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Wisconsin Energy Corp. (NYSE:WEC)

Q3 2008 Earnings Call

October 29, 2008 2:00 pm ET

Executives

Gale E. Klappa – Chairman, Chief Executive. Officer, President

Allen L. Leverett – Chief Financial Officer

Frederick D. Kuester – Chief Operating Officer of Wisconsin Electric Power Company

James Fleming – Executive VP, Gen. Counsel

Jeff West – Treasurer

Steve Dickson - Controller

Analysts

Greg Gordon – Citigroup

Michael Lapides - Goldman Sachs

Paul Ridzon of KeyBanc Capital Markets

Gary Lenhoff – Ironworks Capital

[Ted Hine] - Catapult Capital

[Steve Gambuzo] – Longboat Capital

Dan Jenkins – State of Wisconsin Investment Board

Maurice May – Power Insights

Alex Kania – Merrill Lynch

[Paul Paterson] – Glenrock Associates

Rick – Duff Capital Advisors

Operator

Thank you for holding for today's Wisconsin Energy's 2008 third quarter conference call. (Operator Instructions)

Colleen Henderson

Good afternoon and welcome to Wisconsin Energy's 2008 third quarter conference call. Before the conference call begins, I will read the forward-looking language. All statements in this presentation, other than historical facts, are forward-looking statements that involve risks and uncertainties which are subject to change at any time. Such statements are based on management's expectations at the time they are made.

In addition to the assumptions and other factors referred to in connection with the statements, factors described in the company's latest Form 10-K and subsequent reports filed with the Securities and Exchange Commission could cause actual results to differ materially from those contemplated. During the discussions, referenced earnings per share will be based on diluted earnings per share unless otherwise noted.

This conference is being recorded for rebroadcast and all participants are in a listen only mode at this time. After the presentation the conference will be open to analysts for questions and answers. In conjunction with this call, Wisconsin Energy has posted on its website a package of detailed financial information on its 2008 third quarter results at www.wisconsinenergy.com. A replay of our remarks will be available approximately two hours after the conclusion of this call.

Now I would like to introduce Mr. Gale Klappa Chairman of the Board, President and Chief Executive Officer of Wisconsin Energy Corporation.

Gale E. Klappa

Good afternoon everyone thank you for joining us on our conference call to review the company's 2008 third quarter results.

Let me begin as always by introducing the members of the Wisconsin Energy management team who are here with me today. We have Rick Kuester President and CEO of WE Generation, Allen Leverett our Chief Financial Officer, Jim Fleming our General Counsel, Jeff West Treasurer and Steve Dickson our Controller.

Allen, of course, will review our financial results in detail in just a moment, but as you saw from our news release this morning, we reported net income from continuing operations of $0.65 a share in the third quarter of 2008. This compares with $0.70 a share last year. Earnings were down largely because of the shape of our power purchase payments for the energy we buy from the Point Beach Nuclear Units.

As we discussed in our last earnings call, the Power Purchase Agreement is designed to reflect the change in market prices that occur through the year and market prices are usually higher during the summer months. However, the $0.65 a share we're reporting is clearly better than our financial plan, in large part because of lower than expected costs for diesel and natural gas during the quarter.

Our service area has a well-diversified industrial base, which tends to help mitigate the impact of an economic downturn. However, in the quarter we did see a slight drop in electric sales and that has continued into October. The largest declines have occurred in two sectors where we've seen significant declines over the past several years, automotive and paper production.

At the same time, we've seen sales increases in other areas namely chemicals, mining and parts of the service sector. As you would expect, we're also experiencing a slight increase in past due receivables driven by a combination of higher prices and slower payments. Of course, we currently have some protection in Wisconsin since the residential bad debt that exceeds the level provided for in rates is deferred for future recovery. We're actively monitoring our past due accounts and working with customers on payment plans.

One other positive development, I would expect that energy assistance funds for our residential customers will increase by at least 10% for this heating season. We continue to see positive customer growth in our region, although at a slower pace than in previous years. At the end of September our customer count was one-half of 1% higher than a year ago.

And one other interesting statistic that I'd like to share with you, on the natural gas side of our business, conversions largely from propane, are accounting for more than a third of the customer growth on the gas distribution side. Now, I'd like to switch gears and spend just a moment with you on our continuing effort to upgrade the energy infrastructure in Wisconsin. Our power of the future plan is fundamental to the principle of energy self-sufficiency.

The components of our focus on self-sufficiency include investing in two combined cycle gas fired units at Port Washington, north of Milwaukee, the construction of two supercritical pulverized coal units at Oak Creek, which is south of the city, and our plans to build a significant amount of new renewable generation. Of course, both of the units at Port Washington are now in service. Construction was completed on time and on budget for both Unit 1 and Unit 2.

Now, let's turn to the status of the two new coal fired units at Oak Creek. As you may recall in late July, we and the other two owners of the expansion units at Oak Creek reached an agreement with Clean Wisconsin and the Sierra Club, the groups that had been actively opposing our water intake permit.

Under the settlement agreement, the environmental groups withdrew their opposition and this brought to a close the ongoing litigation and administrative challenges to the permit. In addition, to the deadline for appealing the water intake permit has now passed, so I can report to you that all litigation surrounding the permits for the Oak Creek expansion is resolved.

On the construction front, based on Bechtel's revised schedule of the Oak Creek project overall, was approximately 65% complete at the end of September. Unit 1 and the common facilities are 76% complete and Unit 2 is approximately 30% complete. Bechtel continues to make progress on the project.

Currently there are more than 2,700 workers on the site, and a significant milestone was achieved just last week with the successful completion of the hydrostatic test of the Unit 1 boiler. Progress also continues on the site for winterizing many of the structures including the Unit 1 boiler and turbine generator building to help minimize the impact of the upcoming winter.

As we discussed on our last call, Bechtel is forecasting that completion of Unit 1 and the common facilities will be delayed by three months beyond the guaranteed in-service date of September 29, 2009. Bechtel also advised us, as we reported last time, that they expect Unit 2 to be completed one month earlier than the guaranteed in-service date of September 29, 2010. So, assuming Bechtel maintains its current forecast Unit 1 and the common facilities would begin commercial operation at the end of December 2009, Unit 2 would be in service at the end of August 2010.

