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Nicor, Inc. (NYSE:GAS)

Q3 2008 Earnings Call

November 3, 2008 9:30 am ET

Executives

Russ M. Strobel - President & Chief Executive Officer

Mark Knox – Director, Investor Relations

Richard L. Hawley - Chief Financial Officer

Analysts

Gregory McGowan - Sidoti & Co.

Gary Linhoff – Ironworks Capital Management

Operator

Welcome to the Nicor, Inc. 2008 third quarter earnings conference call. My name is Mylydia (Operator Instructions) I would now like to turn the call over to your host for today, Mr. Russ Strobel, Chairman, President and Chief Executive Officer.

Russ M. Strobel

Good morning, everybody. With me today are Rick Hawley, our CFO, and Mark Knox our Director of Investor Relations.

We’re going to discuss our 2008 third quarter and year-to-date financial results and our annual outlook for 2008 earnings and when we’re done we’ll be happy to take your questions.

Let me know turn things over to Mark.

Mark Knox

First I’d like to remind you that this call will include certain forward-looking statements about the operations and expectations of our company, subsidiaries, and affiliates. Although we believe our representations are based on reasonable assumptions, actual results may vary materially from standard expectations. Information concerning the factors that could cause materially different results can be found in our periodic filings with the Securities and Exchange Commission and in this morning’s press release.

As we reported in our press release this morning, preliminary third quarter 2008 diluted earnings per share were $0.03 compared to $0.32 per share for the same period in 2007. For the nine-month-ended period diluted earnings per share were $1.58 compared to $1.76 per share in 2007. As a reminder, 2007 nine-month results included the positive effects of a reserve adjustment and cost recoveries of approximately $0.11 per share after tax related to our mercury inspection and repair program that commenced in 2000.

Removing the effects of these items for comparison purposes, gives you 2007 nine-months-ended earnings of about $1.65 per share compared to $1.58 per share in 2008.

Let me now turn things over to Mr. Hawley for the discussion of our 2008 results and our outlook for the remainder of the year.

Richard L. Hawley

Compared to 2007, third quarter 2008 diluted earnings per share reflect lower operating income in our gas distribution business and other energy-related businesses and lower corporate operating results, partially offset by higher operating income in our shipping business.

Turning to our year-to-date results, 2008 versus 2007, absent the impact of noteworthy items, reflect lower operating income in our shipping business and other energy-related businesses and lower corporate operating results, partially offset by higher operating income in our gas distribution business.

The nine-month-period comparisons were also favorably impacted by lower net interest expense and higher equity investment income in 2008.

Absent the effect of the previously mentioned mercury-related items, year-to-date gas distribution operating income, compared to last year, was improved. Year-to-date comparisons were favorably impacted by increased natural gas deliveries due to colder weather in 2008 and higher demand unrelated to weather and customer interest.

Partially offsetting these positive factors were the impact of higher operating and maintenance costs due primarily to increased bad-debt expense, billing- and call-center-related expenses, and payroll- and benefit-related costs, partially offset by recoveries of previously incurred costs recorded in the second quarter of 2008 and the absence of the costs associated with our previously discussed PCB matter that were recorded in the third quarter last year.

Operating results were also impacted by lower gains on property sales and higher depreciation expense.

As a reminder, and as discussed in our last earnings call in the second quarter 2008, at the gas-distribution level we recorded $3.9 million in legal recoveries in the second quarter which reduced operating and maintenance costs. We also recorded $3.1 million in legal recoveries in the second quarter at the corporate level.

Nicor Gas’s projected full-year 2008 operating results, while significantly below last year, are expected to exceed our initial budget due primarily to colder weather, the aforementioned legal recoveries, and lower interest expense.

In the third quarter we did begin to see some decline in high natural gas prices. This improved out 2008 outlook as compared to our view at the time of our second quarter 2008 earnings call. However, operating and maintenance costs, including bad debt, are still expected to exceed our original budget for 2008.

As you recall, increases in operating and maintenance costs, together with increases in depreciation expense, were significant factors in our decision to file for rate relief earlier this year. This is still the case.

Moving to our shipping segment, while the third quarter was up from last year, from an operating income perspective, year-to-date operating income was down. Tropical’s year-to-date income has been less than initially budgeted due primarily to its performance in the first half of the year.

While management has been working to mitigate the margin impact of lower volumes, resulting primarily from the effects of an economic slowdown in Tropical’s markets, results continue to be negatively impacted by those lower volumes.

Tropical took, and continues to take, steps to reduce this shortfall, including leveraging our second quarter acquisition, implementing rate adjustments in certain ports, adjusting shipping schedules, and enhancing our focus on fuel, process, personnel, and other costs. Success in these efforts has helped to mitigate the impact of lower volumes and increased costs that we have experienced throughout the year.

Looking at operating results to date and what we believe to be a reasonable level of fourth quarter performance, which is actually below last year’s actual levels, we expect Tropical to deliver solid operating results, although below last year’s record levels, by just over $10.0 million on an operating-income basis.

Our other energy ventures year-to-date reported income was down compared to last year due to lower income at our wholesale natural gas marketing business, partially offset by improved income at our retail products and services business.

