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CWT > SEC Filings for CWT > Form 10-K on 27-Feb-2014All Recent SEC Filings

Show all filings for CALIFORNIA WATER SERVICE GROUP

Form 10-K for CALIFORNIA WATER SERVICE GROUP


27-Feb-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Overview

In 2013 and 2012, net income was $47.3 million and $48.8 million, respectively. Diluted earnings per share decreased $0.15 to $1.02 or 13% from 2012 to 2013. The weighted average number of common shares outstanding used in the diluted earnings per share calculation increased to 46,417,000 shares in 2013 compared to 41,892,000 shares in 2012 mostly due to the sale of 5,750,000 shares of common stock on March 26, 2013. The $1.5 million decrease in net income was primarily attributable to cost increases for employee wages and benefits, water production costs, depreciation on plant placed into service during 2012, and property taxes. The decrease in net income was also due to the 2012 one-time benefit from the reversal of 2011 deferred WRAM revenues of $12.9 million and associated costs of $10.5 million that we recognized in 2012, a $0.6 million decrease in the unrealized pre-tax gain on our benefit plan insurance investments in 2013, and higher net interest expenses mostly due to a reduction in capital project spending in 2013. The one-time tax benefit was $4.9 million in 2013 for state enterprise zone credits and state repairs deductions, and was $6.2 million in 2012 for state repairs deductions. The 2013 cost increases were partially offset by cost reductions to other operations, maintenance expenses, and income taxes.

In 2012 and 2011, net income was $48.8 million and $37.7 million, respectively. Diluted earnings per share increased $0.27 to $1.17 or 30% from 2011 to 2012. The $11.1 million increase in net income was primarily attributable to a one-time income tax benefit of $6.2 million related to 2011 and prior years for state income tax repairs and maintenance deductions that we recognized in 2012, an unrealized pre-tax gain of $2.5 million on our benefit plan insurance investments, a one-time benefit of 2011 deferred WRAM operating revenues of $12.9 million and associated costs of $10.5 million that we recognized in 2012, a decrease in the current year income tax provision due to the repairs and maintenance deductions, and lower financing costs for short-term borrowings, which was partially offset by a $3.9 million reduction to operating revenues due to the cost of capital adjustment mechanism and cost increases for employee wages and benefits, water production costs, and depreciation on plant placed into service during 2011.

We plan to continue to seek rate relief to recover our operating cost increases and receive reasonable returns on invested capital. We expect to fund our long-term capital needs through a combination of debt, common stock offerings, and cash flow from operations.

Critical Accounting Policies and Estimates

We maintain our accounting records in accordance with accounting principles generally accepted in the United States of America and as directed by the Commissions to which our operations are subject. The process of preparing financial statements requires the use of estimates on the part of management. The estimates used by management are based on historic experience and an understanding of current facts and circumstances. A summary of our significant accounting policies is listed in Note 2 of the Notes to Consolidated Financial Statements. The following sections describe those policies where the level of subjectivity, judgment, and variability of estimates could have a material impact on the financial condition, operating performance, and cash flows of the business.

Revenue Recognition

Revenue generally includes monthly cycle customer billings for regulated water and wastewater services at rates authorized by regulatory Commissions (plus an estimate for water used between the customer's last meter reading and the end of the accounting period) and billings to certain non-regulated customers at rates authorized by contract with government agencies.

The Company's regulated water and waste water revenue requirements are authorized by the Commissions in the states in which we operate. The revenue requirements are intended to provide the Company a reasonable opportunity to recover its cost of service and earn a return on investments.


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For metered customers, Cal Water recognizes revenue from rates which are designed and authorized by the CPUC. Under the Water Revenue Adjustment Mechanism (WRAM), Cal Water records the adopted level of volumetric revenues, which would include recovery of cost of service and a return on investments as established by the CPUC for metered accounts (adopted volumetric revenues). In addition to volumetric-based revenues, the revenue requirements approved by the CPUC include service charges, flat rate charges, and other items not subject to the WRAM. The adopted volumetric revenue considers the seasonality of consumption of water based upon historical averages. The variance between adopted volumetric revenues and actual billed volumetric revenues for metered accounts is recorded as a component of revenue with an offsetting entry to a regulatory asset or liability balancing account (tracked individually for each Cal Water district) subject to certain criteria under the accounting for regulated operations being met. The variance amount may be positive or negative and represents amounts that will be billed or refunded to customers in the future.