Bechtel is citing a number of factors that they believe have caused a change in the schedule. The factors include weather conditions in the two most recent winters, heavy rains this past spring and what Bechtel believes to be changes in labor conditions. Bechtel is still analyzing the impact of these factors. They have advised us that they expect to submit claims for schedule and cost relief by the end of this year.

We don’t believe there is a contractual basis for some of the claims that Bechtel may submit. For example, we disagree that Bechtel is entitled to cost or schedule relief as a result of changes in the labor market. To address this and other issues, we have invoked the contract dispute resolution clause. The first step called for management meetings to see if we could reach a resolution.

This step has been completed and we were unable to resolve our differences with Bechtel. So the next step is nonbinding mediation followed by binding arbitration, if necessary. Obviously it's not possible at this stage to provide you with any specifics on what the financial impact of any claims by Bechtel could be, however, I believe there are several key points to keep in mind.

The first relates to the impact of the in-service dates on our reported earnings for 2009 and 2010. As I mentioned on our last call, we estimate that a one-month movement in the in-service date for Unit 1 would result in a change of $0.03 a share in earnings. A one-month movement for Unit 2 has a somewhat smaller impact and we estimate this to be $0.02 per share.

So, for example, if Bechtel's forecast of a three-month delay for Unit 1 comes to pass, our earnings in 2009 as we've reported to you previously would be reduced by $0.09 a share compared to what they otherwise would have been. If Bechtel's forecast of the one-month earlier finish for Unit 2 comes to pass, then our earnings in 2010 would increase by $0.02 a share.

Of course, the ultimate earning power of the assets in 2011 and beyond is unaffected by the specific dates that the units will be placed in service in 2009 and 2010. The next key point relates to cash flow. Under the terms of the lease agreements between Wisconsin Electric and WE Power we are recovering, based on a mix of dead-end equity our capital carrying costs as construction continues on the Oak Creek project and we're allowed to recover our carrying costs up to the total budget for the project that has been approved by the Wisconsin Commission.

So, while reported earnings in 2009 and 2010 would be affected slightly by a change in the in-service dates, our ability to recover cash carrying costs should be largely unaffected. I would also like to repeat the point I made last quarter about the ultimate recovery of any potential cost increases. We have several important layers of protection. To conclude that an additional cost is not ultimately recoverable, you would have to believe that the costs would not quality for recovery under at least four opportunities that are clearly outlined in the Commissions' order.

First, that the remaining contingency in the project is not sufficient to offset the cost. Second, that the cost would fall outside the 5% bandwidth that the Commission has deemed to be reasonable for prudent costs above the approved amount for the project; third, that the cost was not caused by a force majeure event as defined by the lease agreements.

Finally, after an opportunity to demonstrate prudency that the cost would be ultimately deemed improved. So, although we’ve not received any detailed claims or resolved the disputed issues, we believe we have significant layers of protection in place. Of course, we will provide you with any updates on major developments in our SEC filings and in our scheduled earnings calls.

Now as you know Wisconsin has in place a renewable portfolio standard that increases from 5% in 2010 to 10% in 2015 at the state-wide level. The standard set targets for each of the utilities using an historical baseline. Using that baseline, approximately 8 1/2% of our retail electricity sales must come from renewable sources in 2015.

Meeting the aggressive 2015 target will, of course, require several additional projects. With the completion of our Blue Sky Green Field wind farm on May 19th, we took a major step toward meeting Wisconsin’s goal to reduce its carbon footprint. With a total of 88 turbines, each with a capacity of 1.65 megawatts, Blue Sky Green Field is the largest wind farm to date in the state of Wisconsin. It was completed under budget and ahead of schedule.

To continue on a path toward carbon reduction we have recently completed the acquisition of a new wind site located in Columbia County in East Central Wisconsin about 45 miles from Madison. We signed an option to buy this site from FPL Energy in conjunction with the sale last year of our Point Beach Nuclear plant.

And this week we filed for approval to build the new wind project which is called the Glacier Hills Wind Park. We expect the site to accommodate between 100 and 200 megawatts of new capacity depending on the final layout and the turbine equipment that we select. The permitting process is scheduled to begin later this year and the first full year of operation is expected to be 2012

One other development of note from the past quarter, on July 10th the Wisconsin Commission authorized an investment of up to $830 million, including allowance for funds used during construction, with the installation of wet flue gas de-sulfurization and selected catalytic reduction facilities at the four existing units at Oak Creek.

The Commission subsequently denied the petition for reconsideration from the two groups who opposed this environmental upgrade and we expect the new controls to be completed in 2012. One other note, yesterday afternoon we were notified that Wisconsin Energy stock will be included in the S&P 500 index and that inclusion will be effective after the close of trading on Thursday.

And finally, Wisconsin Energy has once again been recognized for excellence in corporate governance. For the fifteenth consecutive time we’ve received a perfect 10 the highest possible score from Governance Metrics International in that agency’s latest evaluation. Wisconsin Energy is one of only four companies worldwide that have been consistently rated a 10 by GMI.

Our board of directors have clearly established high standards for how we manage our company and conduct our business, and GMI’s independent review confirms that Wisconsin Energy ranks among the best in the world in our corporate governance practices. Now I’ll turn the call over to Alan, who will give you more details on our financial performance for the third quarter of 2008.

Allen L. Leverett

As Gale mentioned earlier, our 2008 third quarter earnings from continuing operations was $0.65 per share. I will focus on operating income by segment and then touch on other income statement items. I will also discuss cash flows for the year-to-date and update our earnings guidance for the full year.

Our consolidated operating income was $139 million as compared to $153 million in the third quarter of 2007, a decrease of $14 million. Operating income at our utility energy segment totaled $113 million, a decrease of $24 million versus last year. Now before I discuss the primary drivers, I would like to remind you of a couple of developments that caused significant changes in individual items in the income statement.

First, in September of 2007, we sold our Point Beach Nuclear Plant and entered into a long-term Power Purchase Agreement with the new owner. Since we no longer own Point Beach our results this year do not include operating or maintenance costs related to the facility, nor do we incur any depreciation or decommissioning costs associated with the plant.

Of course, our fuel and purchase power costs this year have increased as a result of the Power Purchase Agreement we now have. Also, as we mentioned in our quarterly conference calls this year, we expect to see a different quarterly distribution of costs and earnings this year as a direct result of the Power Purchase Agreement.

