Pepco Holdings Inc. Q1 2009 Earnings Call Transcript

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 |  About: Pepco Holdings, Inc. (POM)
by: SA Transcripts

Pepco Holdings Inc. (NYSE:POM)

Q1 2009 Earnings Call

May 8, 2009 11:00 am ET

Executives

Donna Kinzel – Director of Investor Relations

Dennis R. Wraase –Chief Executive Officer

Joseph M. Rigby – President and Chief Operating Officer

Paul H. Barry – Chief Financial Officer

David M. Velazquez – Executive Vice President of PHI & Business Leader Power Delivery

Gary Morsches – President & Chief Executive officer Conectiv Energy

John U. Hoffman – President & Chief Operating Officer Pepco Energy Services, Inc.

Analysts

Paul Patterson – Glenrock Associates

Daniel Eggers – Credit Suisse

Steve Fleishman – Catapult

Andrew Levy – Incremental Capital

Dan Jenkins – State of Wisconsin Investment Board

Operator

Welcome to the first quarter 2009 Pepco Holdings, Incorporated earnings conference call. (Operator Instructions). I would now like to turn the presentation over to your host, Ms. Donna Kinzel, Director of Investor Relations. You may proceed.

Donna Kinzel

Good morning, ladies and gentlemen. Welcome to the Pepco Holdings first quarter 2009 earnings conference call. The primary speakers on today's call are Joe Rigby, President and Chief Executive Officer and Paul Barry, Senior Vice President and Chief Financial Officer.

Also available to answer your questions are Dennis Wraase, Chairman, Dave Velazquez, Executive Vice President Power Delivery, Gary Morsches, President and Chief Executive Officer of Conectiv Energy and John Hoffman, President and Chief Executive Officer of Pepco Energy Services.

Before Joe begins, let me remind you that some of the comments made during today's conference call may be considered forward-looking statements. As such, they should be taken in the context of the risks and uncertainties discussed in the Safe Harbor disclosures contained in our Securities and Exchange Commission filings.

Also please note that today's call will include a discussion of our results, excluding certain items that we feel are not representative of the company's ongoing business operations. These special items and their financial impact are described in our earnings release dated May 7, 2009. The earnings release can be found at www.pepcoholdings.com/investors. Joe?

Joseph M. Rigby

Thanks, Donna. Good morning, ladies and gentlemen and thank you for joining us today. Our first quarter earnings are reflective of the key earnings drivers that we discussed at our March 27 analyst conference. The earnings reflect the impact of the challenging power markets, continued recessionary pressures and certain higher costs.

As expected Conectiv Energy experienced lower earnings this quarter, especially as compared to its very strong results in the first quarter of last year, as decreasing energy prices compress generation margins and reduced asset optimization opportunities.

In addition, because of the proactive steps we took late last year, we incurred higher interest expense and dilution from additional shares of common stock outstanding. We also incurred higher pension expense primarily due to the decline in the market value of our pension plan assets, which drove an increase in operation and maintenance expense quarter-over-quarter.

Consolidated earnings for the quarter were $45 million compared to $99 million in the 2008 quarter. In the first quarter of 2009, we recognized an $8 million after tax gain when the District of Columbia Public Service Commission approved Pepco's customer sharing proposal for the remaining balance of the proceeds from the Mirant bankruptcy settlement.

We view this item as not being representative of the company's ongoing business operations. Excluding this gain, earnings for the first quarter of 2009 would have been $37 million. Paul will discuss the financial results in our operating segment performance in more detail, but first I'll address some topics of interest.

In February, we received authorization from the Maryland Public Service Commission to use an existing Certificate of Public Convenience and Necessity for the Chalk Point to Burches Hills segment of our Mid-Atlantic Power Pathway or MAPP transmission project. Construction of this segment is scheduled to begin late this year.

During 2009, we will continue to seek the remaining required Certificates of Public Convenience and Necessity, as well as the required environmental approvals for the Maryland portions of the line. The project completion date officially remains 2013; however, the in-service dates are under review by PJM, with the decision expected later this month or in June.