Cost-recovery rates are designed to permit full recovery of certain costs allowed to be recovered by the commissions. Cost-recovery rates such as the Modified Cost Balancing Account (MCBA) provides for recovery of adopted expense levels for purchased water, purchased power and pump taxes, as established by the CPUC. In addition, cost-recovery rates include recovery of cost related to water conservation programs and certain other operation expenses adopted by the CPUC. Variances (which include the effects of changes in both rate and volume for the MCBA) between adopted and actual costs are recorded as a component of revenue, as the amount of such variances will be recovered from or refunded to our customers at a later date. Cost-recovery expenses are generally recognized when the expenses are incurred with no markup for return or profit.

The balances in the WRAM and MCBA assets and liabilities accounts will fluctuate on a monthly basis depending upon the variance between adopted and actual results. The recovery or refund of the WRAM is netted against the MCBA over- or under-recovery for the corresponding district and the deferred net balances are interest bearing at the current 90 day commercial paper rate. At the end of the calendar year, Cal Water files with the CPUC to refund or collect the balance in the accounts. Most undercollected net WRAM and MCBA receivable balances are collected over 12 and 18 months. Cal Water defers any net WRAM and MCBA revenues and associated costs whenever the net receivable balances are estimated to be collected more than 24 months after the respective reporting period in which it was recorded. The deferred net WRAM and MCBA revenue and associated costs were determined using forecasts of rate payer consumption trends in future reporting periods and the timing of when the CPUC will authorize Cal Water's filings to recover unbilled balances. Deferred revenues and associated costs are recorded in future periods as the collection becomes within 24 months of the respective reporting period.

The net WRAM and MCBA balances included in regulatory assets and liabilities as of December 31, 2013 and 2012 are:

                                                  2013     2012
                                                   Dollars in
                                                    millions
                     Net short-term receivable   $ 30.9   $ 34.0
                     Net long-term receivable      15.4     12.1


                     Total receivable            $ 46.3   $ 46.1




                     Net short-term payable      $  1.0   $  0.4
                     Net long-term payable          0.9      0.1


                     Total payable               $  1.9   $  0.5

Flat rate customers are billed in advance at the beginning of the service period. The revenue is prorated so that the portion of revenue applicable to the current period is included in that period's revenue, with the balance recorded as unearned revenue on the balance sheet and recognized as revenue


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when earned in the subsequent accounting period. Our unearned revenue liability was $1.5 million and $1.7 million as of December 31, 2013 and 2012, respectively. This liability is included in "other accrued liabilities" on our consolidated balance sheets.

Regulated Utility Accounting

Because we operate extensively in a regulated business, we are subject to the accounting standards for regulated utilities. The Commissions in the states in which we operate establish rates that are designed to permit the recovery of the cost of service and a return on investment. We capitalize and record regulatory assets for costs that would otherwise be charged to expense if it is probable that the incurred costs will be recovered in future rates. Regulatory assets are amortized over the future periods that the costs are expected to be recovered. If costs expected to be incurred in the future are currently being recovered through rates, we record those expected future costs as regulatory liabilities. In addition, we record regulatory liabilities when the Commissions require a refund to be made to our customers over future periods.

Determining probability requires significant judgment by management and includes, but is not limited to, consideration of testimony presented in regulatory hearings, proposed regulatory decisions, final regulatory orders, and the strength or status of applications for rehearing or state court appeals. We also record a regulatory asset when a mechanism is in place to recover current expenditures and historical experience indicates that recovery of incurred costs is probable, such as the regulatory assets for pension benefits; and deferred income tax.

If we determine that a portion of our assets used in utility operations is not recoverable in customer rates, we would be required to recognize the loss of the assets disallowed.

Goodwill Accounting and Evaluation for Impairment

In November of 2013 and 2012, we performed annual impairment tests of the remaining goodwill balance of $2.6 million by comparing the fair value of Hawaii Water, the reporting unit, with its carrying amount, including goodwill and no impairment was recorded. Our analysis considered the approval of future rate case proceedings for the various operations of Hawaii Water based on historical rate of return filings allowed by the Hawaii Public Utilities Commission. To the extent the approved rate of return filings allowed by the Hawaii Public Utilities Commission are less than expected, an impairment of the recorded goodwill may occur.