Our income statement this quarter reflects $157 million of gained amortization relating to the gain of the Point Beach sale that is being used for the benefit of our customers. This includes a one-time refund of $62.5 million to our [first] wholesale customers, with the remainder issued in the form of bill credits to our Wisconsin Electric retail customers.

I would now like to briefly expand on this item. The January 2008 Wisconsin rate order resulted in about a 17% increase in electric rates. This increase was needed to recover higher costs associated with transmission expense and environmental expenditures, as well as the lease payments and O&M costs associated with our new power plants and our continued investment in renewable.

However, our customers as a group have seen only about a 3% rate increase in 2008 from this rate order as the balance is being funded through bill credits from the gain on the sale of Point Beach. While we look at the bill credits as a form of revenue, GAAP requires us to record the bill credits as part of the amortization of the gain because we are collecting the cash from the restricted cash account and not from customers.

As we have previously discussed, once all the Point Beach gain has been returned to customers, the full 17% increase will be paid by customers and at that point reflected in operating revenues. But, this is background. I would like to address the primary drivers in our utility operating income for the third quarter of 2008.

First, price increases to our retail and wholesale customers resulted in a $57 million increase in revenues. However, the mild weather in the quarter reduced operating income $13 million. In addition, the conversion of the Point Beach Nuclear Plant from being an asset owned by Wisconsin Electric to one owned by FPL Energy with an associated Power Purchase Agreement, reduced income $60 million. Additional planned operations and maintenance expenses at our power plant decreased income $8 million.

Operating income in the non-utility energy segment, which primarily includes WE Power was up $16 million. The key drivers of this increase were the new coal handling facility at the Oak Creek expansion, which was placed into service in October of 2007 at a cost of approximately $175 million.

And the earnings from unit two at Port Washington, which was placed into service May of this year. Oak Park had lower operating income of $6 million driven by reduced land sales as compared to the third quarter 2007. Making the changes for each of these segments together brings you back to the $14 million decrease in operating income for the third quarter of 2008.

During the third quarter, our earnings from our investment in the American Transmission Company grew by $3 million. Other income declined $7 million because of lower carrying costs and regulatory assets. These regulatory assets are now a component of rate base so that carrying costs are included in the revenues instead of other income.

Total interest expense was down $4 million. This decrease was driven by lower short-term interest rates. Consolidated income tax expense declined by approximately $8 million because of lower pre-tax earnings. I expect that our effective tax rate this year will be between 36% and 38%. Adding these items brings you to $77 million of net income from continuing operations to the third quarter 2008, with earnings of $0.65 per share.

Let me now turn to cash flow, during the first nine months of 2008 we generated $644 million of cash from operations on a GAAP basis, which is up $11 million from the same period in 2007. This increase was driven by the implementation of new prices and reduced cash taxes, offset in part by the earlier timing of a contribution to our pension trust this year.

On an adjusted basis, our cash from operations totaled $924 million. The adjusted number includes the $281 million of cash impact from the bill credit .and the one-time amortization of the gain. Under GAAP, the cash from the bill credits is reflected in the change in restricted cash, which GAAP defines as an investing activity.

From a management standpoint, we consider it a source of cash as it directly relates to the bill credits and the one-time amortization. As long as the bill credits continue, we plan to provide both GAAP and adjusted measures of cash flow. We believe the adjusted measure is more representative of the company's ability to generate cash from operations for two reasons.

First, the customer credits are being funded from the proceeds of the Point Beach sale that are set aside in a restricted cash account. And second, once all of the Point Beach proceeds have been returned to customers, our prices enhanced customer bills will reflect the full cost of electricity without any credits.

Now given the events of the past few weeks, I also wanted to expand more on our liquidity situation. On a consolidated basis, we have $1.61 billion of available undrawn credit facilities that expire in 2011. This amount excludes the $80 million of committed credit that we lost as a result of the Lehman bankruptcy.

Of this, $856 million is at the Wisconsin Energy level and the remainder or $758 million is at our utilities. Our actual commercial paper balances at September 30th, were $541 million and $296 million at the Wisconsin Energy and Wisconsin Electric levels, respectively. We also had $78 million of commercial paper outstanding at Wisconsin Gas.

However, we closed on $300 million bond financing at Wisconsin Electric on October 1st. The proceeds from this transaction were used to repay commercial paper. Pro forma for the impact of these repayments, our commercial paper balances at the end September would have been about $391 million at Wisconsin Energy and $148 million at Wisconsin Electric.

These balances are well within the limits of our credit facilities. The commercial paper at the Wisconsin Energy level is primarily being used to provide construction financing for the Oak Creek units, while the [CP] at the utilities is used to provide working capital. Our financing plan for the remainder of 2008 and all of 2009, calls for approximately $800 million in term financing.

Three hundred million dollars of this is expected to be at Wisconsin Energy and the remaining $500 million is projected to be at Wisconsin Electric. I would stress that the plan calls for these financings over the course of the next 14 months, and that we have a fair amount of flexibility in terms of timing within that window.

So I believe we are currently in good shape from a liquidity standpoint. Now, I would like to move to uses of cash in the first nine months of the year. Capital spending was approximately $889 million in the first nine months in 2008, which is $47 million higher than the comparable period in 2007, but on track with our annual estimates.

We expect to spend nearly $1.2 billion in capital this year in support of our power to the future construction program, the addition of wind generation and ongoing utility infrastructure improvements. We also paid $95 million in common dividends in the first nine months of 2008. On a GAAP basis, our debt to capital ratio was 58.1% as of September 30 and we were at 54.9% on an adjusted basis.

This is down from our December 31, 2007 levels of 58.6% and 55.3% adjusted. The adjusted amount treats half of our hybrid securities as common equity, which is the approach used by the majority of the rating agencies. Given the high level of capital spending in 2008, and the fact that no significant assets sales are planned this year, I would expect our debt-to-capital ratio to increase slightly as of December 31, 2008 as compared to December 31, 2007.

Our goal is maintain our adjusted debt-to-capital ratio at no more than 60% during the period we are constructing our new coal fired generation. We are using cash to satisfy any shares required for our 401k plan, options and other programs. Going forward, we do not expect to issue any additional shares.

