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Southern Union Company (NYSE:SUG)

Q3 FY08 Earnings Call

November 10, 2008, 9:00 AM ET

Executives

John F. Walsh - Director of IR

George L. Lindemann - Chairman and CEO

Eric D. Herschmann - President and COO

Richard N. Marshall - Sr. VP and CFO

Robert O. Bond - Sr. VP, Pipeline Operations and President & COO-Panhandle Energy & CrossCountry Energy

Roger A. Farrell - Sr. VP, Midstream Operations and President and COO, Southern Union Gas Services

Analysts

Carl Kirst - BMO Capital Markets

Faisel Khan - Citigroup

Mark Caruso - Millennium Partners

Operator

Good day ladies and gentlemen, and welcome to the Third Quarter 2008 Southern Union Company Earnings Conference Call. My name is Erica and I'll be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. [Operator Instructions]. I would now like to turn the presentation over to your host for today's call, Mr. Jack Walsh, VP of Investor Relations. Please proceed sir.

John F. Walsh - Director of Investor Relations

Thank you, operator and welcome to Southern Union's third quarter 2008 earnings call and webcast. Presenting on today's call will be George Lindemann, Chairman and CEO; Eric Herschmann, President and COO; Rick Marshall, Senior Vice-President and CFO; Rob Bond, Senior Vice President of our pipeline operations, and Roger Farrell, Senior Vice President of our midstream operations.

A replay of this call will be available for one week by dialing 888-286-8010 and entering passcode 97925208. A replay of the webcast will be accessible through our website at www.sug.com.

Today, we will be discussing results for the third quarter of 2008, significant events and outlook. This morning we issued a press release announcing our third quarter results which is available on our website. Following our presentation, we will be happy to address your questions. If you have any further questions at the end of the call, please contact me directly at 212-659-3208.

Before beginning, I would like to remind everyone that the information discussed on today's call pertains to the financial result of Southern Union Company. Certain amounts and variance explanations for the transportation and storage segment may vary compared to Panhandle Eastern Pipeline Company's standalone financial statements due to consolidating adjustments.

I would also like to caution you that many of the statements contained in our call may be based on management's current expectations, estimates and projections about the industry in which the company operates. These statements are not guarantees of future performance and involve risks. The company undertakes no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise. Such statements are intended to be covered by the Safe Harbor provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934.

I would also refer you to the cautionary statement regarding forward-looking information in our earnings release.

I'll now like to turn the call over to Mr. George Lindemann. Mr. Lindemann?

George L. Lindemann - Chairman and Chief Executive Officer

Good morning. I'm pleased to report adjusted earnings for the third quarter of $0.29 per share. This amount reflects the negative impact of hurricanes Gustav and Ike which is approximately $0.11 per share.

Adjusted earnings per share before the impact of the hurricanes would have been $0.40 per share. Prior to the hurricanes, we were on track to exceed our previously stated adjusted earnings guidance of $1.80 to $1.90 per share. We now expect to come in at the low end of our range.

In addition to the hurricanes, the past several months have witnessed great volatility in the financial and commodity markets. The credit market, which our industry has been dependent on for many years, has also seen major turmoil.

As it relates to the overall liquidity of our company, I would like to emphasize that we do not have any significant short-term capital requirements and believe we have ample liquidity available to cover our near-term needs. Rick Marshall will discuss liquidity in greater detail in a few minutes.

Finally, I would like to welcome Roger Farrell to his first investment call as our new Senior Vice President of Midstream Operations. When we have completed our prepared remarks, we will address your questions.

I would like to turn the call over and out to Eric Herschmann to comment on the quarter. Eric?

Eric D. Herschmann - President and Chief Operating Officer

Thank you, George and good morning. We are pleased that in today's volatile markets, over 80% of our consolidated EBITDA comes from stable regulated businesses with minimal direct exposure to commodity prices. These businesses primarily include interstate pipelines, storage and LNG terminalling with long-term contracts.

The stability in earnings and cash flows helps our company maintain a relatively low risk profile while at the same time providing ample growth opportunities, including our Florida Gas transmission Phase VIII expansion which is on schedule and on budget.

Even though we're experiencing extreme volatility in today's markets, we believe that the fundamentals of the natural gas industry remain sound. As natural gas continues to be the fuel of choice for America, we believe our company is well positioned to create... to grow and create long-term value for our shareholders.

With that, I would now like to turn the call over to Rick Marshall, our CFO to give an overview of our results. Rick?