Late next week, each of our utilities will file an annual formula rate filing with FERC. This filing will reflect updated rate base and operating costs incurred through December 31st, 2008. It will also include the estimated average construction work in progress balance, for the MAPP project for 2009, which earns a return on equity of 12.8%.

Our blueprint for the future initiatives continues to move forward with the recent completion of the vendor selection process. In late March, we announced multi-year contracts with GE Energy and Landis & Gyr for the manufacture of smart meters and with Scope Services for meter installation.

We now have in place all the major vendors necessary for the full-scale deployment of the blueprint. The contracts provide us with the flexibility to expand smart meter purchases and installations, as regulatory authorizations to build a smart grid network are granted.

As we had previously discussed, last year the Delaware Public Service Commission approved the application of advanced metering infrastructure technology across the distribution system. A regulatory asset will be created to assure recovery of and a return on AMI related costs between rate cases. Field testing has begun and is expected to be completed in the third quarter, with meter installations for Delaware customers beginning in the fourth quarter of 2009.

In New Jersey, we recently received approval to accelerate certain previously identified distribution projects. These projects respond to the governor's request that New Jersey utilities accelerate spending on capital improvement projects to help provide economic stability in the state.

The projects include energy efficiency, distribution automation, reliability, and environmental protection. Incremental expenditures for the projects are approximately $13 million in 2009 and $15 million in 2010. Cost recovery has been approved by the New Jersey Board of Public Utilities and will occur through a surcharge beginning June 1, 2009.

We continue to actively work to secure funds under the American Recovery and Reinvestment Act of 2009. This act provides for federal funding in partnership with the governments of the District of Columbia and the states we serve. These funds could become available to jump start shovel-ready projects within our MAPP and blueprint initiatives. The federal government's goal dovetailed well with our smart grid and infrastructure plans to improve reliability and promote energy independence in our region.

On May 1st, PHI's utilities made filings in the regulatory jurisdictions to mitigate the effective of significantly higher pension expense being incurred, as compared to prior periods. These filings request deferral of the amount of pension expense charged to operation and maintenance expense, which is above the amounts currently included in base distribution rates.

In aggregate, these filings request that $35 million of 2009 pension expense be deferred for future recovery. The accumulated deferred balance would be incorporated into rates in the next base rate proceeding.

On May 6th, Delmarva Power filed an electric distribution base rate case in Maryland that seeks approval of an annual increase of approximately $14 million in electric base rates. If our proposal is approved, our typical electric residential customer would see a total bill increase of 2.6%. A decision is expected in December 2009.

We remain on track to file three additional electric distribution base rate cases this year, with Pepco's filing in the District of Columbia targeted for later this month. Each filing will adjust for forward-looking known and quantifiable expenses such as pension expense.

As part of these rate filings, we are asking the commissions to authorize a three-year rolling average treatment of pension, OPEB and bad debt expenses to be recovered through a surcharge which will be updated annually.

The difference between the three-year average of these costs and the incurred amounts would be deferred for future recovery. If this recovery mechanism is approved for Delmarva in Maryland, it would lower the proposed annual base rate increase from $14 million to $10 million.

Now, I'll turn to our competitive businesses. Construction of Conectiv Energy's new power plant at the Delta and Cumberland sites continues to proceed on schedule and within budget. The Cumberland project is nearly completed and is currently undergoing pre-commercial testing. It is expected to be placed in service on June 1, 2009.

The Delta project is expected to become operational during the second quarter of 2011. These additions will enhance the value of Conectiv Energy's generation fleet, while providing needed capacity in the PJM region.

At Pepco Energy Services, we took actions during the quarter to significantly reduce the collateral required under wholesale energy purchase contracts. PES entered into a credit intermediation agreement with an investment bank, under which certain wholesale power supply contracts were novated.

The novation of the contracts not only released nearly $300 million of collateral to Pepco Energy Services, it also insulated a considerable portion of our retail energy supply business from the impact of further power price decreases.

