base will be approximately $3.36 billion with 42% in Oklahoma, 30% in Kansas, and 28% in Texas.

In August, the IRS issued guidance that utility assets placed in service during the fourth quarter of 2017 are eligible for 100% bonus depreciation. We have previously assumed that these assets would not be eligible. This additional bonus depreciation had the effect of increasing deferred taxes, thereby slightly reducing estimated average rate base from our prior estimates.

And now, I'll turn it over to Pierce Norton, ONE Gas President and Chief Executive Officer. Pierce?

Pierce Norton -- President and Chief Executive Officer

Thanks, Curtis, and good morning everyone. I'd like to start by giving you an update on the recent regulatory activity throughout our service areas. So I'm going to begin in Oklahoma. In September, the administrative law judge issued his report regarding our performance-based rate change application. The ALJ recommended the commission approve the non-unanimous consent agreement between the staff and the company except for the amortization period for unprotected excise accumulated deferred income taxes for which he recommended a 10-year amortization period. A hearing is scheduled before the Oklahoma Corporation Commission for November the 28th, and a final order is anticipated by the end of this year.

So on to Texas. New rates went into effect in August for the incorporated customers in the Rio Grande Valley service area, after we received approval for a $1.1 million increase pursuant to the cost of service adjustment filing.

Finally in Kansas. In August, Kansas Gas Service requested an increase of approximately $2.4 million related to its Gas System Reliability Surcharge. An order from the Kansas Corporation Commission is expected in December 2018 with new rates expected to be in effect January 1st of 2019. In the pending Kansas Gas Service rate request, the procedural schedule was approved on August the 2nd, evidentiary hearings are scheduled for December 11th through the 13th, and a final order from the KCC is due February 25th, 2019. New rates are expected to be effective before the end of the first quarter of 2019.

As a reminder, this file request with the KCC is for a net increase in rates of $42.7 million, reflecting investments in the system and changes in operating costs necessary to maintain the safety and reliability of its natural gas distribution system. The requested net increase in rates would be an increase in the operating income of approximately $31 million. The filing is based on a 10% return on equity, and a 62.2% common equity ratio. For every 25 basis point change in our requested ROE, the impact on the operating income is approximately $2.2 million. For every 1% change in our requested equity ratio, the impact on the operating income is approximately $1.4 million.

On October 8th, Kansas Gas Service announced it has been selected by the US Government to own, operate, and maintain the natural gas distribution facilities at Fort Riley under a 50-year contract. Fort Riley is a US Army installation in Kansas and has more than 15,000 active military, 5,600 civilian workers, and supports over 5,000 retirees, 24,000 veterans and more than 18,000 family members living both on and off the post. The terms of the privatization contract will be reviewed by the KCC. If approved, Kansas Gas Service will start the transition process with an intent to take over the gas system operations in April of 2020. At closing, the Fort Riley contract will add approximately $5.8 million to the rate base.

In closing, I'd like to express my gratitude to our 3,500 hard-working employees. Their focus and commitment to provide safe and reliable natural gas service every day to our more than 2.2 million customers is to be commended.

Operator, we're now ready for questions.

Questions and Answers:

Operator

(Operator Instructions) Our first question will come from Chris Sighinolfi with Jefferies.

Christopher Sighinolfi -- Jefferies -- Analyst

Pierce, just had a question on, I guess, the follow-up on your description of Fort Riley. I guess, we talked previously about some municipal systems that may come available but haven't thought about US Government installations. Is that a one-off opportunity or is that an effort by the armed services to move more of, I guess, their gas infrastructure into sort of more private professional hands?

Pierce Norton -- President and Chief Executive Officer

They actually started this in motion, Chris, years ago. We actually own and operate some assets, natural gas assets in other areas of our service territory like Fort Bliss, and they have been moving toward this privatization type effort even prior to the present Trump administration. So this is something I think that they've had ongoing for a while. It just takes a while to run to go through the process.