Given the expected reduction in capital expenditures next year, we believe that we will begin to have more room for dividend payments in our financial plan. We certainly recognize the increased importance of dividends, given the current market conditions. Our director's plans on reviewing our dividend policy at their meeting on December 4th for a potential change to the dividend in 2009.

Now, I'd like to update you on our electric fuel cost recovery position in Wisconsin. On July 31, during our second quarter conference call, we discussed our expectation regarding electric fuel cost recovery. At that time, we projected that under-recoveries would be between $20 million to $40 million for 2008.

Our expectation has now changed because of the substantial drop in natural gas and diesel prices in the past few months and the impact of cooler than normal summer weather in the third quarter. We now expect to be close to a fully recovered position on our fuel costs for 2008.

Now, I would like to wrap things up with a review of our earnings guidance for 2008. Based on our results in the first nine months of the year, and our forecast the remainder of the year, we are slightly ahead of our financial plan; however, weather and economic uncertainty remain in the fourth quarter.

As a result, we are moving our full year guidance to the upper end of our previous range of $2.80 to $2.90 a share. So, our new guidance for 2008 is now $2.90 per share. So, with that I will turn things back to Gale.

Gale E. Klappa

Allen, thank you very much. Overall, we're on track and focused on delivering value for our customers and stockholders.

Question-and-Answer Session

Operator

(Operator Instructions) Your first call comes from Greg Gordon – Citigroup

Greg Gordon - Citigroup

Two questions. One is, as you look at the dividend policy of the company, you did state pretty much the same philosophy on the second quarter call as you're stating now in terms of what you plan on recommending to the Board.

Has your point of view on what a reasonable level of dividend policy in '09 should look like changed at all in the last three months, given how much tighter market conditions have gotten on credit?

Gale E. Klappa

Gregg, not really. I mean we tend to look at things in three to five year increments to the degree that we have certainty and we really are making a dividend decision and recommendation to the Board based on not just a six month look or not just a one year look, but on how we see the business evolving over the next three to five years.

So, if anything, we've been boringly consistent about that. I mean clearly, we've taken into account what we're seeing in the credit markets, but as Allen mentioned to you during his portion of the call, our liquidity situation is in good shape. We have some flexibility in terms of the next 14 months and the debt offerings. We don't need to issue any additional equity.

So, certainly we've taken a look at it and factored in the current credit conditions, but it has not changed our long-term three to five year view.

Greg Gordon – Citigroup

So, all things being equal, the payout ratio that you would have thought appropriate in August is the same payout ratio you would recommend today if you were going to the Board with that recommendation?

Gale E. Klappa

That is exactly right, Greg.

Greg Gordon - Citigroup

The second question for Allen, can you reiterate what you said about where you thought you'd be on fuel recovery going into the summer and where you think you'll be now? And can you tell us whether the majority of that benefit has already occurred in the peak summer months and how much of that do you think is going to flow through into Q4, given the decline in gas prices?

Allen L. Leverett

Sure, I'd be happy too. Just by way of context, again on the July 31 call, at that point Greg, we expected our under-recovery for the calendar year 2008 to be between $20 million and $40 million, and we now sitting here today, our latest projection would be essentially to be in a fully recovered position for calendar year 2008.

And that was very much driven really by three things. First, the move in the natural gas strip. I think it was approximately $14 per million back in July when we did that projection. It's about half that or $7 per million now. Fuel oil went from roughly $4 a gallon in July to roughly $2 now. And, we also over the course of the summer because of the mild weather, just in from a volume standpoint, we burned much less natural gas than we expected.

So, that's really what moves you from the 20 to 40 to the roughly fully recovered. In terms of the timing, Greg, within the year, if you look through the end of the third quarter, say, year-to-date and look at your fuel recovery situation, we were approximately $24.1 million under-recovered on fuel, year-to-date through the end of September 30, under-recovered $24 million.

So, essentially when you look at the fourth quarter, we would expect to have that turn and come to roughly a neutral position by the end of the year.

Gale E. Klappa

Greg, Allen's exactly right and just one other point that might be helpful. We have an agreement in place for this calendar year with the Wisconsin Public Service Commission, that if, if fuel prices where to stay very low and we some how made up all of the deficit fuel recovery and over-recovered, we would return to customers the over-recovery.

So, anything above fully recovered would not float through to earnings, would instead it would roll back to customers next year.

Greg Gordon – Citigroup

So you wouldn't keep the benefit inside the debt [inaudible] then.

Gale E. Klappa

We would keep the benefit up to fully recovered. Anything above full recovery, there would be no debt [inaudible] this year if you will, it would all above fully recovered, go back to customers.

Greg Gordon – Citigroup

Right, because my understanding of the new rules is that there is a 2% bandwidth.

Gale E. Klappa

Well, there's a 2% bandwidth in place today, and the new rules are really not in a position to become new rules yet. I think the Wisconsin Commission's now decided to step back, take another look and perhaps seek some guidance from the legislature. But, there is a 2% bandwidth or sorts in effect today.

Greg Gordon – Citigroup

So the proposed changes in the fuel rules that we were looking at potentially getting codified this year are now sort of been put on hold.

Gale E. Klappa

That is correct.

Greg Gordon – Citigroup

And in their place you have a short-term patch, which basically says, if you get back to fully recovered that's where you stay.

Gale E. Klappa

For this calendar year, that is correct.

Allen L. Leverett

And then Greg maybe one other point of, just point of background, if you look at the fourth quarter of '07 and compare it on really a consistent basis to what we would expect in '08, it's a pretty similar pattern. So we would see on an apples-to-apples, about a $20 million turn last year in the fourth quarter and we're expecting about that kind of swing in the fourth quarter this year to bring us back to that hopefully fully recovered position for the calendar year.

Operator

Your next question comes from Michael Lapides – Goldman Sachs.

Michael Lapides - Goldman Sachs

I actually have two questions. One, on the south Oak Creek environmental CapEx, are there any challenges left over related to that or any rumblings of kind of any of the parties potentially appealing the PSCW opinion or order?

Gale E. Klappa

Good question, Michael, the answer is, no. There was an environmental group that opposed the [AC] upgrade. They asked the commission for reconsideration, but the commission denied that reconsideration and I believe all is clear and there is nothing pending whatsoever in terms of any legal challenge.