Our wholesale gas business is running ahead of expectations on an economic basis but the impacts on reported results of declines in natural gas prices have move income from the third quarter into subsequent periods.

For the full year we continue to expect that our other energy ventures will be down from the record levels of 2007. To date, because of the project shift of GAAP income into future period I just discussed, our current estimates for 2008 operating performance are about $11.0 million, on a pre-tax basis, less than what we were expecting at the time of the second quarter 2008 call.

I want to emphasize again that this change is, in all material respects, just a shift from 2008 into future periods, effectively increasing the amount of cumulative, unrecognized marked to market earnings, as compared to GAAP earnings, from the second quarter estimates.

Year-to-date corporate operating results, compared to 2007, were negatively affected by the weather-related impact associated with certain of our retail utility bill management products, partially offset by the legal recoveries I mentioned earlier.

As we have previously discussed, certain of utility bill management products provide a natural and partial offset to the weather risk of our gas distribution business. In the first nine months of 2008 we recorded a $3.6 million cost associated with this hedge due to the impact of colder than normal weather. This compares to a benefit of $200,000 for the same period in 2007 when we had near-normal weather.

The amount of the offset will vary depending on a number of factors, but it has typically ranged from about 40% to 65% of our gas company’s weather exposure.

Under terms of a corporate swap agreement, benefits or costs resulting from variances in normal weather coming from the retail products, are recorded primarily in the corporate operating results.

Finally, year-to-date comparisons were also impacted by lower net interest income and increases in our effective tax rate.

Before I move into our 2008 earnings guidance I want to comment briefly on all the turmoil in the capital markets and its impact on us. To date we have incurred losses of less than $300,000 after tax and don’t believe we are directly exposed to entities one might consider troubled. Because of our strong credit ratings, we have been able to access the commercial paper markets throughout the crisis.

Having renewed our seasonal credit line before the recent credit market turmoil began, we have $1.2 billion in bank lines supporting commercial paper borrowings, which at the end of October were approximately $637.0 million. We are not aware of any significant issues that would impact our ability to access those lines should we need to. But again, we don’t expect to need to access those lines directly.

Turning to our outlook for earnings for 2008, taking into consideration all the pieces I have just discussed, our 2008 diluted earnings per share estimate is in the range of $2.20 to $2.40, unchanged from the guidance we provided in our second quarter earnings call on August 4, 2008.

Our outlook assumes normal weather for the remainder of the year but excludes, among other things, any future impacts associated with the ICC’s PBR plan and PGA reviews, other contingencies, and changes in tax laws.

Our estimate also does not reflect the variability in earnings due to fair value accounting adjustments and other impacts that could occur because of future volatility in the natural gas markets.

As a reminder, updates to our annual earnings outlook will be only provided as part of our quarterly and annual earnings releases.

Now let me provide a brief update on our regulatory filing for our gas distribution business. As many of you are well aware, in 2008 Nicor Gas filed with the Illinois Commerce Commission a request proposing a revenue increase of $140.3 million. On September 25, 2008, we filed rebuttal testimony updating the proposed revenue increase to $141.6 million.

Rebuttal testimony recently filed by the staff and Attorney General’s office recommends a rate increase of just under $63.0 million on a staff’s perspective and just over $50.0 from the AG’s perspective.

According to the schedule set for the case, evidentiary hearings will begin on November 17, 2008. If the proceeding takes the full 11 months allowed by law, we would expect a decision by the end of March 2009.

With that, let me now turn things back to Russ for a wrap up.

Russ M. Strobel

I want to close by emphasizing several points. First and most importantly, the outlook for our full-year consolidated financial results remain in line with our earlier guidance. Despite colder weather and certain cost recoveries recorded earlier in the year, our gas distribution results continue to be pressured by higher operating costs.

This ongoing trend, combined with other factors, led to our decision in April to file for rate relief with the Illinois Commerce Commission. In that filing we are seeking no more than what we believe is necessary to allow a fair opportunity to meet its obligations to provide safe and reliable service and to recover its costs.

Even with the requested new rates, Nicor Gas would continue to be the lowest cost natural gas provider among major Illinois utilities and among the lowest cost natural gas utilities in the entire nation. These low rates are a testament to our long history of being one of the most efficient natural gas utilities in America.

Tropical shipping is also facing a challenging environment. Importantly, in the past challenging periods Tropical has been successful at finding new ways to reduce costs, improve margins, increase market share, and grow volumes. Tropical will continue to look for ways to rise to the challenges in our current operating environment.

We are pleased with the economic performance of our other energy-related businesses. These businesses are expected to continue to make important contributions to Nicor’s long-term earnings and are an integral part of our overall growth strategy.

And with that, we will be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Gregory McGowan - Sidoti & Co.

Gregory McGowan - Sidoti & Co.

Can you review what are you expecting for EBIT at Tropical Shipping for the full year 2008, as well as EBIT at OEV for the full year 2008? You can give it on a net income basis.

Richard L. Hawley

I will just give it to you on a net income basis. At Tropical we are looking at probably just north of $31.0 million. And other energy ventures, we’re looking at probably just under $14.0 million.