Richard N. Marshall - Senior Vice President and Chief Financial Officer

Thank you, Eric and good morning. For the quarter ended September 30, 2008, Southern Union reported adjusted EBIT of $106 million compared with EBIT of $120 million in the prior year. The decrease is due to the impacts of hurricanes Gustav and Ike during September. We estimate that the hurricanes negatively impacted EBIT by approximately $22 million during the quarter.

References to adjusted EBIT exclude the impact of select items. Select items for the third quarter of 2008 include a non-cash $14 million gain related to mark-to-market accounting on open commodity derivatives.

For the nine months ended September 30th, adjusted EBIT was $408 million compared with adjusted EBIT of $385 million in the prior year. Again, we estimate that the hurricanes negatively impacted EBIT by approximately $22 million during the year-to-date period.

Select items in the current period include a mark-to-market loss on open commodity derivatives of $5 million. Select items in the prior period include a $14 million gain related to the settlement of litigations at Citrus Corp.

For the quarter, adjusted net earnings were $36 million or $0.29 per share. This compares to net earnings of $41 million or $0.34 per share in 2007. For the nine months period, adjusted net earnings were $166 million or $1.34 per share compared with adjusted net earnings of $152 million or $1.26 per share in the prior period.

As George mentioned earlier, we estimate that the hurricanes impacted both the quarter and nine months periods by approximately $0.11 per share. Our earnings release issued this morning sets forth the selected items used in calculating adjusted net earnings. In accordance with Reg G, the release also contains a reconciliation of EBIT to adjusted EBIT as well as EBIT to net earnings.

In terms of segment results, transportation and storage, including our investment in Citrus, had EBIT of $89 million for the quarter compared with EBIT of $90 million during the same quarter last year. The current quarter's results include expenses of $10 million for the expected cost to repair damages to our offshore systems as a result of the hurricanes. The results also include approximately $1 million of lower revenues as a result of reduced volumes following the hurricanes.

Panhandle's operating revenue increase by $14 million in the quarter, largely due to the inclusion of the Trunkline Field Zone which went into service earlier this year. Operating expenses, including expenses associated with the hurricanes, were up $9 million in the quarter.

Depreciation expense increased $4 million in the quarter due to an increase in property, plant and equipment.

Our gathering and processing segment generated $13 million in adjusted EBIT for the quarter compared with EBIT of $20 million in the same period last year. The decrease was driven by the unavailability of third-party fractionation capacity at Mont Belvieu following hurricane Ike.

We estimate the hurricane negatively impacted gross margin by approximately $11 million in the quarter. Unusual items during the quarter also included a $3 million bad debt reserve for a customer that filed bankruptcy, plus a $1 million provision for the settlement of litigation.

Our distribution business generated EBIT of $4 million for the quarter compared with $9 million in the prior year. The $5 million decrease is primarily a result of increased operating expenses and lower net operating revenue. Notwithstanding the year-over-year results, this segment continues to remain on budget, and we expect it to meet its full year targets.

During the quarter, we invested approximately $112 million in our operations; growth capital accounted for $70 million and maintenance capital was $42 million. Broken down by segment, our transportation and storage segment invested $75 million, $52 million for growth and $23 million for maintenance.

Our gathering and processing segment invested $19 million, $10 million for growth and $9 million for maintenance. At our distribution segment, we invested a total of $12 million, $2 million for growth and $10 million for maintenance. Our corporate and other segment invested $6 million for growth capital.

Southern Union does not have any refinancing obligations due until the third quarter of 2009. From a liquidity standpoint, we have approximately $160 million available under our $400 million revolving credit facility, which is a fully committed facility that matures in May of 2010. Based upon our currently anticipated cash needs, we expect borrowings under this facility to be relatively flat through the remainder of 2008 and to decrease slightly during the first six months of 2009.

During the third quarter of 2009 or earlier, if market conditions provide a favorable opportunity, the company will refinance or repay the obligations coming due in 2009 with cash flows from operations, borrowings under our revolving credit facility or proceeds from bank or debt capital market transactions.

Specifically, obligations coming due in 2009 include $61 million of debt maturing at Panhandle Eastern Pipeline Company and a $150 million short-term bank loan at Southern Union.

As we work towards finalizing our 2009 budget, you can be assured that our focus will be on managing both operating expenses and capital projects so they fit within our cash flow generation capability.

Citrus Corp., our joint venture with El Paso and the owner of Florida Gas Transmission will need to access the debt capital markets sometime during the second half of 2009 to fund the ongoing Phase VIII expansion. The exact timing and amount of the offering is yet to be determined and will be based on cash flow needs as the project progresses.

Since the project is secured by 25 year contracts with high quality counterparties, we are confident in our ability to finance the project.