Michael Lapides - Goldman Sachs

And Allen, on short-term debt balance, and I apologize, you talked about it in your prepared remarks, and I'm not sure I captured it all. Can you talk a little about plans for treating the $914 million on the short-term debt, over the next 12 to 14 months?

Allen L. Leverett

You're right on an actual basis. We were at approximately $914 at the end of the third quarter, however, on the very next day after the end of the quarter on October 1st, we closed on $300 million worth of term financing at Wisconsin Electric and we used that to pay down commercial paper.

So, if you looked at our pro forma balances, if you will on September 30, so pro forma for that security issuance, Michael, we were at $391 million at Wisconsin Energy and $148 million at Wisconsin Electric, which if you look at that on a percentage of the debt that we had outstanding at September 30, we had roughly $4.6 billion worth of debt outstanding.

So, those pro forma [CP] balances, would represent about 13.5% of our outstanding debt and roughly 8% of our total capitalization. In terms of security issuances that I would expect for the remainder of 2008 and 2009 combined, we would hope to do on the order of another 300 million of term financing at the holding company and another 500 million of term financing at Wisconsin Electric.

But, I would just stress, Michael that that's over a 14-month period that we would be looking at doing those financings and we really have a fair amount of flexibility in terms of when we time those within that 14-month window.

Is that helpful?

Michael Lapides - Goldman Sachs

That's extremely helpful. Last question, pension cash requirements for the next 12 to 14 months?

Allen L. Leverett

Yes, and maybe to just sort of put that into context. We made a contribution in January of this year to the qualified plans $48 million. So, that's a gross of tax benefit figure, a $48 million contribution. As I sit here today, I would expect in calendar 2009 that we would make approximately a $180 million contribution.

So, up quite a bit in '09 as compared to '08. However, I would just reemphasize what Gale already said in his response to the dividend question that Greg Gordon asked. We look at pension contributions, as well dividend decisions over a multi year basis, so you should not conclude that because we've had a big pick up in the projected pension contribution in '09 as compared in '08, that that somehow impacts our dividend decision.

Gale E. Klappa

Allen's exactly right. We're looking at this, as we've mentioned on a three to five year basis, and I mean, clearly the market conditions are such that many, many companies are going to have to make significant cash contributions to their pension plans next year.

Operator

Your next question comes from Paul Ridzon – KeyBanc Capital Markets.

Paul Ridzon – KeyBanc Capital Markets

Had a question, you gave I think $0.53 to $0.57 guidance for the third quarter. Could you just outline the [delta's] versus plan. I realize fuel must be a really big piece of that.

Gale E. Klappa

Fuel's the biggest piece.

Allen L. Leverett

Almost all of the swing, Paul, as we sort of said, well alright, plan would be $0.53 to $0.57. Almost all of the swing between the $0.53 to $0.57 and the $0.65 actual is what happened with fuel, because we had a very pleasant surprise, I guess if you will, on fuel recovery. But, it was a surprise nonetheless.

Gale E. Klappa

And clearly, none of us anticipated the incredible volatility in the fuel markets, particularly with the crash of natural gas prices. The two things that helped us the most really were the huge decline in the natural gas strip and the fact that the diesel fuel surcharges that were being passed through to us from the railroads for moving coal to our power plants. Those diesel fuel charges already declined as well, as really as oil prices decline.

So, a very positive surprise and our units operated quite well during the summer. So, put those together and we've had a very positive movement in fuel recovery.

Paul Ridzon – KeyBanc Capital Markets

What was the delta in the three Q fuel balance?

Allen L. Leverett

I'm sorry, Paul, say again

Paul Ridzon – KeyBanc Capital Markets

How much did the fuel balance change in the third quarter?

Gale E. Klappa

From the end of the second quarter? We were about, about $3 million. We were expecting much less – we were expecting a greater under-recovery in the third quarter. I think we ended Q2 at about $21 million of fuel under-recovery for the year-to-date. We're now at 24.1.

Allen L. Leverett

And the projected under-recovery for the quarter was much, much greater than that.

Gale E. Klappa

Much greater.

Allen L. Leverett

One other, maybe point of background, Paul, and I don't know if it will be helpful or not, of course, the weather was milder than normal in the third quarter. That certainly helped fuel recovery as we mentioned, but obviously adversely impacts margin otherwise, but we were able to offset that with better experience than we expected on O&M.

So, the O&M and the weather effects were almost neutral when taken together. And, then the big swing that you're left with is fuel recovery.

Gale E. Klappa

And Paul, the other reason that we were projecting a much larger under-recovery for Q3, again as we mentioned earlier in the script, was because of the shape of our power purchase payments for the Point Beach Units.

If you turn back the clock a year ago, we still owned the Point Beach units. This year we have a Power Purchase Agreement after the sale of the units, and as I mentioned the shape of that Power Purchase Agreement has us paying higher purchase power costs in the summer than in the shoulder periods.

Paul Ridzon – KeyBanc Capital Markets

Did you actually absorb fuel under-recovery in the third quarter, but to a lesser extent than planned?

Gale E. Klappa

That is a good way to describe it.

Paul Ridzon – KeyBanc Capital Markets

And do you use five year pension smoothing or what is your smoothing method?

Allen L. Leverett

When we determine the actuarial value of assets, I believe we used two year smoothing when we look at the actuarial value of assets for the purposes of funding. Now, when you look at say [AS 87 expenses, which would be more in the GAAP treatment, you would do smoothing of gains and losses and so if you’re in a position where in a year you earn more than your actuarial return assumption or you earn less, you then smooth that in to income over four years.

But for the purposes of funding and the actuarial value of assets, you do that over two years. Does that help?

Paul Ridzon – KeyBanc Capital Markets

Yes it does.

Operator

Your next question comes from Gary Lenhoff – Ironworks Capital.

Gary Lenhoff – Ironworks Capital

You may have addressed this before and I just missed it, but can you tell us as of the most recent date you have, what the performance of pension assets has been?

Gale E. Leverett

Sure, as a matter of fact, we have that right here in the room with us.

Allen L. Leverett

Yes, Gary, these guys, I tend to get a report every day. Through the end of yesterday, our return was minus 26.7%, so the asset return was minus 26.7 through the end of yesterday, and maybe as some additional context, Michael, he just asked me about the funding assumption for next year.