Gregory McGowan - Sidoti & Co.

Can you give a little bit more detail in terms of what happened at the retail utility products group and [inaudible] of the reduction in profitability there?

Richard L. Hawley

Sure. And actually, the retail business is right on our expectations and looking to be that way for the year. It’s all marked to market accounting at the wholesale marketing business. As I mentioned, when we look at what we were projecting for marked to market earnings to come in to the end of the year, at the end of the second quarter versus what we’re looking at now, there’s actually been a shift into future periods, 2009 and beyond, of about $11.0 million pre-tax. And that’s all with the declining prices. So that’s about $7.0 million on an after-tax basis.

Gregory McGowan - Sidoti & Co.

So it sounds like the change mentioned in the press release, in terms of retail products group, that sound like it was a really smaller piece of why earnings came in below, I’m sure your expectations were understood, but I understand that you didn’t give us any guidance, but it sounds like that’s kind of the reason why, correct?

Richard L. Hawley

Well, is suspect that had we not seen the performance in the wholesale gas business, and again, we’re talking about our expectations versus the Street’s, but that shift certainly, had it not occurred, would have increased reported earnings for the quarter and I suspect moved it closer to what you all had. Although I don’t reconcile to what you have.

Gregory McGowan - Sidoti & Co.

And finally, I’m not sure if you mentioned this, but the tax rate seemed pretty high in the quarter. Was there anything, in terms of reserves, that made the tax rate so high?

Richard L. Hawley

The tax rate is so high because there is no income. There’s a little over $1.0 million of income, so if it’s a dollar-for-dollar it could be 100% tax rate, I guess.

Gregory McGowan - Sidoti & Co.

I got it. That was my fault for not thinking.

Richard L. Hawley

But just so you know, year-to-date, as we look ahead to the fourth quarter, we will probably have about a 28.5% effective tax rate for the quarter and that will put the year at just under a point higher than last year’s. That’s driven from the mix of income. There is less of the Tropical income, which we haven’t provided current taxes on.

Gregory McGowan - Sidoti & Co.

So it’s about 100 basis points. The tax rate for the full year 2008 is probably going to be about 100 basis points higher year-over-year in 2008 versus 2007, right?

Richard L. Hawley

Yes. Just under a point.

Operator

Your next question comes from Gary Linhoff – Ironworks Capital Management.

Gary Linhoff – Ironworks Capital Management

I’m sorry, I missed what you said the fourth quarter tax rate was expected to be.

Richard L. Hawley

Just over 28.5%.

Gary Linhoff – Ironworks Capital Management

Of the 17 vessels at Tropical, can you give us some sense, how many of those are owned versus charter and how long are the charters?

Richard L. Hawley

The charters vary from short term to a number of years. Eleven of them are owned out of the 17.

Gary Linhoff – Ironworks Capital Management

Can you give us a sense of what’s going on with the Baltic Dry Index and give us a sense on what’s going on with rates in your service area?

Richard L. Hawley

Sure. And there’s really not a direct comparison on those, but I think we’re seeing pressure on rates but we also have, in certain ports, been able to adjust rates upwards. In certain ports we have adjusted rates downward. Rates have not been a huge driver versus expectations so far this year.

Gary Linhoff – Ironworks Capital Management

I think in the release you mentioned lower bad debt expense debt in the quarter helped a little bit. Given what’s going on in the economy, can you tell us, what is bad debt expense as a percentage of revenues, maybe in Q3 or for the first nine months? And where does that typically get to, maybe in the last recession or economic downturn? How should we be thinking about how much of an impact bad debt expense could be?

Richard L. Hawley

First thing on the quarter, the number you’re referring to is just a comparison of the bad debt expense recorded in the third quarter this year versus the third quarter last year. If you recall, year-to-date and full year we are projecting bad debt expense to be up.

Third quarter, if you were on last third quarter’s call back in 2007, we actually increased bad debt expense to reflect changing experience over 2007 and added about $7.0 million into the reserve in the third quarter. That’s the primary reason the year-on-year comparison shows a reduction this year.

We have not changed or reduced the percentage of revenue that we expect to run bad. And in fact the 2008 number is up from the 2007 number. Right now it’s running in the neighborhood of 2% of revenue.

Gary Linhoff – Ironworks Capital Management

For the first nine months.

Richard L. Hawley

And that would be our expectation that is built into our full-year forecast. We do expect that we are not going to be immune to this downturn, nor have we been immune. As I said, we have seen, over the past several years, that percentage has probably increased from the 1.3%, 1.4% range up to the 2%. And we actually expect and are performing in line with, I would expect next year’s to be higher than that, somewhere north of 2%. Probably as much as 2.25%.

Gary Linhoff – Ironworks Capital Management

Can you tell us what you expect capex to be for the full year 2008 and any insight into what 2009 capex may be?

Richard L. Hawley

For 2009 we really don’t talk a lot about but I don’t think you’re going to see anything dramatically different. But it’s just north of $260.0 million projected for the year on all the companies combined.

Operator

There are no further questions.

Russ M. Strobel

Thank you all for participating in our call this morning.

Operator

This concludes today’s conference call.

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