Income Taxes

We account for income taxes using the asset and liability method. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. We measure deferred tax assets and liabilities at enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We recognize the effect on the deferred tax assets and liabilities of a change in tax rate in the period that includes the enactment date. We must also assess the likelihood that deferred tax assets will be recovered in future taxable income and, to the extent recovery is not probable, a valuation allowance would be recorded. In management's view, a valuation allowance was not required at December 31, 2013 or December 31, 2012.

We anticipate that future rate actions by the regulatory commissions will reflect revenue requirements for the tax effects of temporary differences recognized, which have previously been passed through to customers. The regulatory commissions have granted us rate increases to reflect the normalization of the tax benefits of the federal accelerated methods and available Investment Tax Credits (ITCs) for all assets placed in service after 1980. ITCs are deferred and amortized over the lives of the related properties for book purposes. The commission granted flowthrough for state taxes.


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In 2013, the Company recorded $4.4 million of State of California enterprise zone (EZ) credits for sales and use taxes and hiring incentives for the period from 2008 to 2013 based on an analysis of all district operations. The Company filed amended state income tax returns for tax years 2008, 2009, 2010 and 2011. The State of California hiring EZ credits were included on the Company's 2012 state income tax returns filed during the fourth quarter of 2013. The Company will amend the 2012 state income tax return for sales and use tax EZ credits in 2014. Unused State of California EZ credits can be carried-forward ten years. The Company estimates the carried-forward portion of its State of California EZ credits at $2.3 million. The Company's analysis of State of California EZ credits as of December 31, 2013 resulted in the recognition of a $0.6 million liability for unrecognized tax benefits.

On September 19, 2013, the U. S. Department of the Treasury and Internal Revenue Service (IRS) issued the final and re-proposed tangible property regulations for repairs and maintenance deductions with an effective date of January 1, 2014. These tax regulations allowed the Company to deduct a significant amount of linear asset costs previously capitalized for book and tax purposes. The Company intends to reevaluate its unit of property for linear assets on its 2013 tax return. The Company's federal fourth quarter of 2013 qualified repairs and maintenance deductions was $25.0 million for 2012 and prior years and created a deferred income tax liability of $8.8 million as of December 31, 2013. The Company's state fourth quarter of 2013 qualified repairs and maintenance deductions was $41.0 million for 2012 and prior years and was recorded as a $2.4 million reduction to state income tax expense. The total federal NOL was $14.8 million and state NOL was $42.0 million as of December 31, 2013 mostly due to repairs and maintenance deductions. The NOL carry-forward amounts are more likely than not to be recovered and therefore require no valuation allowance. The NOL carry-forward does not begin to expire until 2033.

During 2012, the Company filed an application for a change in tax accounting method with the IRS to implement the repairs and maintenance deduction. The Company's federal linear assets qualified repairs and maintenance deduction was $86.7 million for 2011 and prior years and created a deferred income tax liability $30.4 million as of December 31, 2012. The Company's state linear assets qualified repairs and maintenance deduction was $122.2 million for 2011 and prior years and was recorded as a $7.0 million reduction to state income tax expense. The Company planned to carry-back the NOL as of December 31, 2012 and recorded a $0.8 million federal income tax expense. This adjustment was reversed in 2013 when the federal NOL was carried-forward to reduce 2013 income tax payments.

The American Taxpayer Relief Act of 2012 provided the Company with additional 50% first-year bonus depreciation for assets placed in service from December 31, 2012 to December 31, 2013. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 provided the Company with additional federal income tax deductions for assets placed in service after September 8, 2010 and before December 31, 2012. The federal income tax deduction was estimated at $2.1 million in 2013, was $5.1 million in 2012 and was $12.6 million in 2011. The 2013 estimate will be finalized when we file the 2013 tax returns in the third quarter of 2014.

On October 24, 2013, the IRS completed its audit of the Company's 2010 and 2011 federal income tax returns with no audit adjustment. In December 2012, the California Franchise Tax Board completed an audit of the Company's 2008 and 2009 state income tax returns with no audit adjustment. The State of Hawaii Department of Taxation is presently auditing the Company's 2011 and 2012 Hawaii state income tax returns. The State of California Board of Equalization Franchise is presently auditing the Company's 2010, 2011, and 2012 sales and use tax filings. It is uncertain when the State audits will be completed. The Company believes that the final resolution of the state audits will not have a material impact on its financial condition or results of operations.