And that funding assumption one $180 million was based on the assumption that we would experience a minus 25% return this year, but that the liability discount rate would be 6.5%. So although our experience year-to-date is just a little more negative than minus 25, if we’re going run the numbers today in terms of the appropriate liability discount rate, the liability discount rate would be closer to seven which would reduce the present value of the liabilities.

So, net, even with the performance through today or through yesterday rather, I would expect that we will still be looking at about a $180 million contribution.

Gary Lenhoff – Ironworks Capital

So, if I'm thinking about this correctly, the value of the assets is down about $250 million, which at your expected return assumption is about $20 million, $21 million or so of additional pension expense if we though about it on a cash basis.

Allen L. Leverett

On a cash basis, yes.

Gary Lenhoff – Ironworks Capital

That’s helpful thanks very much.

Operator

Your next question is from [Ted Hine] – Catapult Capital.

[Ted Hine] - Catapult Capital

Had a few quick questions. First just on whether year-to-date, where are you guys, ahead or behind kind of compared to normal?

Gale E. Klappa

While Allen looks at his numbers, let me mention one thing to you about the summer. We had a cool summer this year, fairly normal summer last year. But to put this summer's experience in perspective, we did not have one single 90-degree day in Wisconsin the entire summer.

So, you've heard of the endless summer, well this is was a summer that never started. Well, Allen, do we have nine months…

Allen L. Leverett

If you look at in margin level, [Ted], which is probably the most relevant for your purposes, if you look nine months ended September 30, we were about $7 million below normal on margin or in other words if we’d experienced normal weather through the end of September we would have expected our margins to have been in about $7 million higher than normal – than actual.

Through the end of September of '07, so September 30, 2007, it was essentially normal, so if you’re looking at either a comparison to last year’s weather or a comparison to normal, it’s about a $7 million negative swing.

[Ted Hine] - Catapult Capital

Compared to plan at the guidance at the beginning of the year, you're just slightly behind and you’re obviously making it up with better fuel recoveries?

Gale E. Klappa

That’s correct, yes.

Allen L. Leverett

And better O&M, yes.

[Ted Hine] - Catapult Capital

And better O&M. And just secondly, Allen, I know that you mentioned at some previous conferences you expected to be I think $15 million under-recovered in 2009. Is that kind of still where you expect to be or has your outlook changed on that?

Gale E. Klappa

At the moment, [Ted], that’s still the number we’re using for planning purposes, but I would add one thing. In our fuel clause next year will be in the neighborhood of $1.3 billion. So, to be any more precise than a $15 million current projected under-recovery for our base plan, we’re not going to get any more precise than that.

And it will change $15 million times between now and next year, again because of the volatility of the fuel markets and the size of our fuel clause.

[Ted Hine] - Catapult Capital

But the $15 million bogey is still the best one to use at this point?

Gale E. Klappa

That’s unchanged from what Allen mentioned back in September, yes.

Allen J. Leverett

We still view that as reasonable planning assumption.

Gale E. Klappa

Right.

Operator

Your next question comes from Dan Jenkins – State of Wisconsin Investment Board.

Dan Jenkins – State of Wisconsin Investment Board

Just a few questions here. First, I forget, could you remind when does this amortization at a gain end? Does that end at the end of this year or does it still have another year to run after that?

Allen L. Leverett

Just a quick review on that. We’re essentially providing credits if you will, in three jurisdictions, Wisconsin, Michigan, and [inaudible]. Michigan and [inaudible] are done now and I would not expect – well, there won’t be any more credits in Michigan and [inaudible] related to Point Beach.

So, the only credit that would remain would be in the Wisconsin jurisdiction and those were the bulk of the credits. So sitting here today Dan, I would expect that really you would continue to see credits for the remainder of this year, as well as calendar ’09, ’10, and there could be a very tiny amount that would lapse over into the early part of 2011.

But I certainly would expect to see credits for the remainder of this year, '09 and '10.

Gale E. Klappa

And that is exactly what the Wisconsin commission envisioned, at least a three year amortization if you will, of the credits onto customer bills. And I think Allen is right, we may see some additional small amount of credit move into 2011, depending upon energy sales and depending upon the interest that’s earned in this restricted account.

But certainly for three years, eight, nine, and 10 and maybe a chunk into ’11.

Dan Jenkins – State of Wisconsin Investment Board

That's pretty much like a straight line amortization, so the –

Allen L. Leverett

The amount of credit, obviously, if you have this based on energy usage so you can get variability there. But also even at target – even at the budget if you will on energy sales or at least the budget they set rates based on, there was a downward pattern in credits as you go over that roughly four-year period.

Gale E. Klappa

The biggest credit amounts will be this year and then it will step down next year. And then, there will be another step down in 2010.

Dan Jenkins – State of Wisconsin Investment Board

So it was front-end loaded then.

Allen L. Leverett

Exactly.

Gale E. Klappa

To some degree, yes.

Allen L. Leverett

Yes.

Dan Jenkins – State of Wisconsin Investment Board

On the financing needs, I know you have $320 million that matures in December and it sounds like you used that $300 million you issued at the first of this month to pay down short-term debt. Would you anticipate returning to the market or taking short-term debt back up or how you would manage that maturity?

Allen L. Leverett

Well, at this point looking at the financing plan over the next 14 months, $300 million at the whole debt, $500 million in term financing at the utility. I have a fair amount of flexibility within that 14 month window, so we’ll look at conditions and pick what we think are appropriating timing for those offerings, although, my philosophy is sort of a more dollar cost average.

So I certainly wouldn’t expect to go out and do all the $800 million within a very compacted period of time. I think we would try to spread it out a bit more over the period, because candidly I don’t know which way spreads or treasury yields are headed.

Dan Jenkins – State of Wisconsin Investment Board

On your cash flow statement, what was going on with the differed taxes and the working capital changes from this year versus last year's? Is the deferred taxes related to the amortization of the debt?

Allen L. Leverett

In terms of cash taxes, let me address that and then I'm going to ask Steve Dickson to talk about the working capital component of it, Dan. But on the cash taxes question, what's really our deferred taxes, which is of course related to cash taxes, we had a lower cash tax rate in 2008 because we were able to recognize quite a bit – we were able to go ahead and expense for tax purposes, items that previously would have been depreciated for tax purposes over a longer period of time.