We will closely monitor the markets throughout next year and may opportunistically pre-fund part of the capital, if market conditions provide a favorable opportunity.

I'll now turn the call over to Rob Bond who will discuss our transportation and storage segment.

Robert O. Bond - Senior Vice President, Pipeline Operations and President & Chief Operating Officer-Panhandle Energy & CrossCountry Energy

Thank you, Rick and good morning. Following the impacts of the hurricanes which Rick just described, the third quarter was a solid quarter for our transportation and storage businesses, both operationally and financially.

At this point, I'd like to spend a few minutes, updating you on the key growth projects that are currently underway.

At Trunkline LNG, our infrastructure enhancement project continues to progress with the second quarter of 2009 in-service date. Because of the delays associated with the two hurricanes, we now expect the project to come online towards the end of the second quarter. The estimated cost of this project, which is fully contracted to BG LNG Services for 20 years, is now approximately $400 million, excluding capitalized interest.

The increase in costs compared with our prior estimate of $365 million, is due to higher labor costs, including the reduced productivity as a result of the hurricanes, as well as generally higher material costs. Because of our negotiated rate is based on the formula of capital invested, we now expect the project to generate EBIT of $55 million to $60 million and EBITDA of $65 million to $70 million on an annual basis.

Our other major project underway is the Florida Gas Transmission Phase VIII project. As you know, we have a 50% interest in service operator of Florida Gas Transmission through our investment in Citrus Corp. The Phase VIII project is designed to add approximately 820 million cubic feet of incremental delivery capacity into Florida through the addition of 500 miles of pipe and over 200,000 horsepower of compression.

We remain currently contracted for approximately 90% of the capacity under 25 year agreement. We estimate the project will cost approximately $2.4 billion and generate operating income of $240 million to $260 million and EBITDA of $290 million to $310 million when fully contracted.

At this point, we've locked in the cost of our pipes, ordered our compression, begun procuring valves, regulators and other necessary equipment, and lastly, have finalized the commercial terms with our pipeline contractors.

With that, I'd like to turn the call over to Roger. Roger?

Roger A. Farrell - Senior Vice President, Midstream Operations and President and Chief Operating Officer, Southern Union Gas Services

Thank you, Rob and good morning everyone. Up until hurricane Ike hit on September 11, the third quarter was shaping up as a very good quarter for us. The hurricane did not damage our system. However, it did cause damage and power outages in Mont Belvieu, Texas where we fractionate our natural gas liquids. Because much of the gas in our system is higher BTU gas and must be processed to meet pipeline quality standards, we ended up being shut in for approximately one week and then operated only 30% capacity through the end of the month. As Rick Mentioned earlier, we believe this cost us approximately $11 million of gross margin during the quarter.

As of October 1, we were back to pre-hurricane production levels. On October 10, our third-party fractionator went down from a previously scheduled 30-day turnaround. During this turnaround, we have been fractionating approximately one-third of our NGL production at another facility while storing the remaining two-thirds at Mont Belvieu.

The NGLs in storage will begin to be fractionated and sold once the turnaround is completed in the next week or so. At this point, we do expect that there will be some level of NGLs in storage at year end which will not be sold until the first quarter of 2009.

Prior to the hurricane on September 11, our equity volumes for the first two months of the quarter averaged approximately 43,000 MMBtu per day of natural gas liquids and 6,000 MMBtu per day of residue gas. As you will recall, our equity volume guidance for 2008 was for 40,000 to 45,000 MMBtu per day of natural gas liquids.

As it relates to our hedging program for the last quarter of 2008, we continue to be hedged on 30,000 MMBtu per day at a realized price of $15.02. We achieved this price through a combination of put options and swap contracts on natural gas and processing spreads. Also for the balance of 2008, we have entered into additional processing spread swaps on 10,000 MMBtu per day at $7.10.

To calculate the impact from our gross margin related to the additional 10,000 MMBtu per day swap, you have to remember to add in the then current natural gas price to the $7.10 processing spread swap to arrive the total value we are realizing from the sale of our product.

For 2009, we are hedged on 20,000 MMBtu per day at a realized price of $16.40. Again, this was done through a combination of swap contracts of natural gas and processing spreads.

We've also entered into an additional processing spread hedge on 10,000 MMBtu per day at $8.37. Again, you need to add in the then current natural gas price to arrive at our total net price.

I'd now like to turn the call back over to George.

George L. Lindemann - Chairman and Chief Executive Officer

Thank you, Roger. At this point, we would like to open the meeting up to questions.

Question And Answer

Operator

[Operator Instructions]. Our first question comes from the line of Carl Kirst [BMO Capital Markets]. Please proceed.