While these actions greatly improved our liquidity position, we continue to evaluate a possible restructuring, sale, or wind-down of the retail energy supply portion of the business. We expect the business to remain profitable, based on its existing contract backlog, and the margins that have been locked in with corresponding wholesale energy purchase contracts. However, as we factor in the retail pricing, the increased cost of capital, we continue to experience reduced retail customer retention levels and reduced levels of new retail customer acquisitions.

At this point let me turn it over to Paul Barry.

Paul Barry

Good morning and thank you for joining us today. I hope you've had a chance to review our earnings release. I'll go through some of the highlights and provide some additional detail. We'll then open the call to your questions. First I'll recap our consolidated earnings and then I'll address our performance by operating segment.

Consolidated earnings for the first quarter were $45 million or $0.21 per share compared to $99 million or $0.49 per share for the first quarter of last year. Excluding the special item related to the Mirant bankruptcy settlement, earnings for the 2009 quarter would have been $37 million or $0.17 per share. For the first quarter, power delivery earnings were $0.19 per share compared to $0.24 per share for the 2008 period. Excluding the special item earnings would have been $0.15 per share for the 2009 quarter.

Effective dilution negatively impacted earnings by $0.02 per share. The biggest factors that decreased earnings period-over-period were higher interest and operations and maintenance expenses. The higher interest expense which impacted power delivery earnings by $0.03 per share is primarily due to the debt financing we completed last fall.

The higher O&M expense, which was an impact of $0.02 per share is being driven by increased pension expense. Excluding the increase in pension expense, O&M expense is essentially flat, demonstrating our continued focus on cost control. A partially offsetting factor for the quarter was higher weather related sales versus the prior year, which resulted in earnings increase of $0.02 per share year-over-year.

Heating degree days were up 15%. The impact of the weather for the quarter versus normal weather is an earnings increase of $0.01 per share. Keep in mind that our distribution revenue in Maryland represented approximately 40% of total distribution revenue, is currently decoupled from consumption. As Joe discussed, Connectiv Energy experienced lower earnings this quarter, especially as compared to the very strong results in the first quarter of last year.

Earnings were $0.02 per share compared to $0.24 per share for the first quarter of last year. Merchant generation and load service gross margins decreased $72 million quarter-over-quarter. About $44 million or $0.13 per share of this decrease was a function of three significant factors. The first is lower margins from fuel switching as the result of fewer opportunities to utilize the fuel switching capability of our combined cycle unit to the lower gas prices and less price volatility.

The second is lower margins from gas remarking activities around firm natural gas transportation and storage possessions due to lower demand, price and market volatility for natural gas during the 2009 winter period. And the third is the lack of opportunity to lever the operating flexibility of our generating units.

The magnitude of the margin derived from these activities was significantly less than was realized in the first quarter of last year, primarily due to less favorable energy prices and less price volatility in 2009. Other factors that lowered gross margin by about $19 million quarter-over-quarter or about $0.06 per share were significantly lower generation output and reduced spark spreads.

Output was down 12% quarter-over-quarter. The decrease was driven primarily by lower run times at the coal units due to lower natural gas prices that resulted in gas generation displacing some coal generation as well as lower demand for electricity relating to recessionary pressures.

At our March analyst conference we indicated that $270 million of gross margin was locked in for 2009 through hedges and that is still the case. However, given the recent further deterioration of prices, spark spreads and volatility, we now expect to achieve total gross margin below the midpoint of our 2009 forecasted range of $325 million to $425 million. We are confirming the forecasted 2010 gross margin range of $340 million to $450 million and the 2011 gross margin range of $380 million to $500 million.

Pepco Energy Services first quarter earnings were $0.03 per share compared to $0.04 per share in the 2008 quarter. Higher interest expense associated with new credit agreements drove the earnings decrease. On March 31, Pepco Holdings and its subsidiaries had $1.7 billion in cash and credit facility capacity available. As Joe discussed, Pepco Energy Services credit intermediation arrangement significantly improved liquidity position, also contributing to the improvement of Pepco's resell of $110 million of tax exempt bonds.

These bonds have a fixed rate of 6.2% with a 2022 maturity. Pepco repurchased the bonds in 2008 in response to the disruption in the tax exempt auction rate bond market. The proceeds of this sale reimbursed Pepco for the purchase of the bonds.