Pension Benefits

We incur costs associated with our pension and postretirement health care benefits plans. To measure the expense of these benefits, our management must estimate compensation increases, mortality rates,


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future health cost increases and discount rates used to value related liabilities and to determine appropriate funding. Different estimates used by our management could result in significant variances in the cost recognized for pension benefit plans. The estimates used are based on historical experience, current facts, future expectations, and recommendations from independent advisors and actuaries. We use an investment advisor to provide advice in managing the plan's investments. Beginning with the 2009 California GRC decision effective January 1, 2011, we anticipate any increases in funding for the pension benefits plans will be recovered in future rate filings, thereby mitigating the financial impact. We believe it is probable that future costs will be recovered in future rates and therefore have recorded a regulatory asset in accordance with generally accepted accounting principles.

Workers' Compensation and Other Claims

We are self-insured for a portion of workers' compensation and other claims. Excess amounts are covered by insurance policies. For workers' compensation, we work with an independent actuary firm to estimate the discounted liability associated with claims submitted and claims not yet submitted based on historical data. These estimates could vary significantly from actual claims paid, which could impact earnings and cash flows. For other claims, management estimates the cost incurred but not yet paid using historical information. Actual costs could vary from these estimates. Management believes actual costs incurred would be allowed in future rates, mitigating the financial impact.

Results of Operations

Earnings

In 2013 and 2012, net income was $47.3 million and $48.8 million, respectively. Diluted earnings per share decreased $0.15 to $1.02 or 13% from 2012 to 2013. The weighted average number of common shares outstanding used in the diluted earnings per share calculation increased to 46,417,000 shares in 2013 compared to 41,892,000 shares in 2012 mostly due to the sale of 5,750,000 shares of common stock on March 26, 2013. The $1.5 million decrease in net income was primarily attributable to the cost increases for employee wages and benefits, water production costs, depreciation on plant placed into service during 2012, and property taxes. The decrease in net income was also due to the 2012 one-time benefit from the reversal of 2011 deferred WRAM revenues of $12.9 million and associated costs of $10.5 million that we recognized in 2012, a $0.6 million decrease in the unrealized pre-tax gain on our benefit plan insurance investments in 2013, and higher net interest expenses mostly due to a reduction in capital project spending in 2013. The one-time tax benefit was $4.9 million in 2013 for state enterprise zone credits and repairs deductions, and was $6.2 million in 2012 for state repairs deductions. The 2013 cost increases were partially offset by cost reductions to other operations, maintenance expenses, and income taxes.

In 2012 and 2011, net income was $48.8 million and $37.7 million, respectively. Diluted earnings per share increased $0.27 to $1.17 or 30% from 2011 to 2012. The $11.1 million increase in net income was primarily attributable to a one-time income tax benefit of $6.2 million related to 2011 and prior years for state income tax repairs and maintenance deductions that we recognized in 2012, an unrealized pre-tax gain of $2.5 million on our benefit plan insurance investments, a one-time benefit of 2011 deferred WRAM operating revenues of $12.9 million and associated costs of $10.5 million that we recognized in 2012, a decrease in the current year income tax provision due to the repairs and maintenance deductions, and lower financing costs for short-term borrowings, which was partially offset by a $3.9 million reduction to operating revenues due to the cost of capital adjustment mechanism and cost increases for employee wages and benefits, water production costs, and depreciation on plant placed into service during 2011.

Dividends

At the January 2014 meeting, the Board of Directors declared the quarterly dividend, increasing it for the 47th consecutive year. The quarterly dividend was raised from $0.1600 to $0.1625 per common share,


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or an annual rate of $0.65 per common share. Dividends have been paid for 69 consecutive years. The annual dividends paid per common share in 2013, 2012, and 2011 were $0.640, $0.630, and $0.615, respectively. Earnings not paid as dividends are reinvested in the business for the benefit of stockholders. The dividend payout ratio was 63% in 2013, 54% in 2012, and 68% in 2011, for an average of 61% over the three-year period. Our long-term targeted dividend payout ratio is 60%