Carl Kirst - BMO Capital Markets

Good morning, everybody. Couple of question on the pipes first. Rob, with respect to the Florida Gas, right, I assumed the interest expense of whatever of project financing is raised next year, is that kept at the Citrus level or are any of those interest expense passed on to customers, i.e. if you don't get the interest expense, your thinking relative to your budget, relative to what presumably be the fixed contract you sign up [ph]?

George L. Lindemann - Chairman and Chief Executive Officer

Yes. Go ahead, Rick.

Richard N. Marshall - Senior Vice President and Chief Financial Officer

The fixed contract assumed a level in debt... indebtedness [ph] in today's market. We're still comfortable that, that we'll ultimately finance the projects that will provide the returns that we're expecting for that project. As far as the question as to where the interest expense will remain and it obviously depends on whether the financing is done at the Citrus level or the FGT level. But most of that financing... most of the finance will be done at either the Citrus or the FGT level.

Carl Kirst - BMO Capital Markets

Okay. But wherever it is raised, any... say for instance, elevation in the interest expense that is borne by you guys and El Paso, right? I mean that's not a pass-through --

Richard N. Marshall - Senior Vice President and Chief Financial Officer

That's correct.

Carl Kirst - BMO Capital Markets

Okay. It's what I thought. I just wanted to clarify. Appreciate that. The second question, it sounds like there really is no additional lingering impacts from the hurricane on the midstream. Is that going to be the case for the pipes? Are they're going to continue to be some lingering repair expenses, if you will?

Roger A. Farrell - Senior Vice President, Midstream Operations and President and Chief Operating Officer, Southern Union Gas Services

Well, I think the only lingering piece, Carl, is we've got a bit of work left to do on Sea Robin particularly, to get some of those volumes flowing again. And so we'll see some reduced volumes on Sea Robin and that will impact us slightly going forward. We expect to have most of that work completed by the end of the year.

Carl Kirst - BMO Capital Markets

Rob, can you kind of estimate sort of what impact we're talking about right here between... I now understand Sea Robin is not a very big part of the business but just with respect to the reduced volumes and increased expense, I mean is there something in the neighborhood of $5 million, less, more?

Robert O. Bond - Senior Vice President, Pipeline Operations and President & Chief Operating Officer-Panhandle Energy & CrossCountry Energy

Yes, I think in the third quarter we showed revenue was down by about a million buck. I would expect that in the fourth quarter it would be similar.

Carl Kirst - BMO Capital Markets

Okay. And then... I appreciate that. Last question, Rick, can you care to sort of throw what a preliminary budget might be for 2008 or 2009, barring that what you think the timing is on coming forth with the 2009 outlook?

Richard N. Marshall - Senior Vice President and Chief Financial Officer

Well, I'm not prepared to do that at this point in time, Carl, from an earnings per share guidance number. But just to give you some color on capital, the capital budget that we put out this year was in the mid 500 range, and you can expect that that we'll see a capital budget much less than that in 2009.

We're still in the process of fine tuning that. But as you can imagine, there are some significant expenditures that relate to the infrastructure enhancement project that aren't going to be repetitive, although we do have some expenditures to complete IEP in the 2009... will be in the 2009 budget, but not to the level that we had in 2008. And there were additional capital projects... specifically, there were some amounts related to the field zone expansion that don't... aren't reoccurring in 2009. So what you'll see is that from a cash flow standpoint, Southern Union Company will have free cash flows... will be free cash flow positive from $75 million to $100 million in 2009 which also helps us out with our short-term liquidity needs for 2009.

Carl Kirst - BMO Capital Markets

No... very, very helpful. And any thoughts on timing as far as coming out with the 2009 outlook, should we think about it early next year or --

Richard N. Marshall - Senior Vice President and Chief Financial Officer

Again, I'm not sure but I'd think that, that's within the realm of possibility.

Carl Kirst - BMO Capital Markets

Appreciate the color.

Richard N. Marshall - Senior Vice President and Chief Financial Officer

Okay.

Operator

Our next question comes from the line of Faisel Khan with Citigroup. Please proceed.

Faisel Khan - Citigroup

Good morning, guys. It's Faisel from Citi. The question on the... follow-up on FGT, in terms of where you guys are, with regards to procurement of steel, labor buy away [ph], can you talk about how the capital plan or the budgeted amount to complete the expansion is affected by the current market situation... meaning, I know you guys locked in a lot of your steel but what about the labor and buy away [ph] costs, all that sort of other stuff that's embedded in the construction?