Later this year, Delmarva Power and Atlantic City Electric expect to undertake similar refinancing of approximately $189 million of tax assessed debt in aggregate. Other than this refinancing we do not expect to issue debt or equity this year.

We continue to believe that the long-term fundamentals of our business remain strong. We expect to face challenges in 2009 and we believe we are positioned for longer term earnings growth. We continue to demonstrate effectiveness in the regulatory arena. We have a construction program that is heavily focused on transmission and distribution reliability projects and we continue to focus on executing our business plan.

With that we would like to open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from the line of Paul Patterson – Glenrock Associates.

Paul Patterson – Glenrock Associates

So, if I understand this decrease at Connectiv, it's within your range but it's a lower end of the range, is that sort of what the thought process is?

Paul Barry

That's correct.

Paul Patterson – Glenrock Associates

Okay, but there's no need to change the range?

Paul Barry

No, we're not changing the range, Paul.

Paul Patterson – Glenrock Associates

Okay, and what is it that offsets, I mean, what should we think about offsetting the $72 million decrease in the next three quarters?

Paul Barry

I'm not sure I understand the $72 million.

Paul Patterson – Glenrock Associates

Well, there's a $72 million reduction this quarter versus last year and –

Paul Barry

Gary Morsches probably can respond to that.

Gary Morsches

Yes, again we came out of 2008 with a very strong first quarter. The market fundamentals were totally different than where they are in 2009. We do expect to see more normal pricing come in, more normal volatility across the PJM fleet.

With that we will be able to capture the margins that we've done year on year around fuel switching, around optimizing our assets, and our gas remarketing around our contracted natural gas storage and transport positions.

Paul Patterson – Glenrock Associates

Okay, with the novation of those contracts that you mentioned with Morgan Stanley, I read in the 10-Q that there was a $25 million fee that was going to be amortized in declining amounts over the life of the arrangement, could you give us a feeling as to what that impact is for 2009?

Joseph Rigby

I think John can probably respond that that.

John U. Hoffman

Yes, hi this is John Hoffman, the cost that we took in the first quarter for that transaction was about $3 million pre-tax so we expect to see that for the remainder of the year.

Paul Patterson – Glenrock Associates

So, you had a $3 million hit, is that right, in the quarter and that's going to come back for the rest of the year?

John U. Hoffman

No, no, no, we expect that level to continue through the rest of the year.

Paul Patterson – Glenrock Associates

Okay, but did you guys – okay I got you. So, when we look at this $25 million number over the space of 2009 through 2011, it sounds like I guess $3 million a quarter, is that right, or is it $3 million for the rest of the year?

Joseph Rigby

For the year.

Paul Patterson – Glenrock Associates

Six million for the year, okay.

Joseph Rigby

To earnings, that's the earnings impact.

Paul Patterson – Glenrock Associates

That's the earnings impact, is there any other earnings impact associated with this?

Joseph Rigby

No, that's it.

Paul Patterson – Glenrock Associates

Okay, and then when we look at this deferral that you're asking for with respect to the pension, when do we get a sense as to what, or when will we get a decision on that and sort of schedule in terms of how people respond to that, and are you deferring that expense right now in expectation of that?

Paul Barry

No, Paul we're not deferring and as I noted we just recently filed, there has not been a procedural schedule set yet, so it would be difficult to try to anticipate when we might get a response and a resolution. We certainly hope we are going to have some resolution before the end of the year.

Operator

Our next question will come from the line of Daniel Eggers – Credit Suisse.

Daniel Eggers – Credit Suisse

Can you just walk me through kind of precedent on the pension expensed kind of the deferral mechanism and how you would envision it working, and any other sort of details we should know as we think about this year?

Gary Morsches

Well, the most near term precedent although it's not in our service territory was with South Carolina, so we've not had a precedent specifically on that particular issue with our jurisdictions.

Daniel Eggers – Credit Suisse

You think this is something you can do outside of a rate case or just since you're filing rate cases across all jurisdictions effectively –

Dennis R. Wraase

Yes, yes, we do.

Daniel Eggers – Credit Suisse

It's probably better served in a rate case format.