     Operating Revenue

    Operating revenue in 2013 was $584.1 million, an increase of $24.1 million,
or 4.3%, over 2012. Operating revenue in 2012 was $560.0 million, an increase of
$58.2 million, or 11.6%, over 2011. The estimated sources of changes in
operating revenue were:

                                                               2013      2012     2011
                                                                 Dollars in millions
Rate increases                                                 $ 13.6   $ 28.9   $  53.2
Net change due to actual versus adopted results, usage, and
other(1)                                                          8.4     14.0       4.4
Conservation balancing account(2)                                 0.3     (2.2 )    (4.3 )
Pension balancing account(2)                                      0.6      4.3      (1.9 )
Deferral of net WRAM and MCBA revenue(3)                         (0.3 )   12.0     (12.9 )
New customers                                                     1.5      1.2       2.9


Net change                                                     $ 24.1   $ 58.2   $  41.4


(1)
The net change due to actual versus adopted results, usage, and other in the above table was the increase in customer usage and the net effect of WRAM. The usage by existing customers can materially change based upon current weather patterns and is influenced both by temperature and rainfall; however, the impact of weather on gross margin has been minimized with the adoption of WRAM and MCBA for California customers on July 1, 2008.

(2)
The pension and conservation balancing accounts in the above table was the difference between actual expenses and adopted rate recovery.

(3)
The deferral of net WRAM and MCBA revenue in the above table was the net receivable balances that are expected to be collected from ratepayers beyond 24 months following the end of the accounting period in which these revenues were recorded. Early in 2012, Cal Water received CPUC decision 12-04-048, which decreased the amortization periods of Cal Water's receivables and resulted in the recognition of the $12.9 million WRAM revenue that was deferred in 2011. In 2013, the net WRAM revenue deferral was $0.3 million.

Water Production Expenses

Water production expenses, which consist of purchased water, purchased power, and pump taxes, comprise the largest segment of total operating expenses. Water production costs accounted for 44.3%, 41.6%, and 41.8% of total operating costs in 2013, 2012, and 2011, respectively. The rates charged for wholesale water supplies, electricity, and pump taxes are established by various public agencies. As such, these rates are beyond our control.


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The table below provides the amount of increases and percent changes in water production costs during the past two years:

                          2013                             2012                             2011
             Amount    Change     % Change    Amount    Change     % Change    Amount    Change     % Change
                                                   Dollars in millions
Purchased
water        $ 183.1    $ 21.8         13.5 % $ 161.3    $ 18.7         13.2 % $ 142.6    $ 16.7         13.3 %
Purchased
power           32.2       1.2          3.8 %    31.0       0.9          3.2 %    30.1       0.5          1.7 %
Pump taxes      10.8       0.5          4.4 %    10.3       1.2         13.2 %     9.1       0.5          5.8 %


Total
water
production
expenses     $ 226.1    $ 23.5         11.5 % $ 202.6    $ 20.8         11.5 % $ 181.8    $ 17.7         10.8 %

The principal factors affecting water production expenses are the quantity, price and source of the water. Generally, water from wells costs less than water purchased from wholesale suppliers.

The table below provides the amounts, percentage change, and source mix for the respective years:

                         2013                        2012                        2011
                  MG         % of Total       MG         % of Total       MG         % of Total
                                    Millions of gallons (MG)
 Source:
 Wells            58,435            46.3 %    59,932            47.6 %    57,433            47.7 %
 % change
 from prior
 year               (2.5 )%                      4.4 %                      (2.0 )%
 Purchased        62,202            49.2 %    59,708            47.4 %    56,253            46.7 %
 % change
 from prior
 year                4.2 %                       6.0 %                      (0.7 )%
 Surface           5,727             4.5 %     6,252             5.0 %     6,667             5.6 %
 % change
 from prior
 year               (8.4 )%                     (6.2 )%                     (0.2 )%


 Total           126,364           100.0 %   125,892           100.0 %   120,353           100.0 %


 % change
 from prior
 year                0.4 %                       4.6 %                      (1.3 )%

Purchased water expenses are affected by changes in quantities purchased, supplier prices, and cost differences between wholesale suppliers. The MCBA mechanism is designed to recover all incurred purchase water expenses. For 2013, the $21.8 million increase in purchased water is due to wholesaler water rate increases between 3% and 12% and a 4% increase in purchased quantities. On an overall blended basis, wholesale water rates increased 8% on a . . .

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