So, another way to think about that is we basically were able to advance some deductions for tax purposes that reduces cash taxes and then of course, results in a buildup in the deferred tax liability.

Gale E. Klappa

This was a result of a very thorough tax depreciation study that we completed.

Steve Dickson

And, Dan, as you look at the consolidated condensed statement of cash flow, I assume the line item you're looking at is working capital and other where it looks like it increased about $226 million between years, the two biggest drivers really to deferred costs and then deferred revenue.

On the deferred costs, last year we in a position where we incurred high fuel cost and we deferred them on our balance sheet as we requested recovery of those, and so that was a cash outflow. This year with the new rate order, we are amortizing a lot of those costs, so the swing related to deferred cost is about $130 million this year compared to last year.

The second largest component relates to the deferred revenue. As Al and Gale mentioned, we're collecting cash carry costs in the power of the future plans, that is as construction of progress balances grow, the amount of cash that we collect increases and that is about $33 million. So those are the two largest items in that account.

Dan Jenkins – State of Wisconsin Investment Board

It sounds like since the recovery of fuel costs, what kind of reverse in the fourth quarter would you expect to see that then expand even more in the fourth quarter.

Steve Dickson

I think that's two different things, Allen was talking about the ongoing fuel costs. The costs that we deferred last year did not go through fuel expense, and so that was not in the calculation last year.

What we would expect to see in the fourth quarter is a continue amortization of the regulatory assets and so that's a non-cash item, which will increase cash flow. And I don't think we had significant deferred items in the fourth quarter last year, so we won't see a huge change.

Dan Jenkins – State of Wisconsin Investment Board

The last thing I was wondering about is on your sales numbers for the third quarter, you actually had negative revenues from wholesale other, which seems somewhat unusual. I was wondering if you could explain.

Gale E. Klappa

I don't have that CapEx detail.

Steve Dickson

Yes, Dan, as Allen mentioned in his discussion, in the third quarter we made a one-time refund to our preferred wholesale customers and that was for their share of the amortization of the gain and that was $62.5 million. Where that was reflected on our income statement was we reduced our revenues, our wholesales revenues by $62.5 million, and then we increased the amortization of the gain.

So, on the income statement it was neutral, but GAAP requires us to show refunds as a reduction of revenues and so that's why it looks like negative revenues for that customer class.

Operator

Your next question from [Steve Gambuzo] – Longboat Capital

[Steve Gambuzo] – Longboat Capital

A question on the pension funding. How does that $180 million compare to the amount of kind of non-cash accrued pension expense embedded in your rate, because I would imagine that it's really the differential between those two numbers that is really kind of the outflow in the cash flow statement. Is that right?

Allen L. Leverett

I believe the pension expense that was in the last rate case was probably on the order of $30 million.

[Steve Gambuzo] – Longboat Capital

So, that's how much is non-cash accrual as in your rate structure?

Allen L. Leverett

That's how much is included in rates and therefore you recover in cash, so that's the $30 million. And then the deficit that you're in effect are having to fund above that, is the difference between the 180 and 30 or 150 million, if I'm following you.

And then, of course, you know that [Steve], but just to remind everybody on the call, the 180 is tax deductible so I take gross 180 and then will tax benefit that 180, so I'll get a deduction for 180 on the tax return.

Operator

Your next question comes from Maurice May – Power Insights

Maurice May – Power Insights

I'm old fashioned and I have another question on dividends. Your previous comments I recall as being a dividend payout target of some 50 to 60%, is that what it was?

Gale E. Klappa

Maury, what we've said is that we have a near-term policy, which we are now revisiting, and that near-term policy basically is tied to what we believe we can afford during this period of heavy construction spending and that is trying to grow the dividend about half the rate of earnings per share growth.

Now we're revisiting that, but we have not yet publicly discussed what the new dividend payout ratio range would look like. That's something we're going to have a very thorough discussion with our Board about in early December and hope to communicate with you after that.

Operator

Your next question comes from Alex Kania – Merrill Lynch

Alex Kania – Merrill Lynch

Just some thoughts I'd like to hear from you guys on just the breakdown on your retail sales about how you think weather versus some of the economic factors, especially on a pretty quick crazy quarter with respect to weather, but just what your thoughts are just generally on fundamental demand and trends you've been seeing recently.

Gale E. Klappa

I'd be happy to discuss that. First of all, in general terms just to kind of set the playing field, manufacturing demand for electricity is not very weather-sensitive, and you heard us talk earlier about some of the pluses and minuses we're seeing in our base of manufacturing customer. So, in looking at roughly 37, 38% of our total retail sales being to manufacturing customers, we're only down about 1% so far this year in terms of energy consumption by our manufacturing base.

Clearly, paper production and automotive and automotive parts are deteriorating no question about that, but we've seen other bright spots and we continue to see interesting growth in the commercial or non-manufacturing segment of our customer base. There's a significant expansion here in healthcare. We have several new hospitals, several new medical research centers being built so we really see some interesting expansions that has offset some of the weakness in the non-manufacturing base.

So, down about 1% on the manufacturing side so far. In the commercial or non-manufacturing side, a little more weather sensitive but we're seeing some growth offset other weakness, and then residential really is tied to two things, your household formation and customer growth and the weather and the residentially obviously swings very much with the weather.

I mentioned earlier that we're still seeing positive customer growth. That is not the case in other parts of the country, but we're still seeing slower, but positive customer growth about up one-half of 1% over the last 12 months, and a fair amount of conversions on the natural gas side from propane to natural gas.

So, I would look at the weakness that we saw so far this year particularly this summer in residential demand as purely weather driven.

Operator

Our next question from [Paul Paterson] – Glenrock Associates]

[Paul Peterson] – Glenrock Associates

Almost all my questions have been asked, but the only thing I wanted to follow up was, when you were talking to Greg about the legislature looking at the new fuels or I guess the

PSC going to the legislature, could you just elaborate a little bit more about what that looks like now. Is there a bill or when would that happen or...