Christopher Sighinolfi -- Jefferies -- Analyst

And I guess, so the fact that you have done it previously, the experience in overtaking formally federally run assets. What -- can you say anything about the state of those systems relative to your own systems and any sort of associated upgrading, or I guess, if there's a standardization that's required in terms of how you guys operate or some of the hardware you use versus what's being used by government? Is there anything to be expected in that regard?

Pierce Norton -- President and Chief Executive Officer

It's the same thing that we do in every other place. As far as your question Chris, it really come down to -- that's part of the due diligence and that's part of what takes as long as it does. There's already been a significant amount of due diligence already done on those systems. So we know who built them, we know who maintain them, it's some of the same contractors that we use on our system. So we have confidence that the systems were put in correctly and its routine maintenance from here on out just like we'd do on our systems.

Christopher Sighinolfi -- Jefferies -- Analyst

Okay. And the contracts' 50-year life is what I think I heard you mentioned in your prepared remarks, that would just be inoculate risk in case there is a base closure at some point in the future?

Pierce Norton -- President and Chief Executive Officer

That's exactly right. There are some things in there that allow us to do some different things that for some reason that was a base closure or whatever. So we can roll out of that contract.

Christopher Sighinolfi -- Jefferies -- Analyst

Okay. That was really impromptu on my part, I didn't -- it was really just bond based on your prepared remarks. I appreciate the color. I was interested, Curtis, in terms of, I guess, as I look forward into future periods and more think of that next year, the maturity that you have in February. Just curious your thoughts on refinancing that and then with a capital program, if you thought you do it the same size and what duration you thought would be appropriate given what the flattening and curve yield do at this point? Just curious thoughts on that. Thanks.

Curtis Dinan -- Senior Vice President & Chief Financial Officer

Yeah, so we -- what you're referring to is the $300 million of bond maturity that we have at the end of January next year, we haven't made final determinations as to how we'll refinance that or what that tenure may look like when we do or even what the timing of it will be. The one thing I'd say is, at the end of the third quarter, we had under $300 million outstanding under our $700 million revolver. So our liquidity position is really, really strong at this point, and so that gives us options as to how we think about what that refinancing and what the timing of that may look like.

Christopher Sighinolfi -- Jefferies -- Analyst

Okay. So something just you'll evaluate as we grind closer to it, but capacity to put down the revolver if markets aren't super attractive at that point. Is that how we think about it or you just -- or do you think it will be not that way that you'll actually determine output before it comes to maturity but you just haven't decided on what the structure exactly looks like?

Pierce Norton -- President and Chief Executive Officer

Yeah, we haven't decided exactly what that's going to look like or what the timing would be. So sort of a little bit of both of your assumptions there.

Christopher Sighinolfi -- Jefferies -- Analyst

Okay. That's helpful. Thanks a lot guys. I appreciate the color.

Pierce Norton -- President and Chief Executive Officer

Thanks, Chris.

Curtis Dinan -- Senior Vice President & Chief Financial Officer

Thank you, Chris.

Operator

All right. Thank you. Our next question will come from Aga with UBS.

Aga Zmigrodzka -- UBS -- Analyst

Good morning.

Pierce Norton -- President and Chief Executive Officer

Good morning, Aga.

Aga Zmigrodzka -- UBS -- Analyst

Could you please discuss the customer growth around your footprint and how do you think about the customer growth going forward? It looks like the third quarter customer growth was down to 0.4% from 0.7% in '17? Thank you.

Curtis Dinan -- Senior Vice President & Chief Financial Officer

So Aga those growth numbers are net numbers. So you have customers that exit the system and customers that come on. So from -- if you're looking from quarter-to-quarter, you do find some movement in that. The best time to mark that in the year is during the middle of the winter, so in the January time frame. So when we give the annualized numbers, those are the best ones to compare year-over-year. But if you look at year-to-date numbers, it's about 0.3% in Kansas, about 0.5% in Oklahoma, and about 0.8% in Texas, which is very similar to what we've been experienced over the past several years.

Aga Zmigrodzka -- UBS -- Analyst

Thank you. That's very helpful. I have one follow-up question. Full year O&M expense guidance implies roughly $18 million quarter-over-quarter increase. Typically, O&M is highest in 4Q. But you do see any potential room for incremental efficiencies to get the full year O&M guidance below of what you've provided -- a number before the guidance, below the guidance.