Richard N. Marshall - Senior Vice President and Chief Financial Officer

Faisel, we're well underway with... in fact, I hope to sign the contracts within the next couple of weeks on our pipeline contractors. We've negotiated unit price contracts there so that we don't really have any exposure to labor cost or even weather delays, quite frankly. So it's... we're very happy with what we have negotiated with our pipeline contractors. Our steel prices, as you have mentioned, are locked in right away. Acquisition has begun. I think we're well on target to complete it on time and on budget as I believe Eric mentioned earlier in the prepared remarks.

Faisel Khan - Citigroup

Okay. Do you think there is any sensitivity to some of those costs in the current market?

Richard N. Marshall - Senior Vice President and Chief Financial Officer

I don't think so. I think obviously there is... you still have to get it constructed, but I feel very comfortable with where we are, with the amount of contingency that we have left in the project that we'll complete it as I said earlier on budget.

Faisel Khan - Citigroup

Okay. Can you just talk about how much contingency you have in that budget or is there something you guys are --

Richard N. Marshall - Senior Vice President and Chief Financial Officer

No.

Faisel Khan - Citigroup

Okay, got you. Thanks for the time.

Richard N. Marshall - Senior Vice President and Chief Financial Officer

Okay. Thank you.

Operator

Our next question comes from the line of Sarah Nainzadeh with Millennium Partners. Please proceed.

Mark Caruso - Millennium Partners

Good morning. It's actually Mark Caruso. I just had a few quick questions. In the quarter, you're impacted by the one of fractionator being down. I know it's on for maintenance. Is it currently back up, and can you kind of give us a sense of the current environment in midstream? Because I know we've seen Pinedale [ph], take down some of their plants because not currently economic. I just want to get a sense of how things are playing out around your system?

Roger A. Farrell - Senior Vice President, Midstream Operations and President and Chief Operating Officer, Southern Union Gas Services

The one of fractionator... my intelligence as of this morning was that they would not be coming back on until late this week. We'd expect them to come on this weekend, but due to a permitting issue, I think it's going to be later on in the week.

As far as generally the process environment, product prices continue to be weak. And at this point in time, we are still in full recovery mode. Although we watch daily what the processing spreads are and are certainly in a mode that we can quickly go to at least partial FA rejection if need be. In the long term it's difficult to tell on the processing side but we're hopeful that when the petrochemical complex gets back up and running, after they get the repairs done from the hurricanes and hopefully we'll see some improvement on the NGL pricing.

Mark Caruso - Millennium Partners

Got you. And then are you seeing any impact of volumes... lot of the E&P companies are talking about laying down rigs because of commodity prices. Have you seen any impact to volumes yet?

Roger A. Farrell - Senior Vice President, Midstream Operations and President and Chief Operating Officer, Southern Union Gas Services

We haven't seen anything acute... certainly we do have some intelligence that there are some companies that are planning on reducing their drilling but without saying name, the couple of them actually are talking about, maybe not drilling in the first couple of months of the year until rig prices come more in line with commodity prices. But so far, we haven't seen a significant impact on drilling in our area. There are some areas actually where we are seeing an increase because they found a particularly nice little oil play that is very good for our business. So, right now, we haven't seen any material impact on the drilling situation.

Mark Caruso - Millennium Partners

Okay. So just one last question... you had mentioned sort of the timing, can you kind of... can you give us a better sense of how that... that you're working at the timing of NGL barrels that are in storage. Are you able... so you don't recognize any revenues until those are sold or just sort of how that mechanics of that work?

Roger A. Farrell - Senior Vice President, Midstream Operations and President and Chief Operating Officer, Southern Union Gas Services

Well obviously, the longer the fractionator is down, the more difficult it will be for to be fractionated. Right now, we were expecting majority to be fractionated before the end of the year. However, there were a... not any significant number of barrels we expected to be left unfractionated through the first quarter.

Mark Caruso - Millennium Partners

That's it. Thanks so much.

Roger A. Farrell - Senior Vice President, Midstream Operations and President and Chief Operating Officer, Southern Union Gas Services

Thank you.

Operator

Our next question comes from the line of Allah Bonic [ph] with RBC Capital Markets. Please proceed.

Unidentified Analyst

Thanks very much. Actually those were just my questions and they have been answered.

Operator

There are no further questions. I'd now like to turn the call over to George Lindemann for closing remarks.

George L. Lindemann - Chairman and Chief Executive Officer

Thank you and I'd like to thank everyone again for participating in today's call, and we hope to see everyone again at year end.

Operator

Thank you for your participation in today's conference. This concludes the presentation. Everyone have a great day. .

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