Dennis R. Wraase

No, we made the filing because we do believe we can do it outside of a rate case proceeding.

Daniel Eggers – Credit Suisse

The PES I think at your analyst day I you guys talked about PES earnings kind of down to about half of what it was last year, does that still seem accurate or on track after the first quarter?

Dennis R. Wraase

That's still our view.

Daniel Eggers – Credit Suisse

And then on, yes, I guess kind of Connectiv with the generation being displaced, with the coal plants being displaced, is that continuing to occur in the market today and have you guys seen any signs of a kind of better fuel switching opportunity since first quarter?

Gary Morsches

No, Dan, the fuel switching displacement of coal is still going on today in PJM and we've seen depressed prices and a real lack of volatility, not only across power, but across all of the spot contracts, coal and gas, which does mitigate you might say of the opportunity that we have around fuel switching and optimization.

Daniel Eggers – Credit Suisse

So with losing the coal plant and the contributions to the coal plants is more meaningful than the take up you have from the gas plants because they're more economical on a low gas price environment?

Gary Morsches

Well, typically the coal plants do provide a much nicer dark spread you might say but with where the compression across the entire BTU complex be it coal or gas has eliminated the advantage. In fact we've actually seen our gas plants being dispatched a little bit more because of the operating flexibility they bring to PJM.

Unfortunately we have not seen volatility in the hourly prices around PJM, so although we and other folks like us with combined cycle plants are dispatching more, the margins are just not there right now. We do expect to see that change when we get some real weather. We are in the midst of the [shorter] period right now.

Daniel Eggers – Credit Suisse

I guess when you think about the spring time does that mean that probably we're going to see most of the second quarter generally seeing dynamics like the first quarter, since we won't get any weather until probably mid-June?

Joseph Rigby

Well, I can't predict the weather or anything like that, but if you recall actually last June was a decent month for us. We did see some volatility, and you've got to remember too, it's not just overall demand from weather, but it's also where supply is, and it depends on outage schedules and things of that nature which can impart volatility in the hourly occurring prices.

Daniel Eggers – Credit Suisse

What would – you think about going to the lower end of the guidance range for this year, at what point in time or what conditions would you need to see to have that go below the low end of the current year guidance?

Dennis R. Wraase

Well, let me just make the comment, we indicated it's below the mid-point, just to clarify that, and Gary if you want to comment on the second part of the question.

Gary Morsches

Right, again remember, Dan, our fleet is mid [merit] mid [merit] past that fleet and we are very physical in nature. We are dispatching our plants into the volatile market. We capture margin by doing that, through fuel switching, through the volatility of power prices. We depend on volatility. We depend on higher prices, hot weather imparting those prices and things of that nature.

If we have no weather, if we have no volatility, if we don't see improvement in prices it's going to be a more difficult year for us, but that's not what we expect.

Dennis R. Wraase

But Dan, one we still expect to be in the range, and obviously we still have the summer ahead of us, so I think in many ways the story is yet to be told.

Operator

Our next question will come from the line of Steve Fleishman – Catapult.

Steve Fleishman – Catapult

Just I guess you just did clarify. You're saying just on the Connectiv below the midpoint for the year, not below end, is that correct?

Dennis R. Wraase

That is correct.

Steve Fleishman – Catapult

Okay, and then, on the pension deferrals, you did not when you gave the pension increase for 2009, you were not including the deferrals in there or were you including them in there?

Dennis R. Wraase

No, we reflected when we commented about pension, we did not show any positive impact debt if you will related to the deferrals, so you got the full P&L impact of that.

Steve Fleishman – Catapult

Okay, and just I didn't get to see your filings yet, but would you just seek deferral from whenever it's approved or seek deferral going back to the beginning of the year?

Dennis R. Wraase

It would be for the calendar year, Steve.

Steve Fleishman – Catapult

Okay, so it would be potentially somewhat retroactive.

Dennis R. Wraase

Through January 1, yes.

Operator

Our next question will come from the line of Andrew Levy – Incremental Capital.