Curtis Dinan -- Senior Vice President & Chief Financial Officer

Yeah, we still believe that our O&M stuff and our overall guidance numbers are right and they're definitely within our range that we have given to you guys earlier.

Aga Zmigrodzka -- UBS -- Analyst

Got it. Thank you for the color.

Curtis Dinan -- Senior Vice President & Chief Financial Officer

Thank you, Aga.

Operator

All right. Thank you. Our next question comes from Dennis Coleman with Bank of America.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

Yeah, hi good morning everyone. Just a couple of quick ones. Pierce, can I just ask you to repeat the numbers on the Fort Riley? How many people in total is it? If I can just get a single number there and so how many customers would it be?

Pierce Norton -- President and Chief Executive Officer

Well, in total, there is about 15,000 active military on that base. Now that can ebb and flow because they could be deployed or whatever and then you've got about 5,600 civilian workers. The important number that was disclosed on that is the $5.8 million of rate base, because their meters and stuff are configured sometimes differently than what you might see in the civilian market. So the thing to focus on there is the $5.8 million of rate base and I'd then remind it's about $3.36 billion overall of the entire company. So it's important to us, but it's not -- it's just routine business for us.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

I got you. And so, is it -- does it have a different regulatory authority? Is it just the federal government or the military or is it a --

Pierce Norton -- President and Chief Executive Officer

It all falls under the Kansas Corporation Commission. So it's all rolled into the whole rate base of Kansas.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

Okay. And you mentioned the $3.36 billion of rate base and I should know this, but just to make sure I do understand. So you said it was $3 billion of authorized rate base at the end of September, an estimated average rate base of $3.36 billion which would be at the end of 2018? And so --

Pierce Norton -- President and Chief Executive Officer

Yes.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

So the difference the $360 million has been filed for?

Pierce Norton -- President and Chief Executive Officer

No, what that represents is that capital expenditures primarily that have been made since the last rate filings. So what established the $3 billion that was our authorized rate base. So like the last Oklahoma PBR filing, the last GSRS filing in Kansas, all those different things established that $3 billion. But we continue to spend money and so we average $3.36 billion that's not yet fully reflected in those rate filings.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

Okay.

Curtis Dinan -- Senior Vice President & Chief Financial Officer

Dennis, the reason we reported that way is because we think that's the most accurate. We as the company know all the components to those rate basis in every single state. And so, to be able to give you all guidance is, what those numbers are going to be? We feel like that's the most accurate reflection in real time.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

I see. So, but just for example, if I make sure I understand, so the Kansas rate case when it presumably is approved at some level, the next year that will change the authorized rate base?

Curtis Dinan -- Senior Vice President & Chief Financial Officer

That's correct. Yeah, that $3 billion the first number I gave you would increase following that.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

And so would -- presumably narrowing to that $3.36 billion?

Curtis Dinan -- Senior Vice President & Chief Financial Officer

Yes.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

Okay. All right. That's what I've got. Okay. Thanks very much.

Curtis Dinan -- Senior Vice President & Chief Financial Officer

Thanks, Dennis.

Pierce Norton -- President and Chief Executive Officer

Thanks, Dennis.

Operator

All right. Thank you. (Operator Instructions) And all right gentlemen, we currently have no questions in queue at this time.

Brandon Lohse -- Investor Relations

Thank you for joining us this morning. Our quiet period for the fourth quarter starts when we close our books in early January and extends until we release earnings in February. We'll provide details on the conference call at a later date and have a great rest of your day. Thank you everybody.

Operator

Thank you, ladies and gentlemen. This concludes today's teleconference and you may now disconnect.

Duration: 23 minutes

Call participants:

Brandon Lohse -- Investor Relations

Curtis Dinan -- Senior Vice President & Chief Financial Officer

Pierce Norton -- President and Chief Executive Officer

Christopher Sighinolfi -- Jefferies -- Analyst

Aga Zmigrodzka -- UBS -- Analyst

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

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