Gale E. Klappa

I would be happy to elaborate. The answer is we're not certain. The Commission is still considering what path to take and what specific actions to move forward on. My sense is, although the commission has not made a final decision, that there is some uncertainty about whether the Commission has the administrative authority under Wisconsin law to change the fuel rules.

And in light of that uncertainty, they may submit to the legislature a proposed changed in the fuel rules for the legislature to vote on. That’s the current discussion at the Commission. Does the Commission have the legislative authority under the law to make an administrative change in the fuel rules or not.

So I would expect that if the Commission makes a final decision that they need to go to the legislature for a change in the fuel rules. If they would probably propose the change to the legislature in the form of a bill or part of an energy package that might be submitted in the spring. That’s my current guess, but no final decision has yet been made by the commission.

Forward on my sense is although the commission has not made a final decision. That there is some uncertainty about whether the commission has the administrative authority under Wisconsin law to change the fuel rules. And in light of that uncertainty they may submit to the legislature a proposed changed in the fuel rules for the legislature to vote on. That’s the current discussion at the commission. Does the commission have the legislative authority under the law to make an administrative change in the fuel rules or not.

So I would expect that if the commission makes a final decision that they need to go to the legislature for a change in the fuel rules. If they would probably propose the change to the legislature in the form of a bill or part of an energy package that might be submitted in the spring. That’s my current guess but no final decision has yet been made by the commission.

[Paul Peterson] – Glenrock Associates

So it’s going to be some time before it’s resolved it sounds like?

Gale E. Klappa

I would think we’ll see some sort of resolution next year. If I were a betting man that would be my bet.

Operator

Your next question is from Rick [Inaudible] – Duff Capital Advisors

Rick – Duff Capital Advisors

I was just wondering kind of a different topic, can you update us on the carbon capture pilot that’s going out at your coal plant?

Gale E. Klappa

We’ll be happy to give you the data we have at the moment. Remember we have a one-year experiment here. The manufacturer had some technical difficulty in the early stages with some aspects of the technology, particularly the chilled ammonia piece. And that has now been rectified and data collection is underway and Rick I would expect sometime early next year we’ll see some specific data, but I understand they’ve been reasonably pleased with the performance.

Allen L. Leverett

Yes, I think that’s right Gale, and of course this is being funded by a consortium and that data probably will take a while to work its way through that before it becomes public.

Gale E. Klappa

We will certainly as part of our commitment that the group of utilities through the Electric Power Research Institute in Austin, which is the manufacturer, we will make a public report on the on this data, as we collect the data and as we understand the efficiencies of the technology, and the effectiveness of capturing the carbon with this chilled ammonia process.

Rick – Duff Capital Advisors

So basically that beginning problem, because I think last call or one of the more recent times you’d indicated about this time you’d have a much better sense. It seems like it’s a two three-month delay in that.

Gale E. Klappa

Exactly right, because there was about a two to three month delay in getting consistent operation of the technology in light of just some of the startup issues they had. But they’ve overcome those issues and again the sense we get is that they’re pretty pleased with the performance, so we’ll know a lot more I’m sure early next year.

Operator

Your ext question comes from Greg Gordon – Citi Group

Greg Gordon – Citi Group

Pension you’ve told us about your projected cash obligations you have $30 million in rates in terms of operating expenses from the last rate plan. Relative to FAS 87, what would you project to be your increase if any in FAS 87 pension expense next year as you look at it today and as the regulatory mechanism that mitigates the impact on earnings between rate cases?

Allen L. Leverett

Well, certainly we'll start with the second question first. We run a two-year cycle, so in Wisconsin your pension expense is sort of is what it is, the one that’s included in rates and there is no true offer of anything. So if you have either a big increase or big decrease that that's just something that you have to plan around as a company. So, there’s not any true up mechanisms.

Gale E. Klappa

Not between rate cases.

Allen L. Leverett

Not between rate cases, but obviously when you five a rate case say next spring, you put in your latest projection for 10 and 11 and then they’ll set rates on that. And in terms of an annual increase because of the smoothing, I don’t know, Steve, did you want to take a crack at what that increase might be?

Steve Dickson

There’s so many factors that go into pension expense and the smoothing of returns, down to the asset discount rates changes in asset class. This year we think we’ll have about $22 million, $24 million pension expense. Next year we expect to see an increase, but at this time we’re not in a position to say.

Allen L. Leverett

There’s one big variable obviously Greg in addition to the asset returns is where that liability discount rate turns out. And so you can get moved – very big move in pension expense based on what happens to that liability rate. So it’s a little hard and I mean, I'll certainly be happy when we do our February call to talk about what we project and what the key assumptions are then, but it’s still a little early.

Gale E. Klappa

Right now, as I think Allen mentioned earlier, if the year were to end today we would actually be helped a little bit by the difference in our assumption on the discount rate versus where the discount rate really appears to be.

So we will be happy to discuss in great detail with you on the call, but at the moment we’re not panicking over this because again, I think we have some conservative assumptions and that discount rate could make a huge difference.

Greg Gordon – Citi Group

My understanding is that you would amortize the under-recovered balance you’re saying over, is it a four-year period?

Allen L. Leverett

A four-year smoothing of the asset returns yes.

Greg Gordon – Citi Group

But to the extent your discount rate goes up that reduces the projected benefit obligation by a pretty meaningful amount and that’s an offsetting factor in the impact on earnings, correct?

Gale E. Klappa

Absolutely, right.

Greg Gordon – Citi Group

And how does that offset is that also smoothed over a four-year period or is that booked in, is that offsetting the production in the [PBO] book just in the period?

Allen L. Leverett

Off the top of my head I don’t know the period over which you do the effect liability smoothing. I think it’s’ more than four years though, Greg.

Greg Gordon – Citi Group

But there’s a big mitigating factor to the extent that interest rates stay high?

Gale E. Klappa

You are correct.

Allen L. Leverett

Yes, you have to be careful what you hope for, but yes, that’s right if you have high interest rate.

Gale E. Klappa

Well that concludes our conference call for today ladies and gentlemen. We appreciate your participating. If you have any other questions, Colleen Henderson will be available in our investor relations office at area code 414 221 2592.

Thank you again, good afternoon everybody.

Operator

This concludes today's conference call. Than you for joining and have a great day.

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Source: Wisconsin Energy Corp. Q3 2008 Earnings Call Transcript
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