Andrew Levy – Incremental Capital

Just take us in light of where your earnings may be this year and depending on prices obviously where it may be next year, seems that your payout ratio is rising so I'm sure you anticipate this question, but could you just talk about the safety of the dividend and what you're thinking.

Joseph Rigby

Our thinking hasn't changed since the analyst conference. We are committed to maintaining dividends so I can't be any more clear than that.

Andrew Levy – Incremental Capital

Thank you. Well, actually you know what, when you say committed, at what point do you have to start looking at it as far as whether it's sustainable or not, what are some of the criteria that we need to kind of focus on?

Joseph Rigby

Well, let me – okay well, committed means committed in my mind, but it's important to note that we see this as a really important component of our value proposition. And as we think over the longer haul we think it's very reasonable that we're going to have constructive outcomes, and that the outcome on our rate, the impact on our ratio when the utility earnings is going to give us the confidence that we have to be able to maintain the dividend.

Andrew Levy – Incremental Capital

So it sounds like to me, assuming you get fair treatment in your states you should be able to maintain the dividend?

Joseph Rigby

That's always been our perspective.

Andrew Levy – Incremental Capital

And obviously power prices going up and all that stuff.

Operator

(Operator Instructions) Your next question comes from Dan Jenkins – State of Wisconsin Investment Board.

Dan Jenkins – State of Wisconsin Investment Board

First thing I was wondering is on this arranged credit intermediation arrangement with the investment bank, I mean just say you got approximate $294 million of collateral returned. But then when I look at the cash flow statement it says, cash collateral rated derivative activities is a big negative. Is that included in there or how is that reflected on statements, the cash flow statements?

Paul Barry

I think probably it's the balance is attributable to the letters of credit which explains that versus the cash flow.

Dan Jenkins – State of Wisconsin Investment Board

Say that again it's –

Paul Barry

We had some returns of letters of credit which was not necessarily cash so that would not impact the cash flow statement. But letters of credit is still credit capacity and improves our liquidity position.

Dan Jenkins – State of Wisconsin Investment Board

I was curious on the pension proposal, given that you're filing rate increases or rate cases anyway, why do you have the separate action? Like what's the benefit of the separate action as opposed to just pursuing the same thing?

Daniel Wraase

We're looking to have relief in advance of the cases. At this point given the case we filed for Delmarva in Maryland which we do expect to get resolved this year, the other cases would not be impactful to us until the following year. And it's a significant issue for us so, and we believe it's a fair approach so we're going to proceed as we file.

Dan Jenkins – State of Wisconsin Investment Board

Sounds like you've already filed in Maryland and then you plan later this month in D.C. What's the timeframe for the other two cases?

Daniel Wraase

Just the latter part of the year, the latter half of the year.

Dan Jenkins – State of Wisconsin Investment Board

And then you mentioned Indiana's proposal in New Jersey related to CapEx and then in Maryland related to the transmission line, I was just wondering how does that change your CapEx budgets for '09 and 2010?

Joseph Rigby

Well the impact in 2009 is obviously very de minimus because it's only $13 million for Jersey at which point – and just also recall that we begin to collect on that via surcharge on June 1 with the return. So it really is somewhat of a non-event from a cash point of view.

Dan Jenkins – State of Wisconsin Investment Board

Then on pensions will you have to do any funding this year related to the pension plans?

Joseph Rigby

Right we expect to fund approximately $300 million and we've already done $100 million to date this year.

Operator

(Operator Instructions) Your final question comes from Paul Patterson – Glenrock Associates.

Paul Patterson – Glenrock Associates

Just a quick follow-up, there's been no change in your need for equity outlook for this year. You guys don't expect that. Is that still the case?

Joseph M. Rigby

That is still the case. Do we have any more questions, operator?

Operator

Ladies and gentlemen, this concludes the question and answer portion of today's conference. I will turn the call back to Mr. Rigby for any closing remarks. Sir?

Joseph M. Rigby

Thank you all for joining us and for your interest in PHI, and we'll be looking forward to speaking with you again soon. And I hope everyone has a good day. Thank you.

Operator

Thank you, sir. And thank you for your participation in today's conference. You may now disconnect.

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