Image source: California Water.

The California drought shows no signs of letting up anytime soon, forcing the state to take drastic measures to encourage conservation and prevent waste. Water utility California Water Service Group (NYSE:CWT) has had to deal with the immediate consequences of the drought, and unlike more geographically diverse utilities like American Water (NYSE:AWK), California Water has much bigger potential exposure.

Coming into Wednesday night's third-quarter financial report, California Water investors had recognized the long-term potential for higher rates and profits, but they still expected declines in earnings and revenue. In the end, the water utility's results were worse than expected, with much bigger drops in its headline numbers that raised additional concerns about its near-term future. Let's look more closely at California Water to see whether shareholders should worry.

Short-term pain
California Water's third-quarter results showed just how much a drop in usage can affect near-term results for a water utility. Revenue dropped 4% to $183.5 million, which was roughly in line with the consensus forecast among investors. Yet net income plunged by more than 25% to $25.1 million, and that produced earnings of $0.52 per share, fully $0.15 less than what investors had expected to see.

Utility financial results are littered with adjustments, and some of those factors played a role in California Water's performance. For instance, in last year's third quarter, California Water got a one-time benefit of $6.8 million in net income due to an interim recovery following the state public utilities commission's general rate case decision. One-time tax benefits also lifted last year's results. Moreover, as we saw last quarter, California Water cited a $3.9 million rise in unbilled revenue that should help the company in the future when those charges are actually billed.

Nevertheless, California Water had to deal with other headwinds. Despite the lower revenue, operating expenses rose slightly, with higher labor costs, drought program and conservation expenses, and uninsured losses boosting overall expenses. Drought restrictions did lead to savings in water production expenses, with a 19% drop in production volumes cutting costs by $6.5 million. However, maintenance expenses also rose, further hitting the bottom line.

CEO Martin Kropelnicki emphasized the extent to which the utility is prepared to assist the state and its residents under dry conditions. "Our California customers excelled at reducing their water consumption in response to the Governor's emergency drought declaration," Kropelnicki said. "We are committed to meeting the state's reduction targets, and we are headed in the right direction for the remaining five months of the emergency drought declaration period."

Why California Water shouldn't worry
The key thing for investors to remember is that California Water can recover any lost revenue by applying for higher rates in the future. The company said that it has incurred $3.1 million in incremental drought expenses over the past couple of years, with $1.8 million of that coming in the third quarter. It intends to have the utilities commission do a reasonableness review at a later date in order to recover those costs through a rate increase. Still, the situation in California is tough, as California Water imposed drought surcharges to customers who exceeded water budget targets, with the total amounting to $23.6 million during the quarter. American Water's California unit also recently started charging surcharges to high-use customers, and it has seen some mild push-back from the public but without major controversies in most cases.

California Water also hasn't given up on its long-term strategic plans. It sold $100 million in bonds in order to refinance some of its short-term loans that it incurred to fund utility plant investments. The company expects to issue another $50 million in bonds early next year, with the intent of keeping up with long-term demand.

In the end, California Water can count on the regulatory framework ensuring it a reasonable rate of return, adjusting gradually to falling short-term demand but eventually working out to even things out. It might take a while for California Water's quarterly results to catch up, but in the long run, strong fundamentals should support the business for years to come.