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Southern Company (NYSE:SO)

Q2 2006 Earnings Conference Call

July 27 2006, 1:00 pm ET

Executives

David Ratcliffe - Chairman, CEO, President

Tom Fanning - CFO

Analysts

Keri St. Louis - Fidelity

Greg Gordon - Citigroup

Nathan Judge - Atlantic Equities

Leslie Rich - Columbia Management

Ashar Khan - SAC Capital

Scott Engstrom - Satellite Asset Management

Vidula Merke - Tribeca Global Management

Darin Conti - Wachovia Securities

Dan Eggers - Credit Suisse

Paul Patterson - Glenrock Associates

Shalini Mahajan - UBS

Margaret Jones - Citigroup

Jay Yannello - Pali Capital

Paul Ridzon - Keybanc

Dan Jenkins - State of Wisconsin Investment Board

Presentation

Operator

At this time I would like to welcome everyone to the Southern Company second quarter 2006 earnings conference call. (Operator Instructions) At this time, I would like to introduce and turn the call over to Mr. Ratcliffe, President, Chairman, and Chief Executive Officer. Mr. Ratcliffe, you may begin your conference.

David Ratcliffe

Good afternoon and thank all of you for joining us. Joining me today is Tom Fanning, our Chief Financial Officer.

Let me remind you that we will be making forward-looking statements today in addition to providing historical information. There are various important factors that could cause actual results to differ materially from those indicated in the forward-looking statements, including those matters discussed in our Form 10-K and other SEC filings.

As you can see from the earnings materials we released this morning, we had a very good quarter. Our businesses are performing well, and we're on track to meet our financial targets for the year. In addition to delivering solid earnings, we've also had a number of developments this quarter that we believe are very positive for the Company.

As we indicated in our last earnings call, we've announced several major transactions in our competitive generation business. We've also been working hard to reduce the ongoing uncertainty related to our syn fuels investments and have accomplished that goal.

Finally, we have some updates on regulatory actions in our retail business that while they don't impact earnings, we're very positive about these accomplishments.

At this point I will turn things over to Tom Fanning for a discussion of the financial highlights for the second quarter and our earnings guidance for the remainder of '06.

Tom Fanning

Thank you, David. Our second quarter results were consistent with our financial plan to provide regular, predictable, and sustainable performance over the long term.

We earned $0.52 a share in the second quarter of this year. This compares to $0.52 in the second quarter of 2005. Excluding our synthetic fuel investments, we earned $0.53 a share in the second quarter of this year compared to $0.49 a share in the second quarter of 2005.

For the first half of this year, our earnings are $0.87 a share. This compares to $0.95 a share for the first six months of 2005. Again, excluding our synthetic fuel investments, we earned $0.87 a share in the first six months of this year compared with $0.89 per share in the first six months of 2005.

Here's the break down of our earnings for the second quarter compared with the same period last year:

First, the negative factors. Interest expense, depreciation, and amortization, and taxes other than income taxes, reduced our earnings by a total of $0.04 a share compared to the second quarter of 2005. Non-fuel O&M, primarily higher costs related to transmission and distribution projects necessary to keep pace with customer growth, had negative impact of $0.01 a share on our earnings in the second quarter. One indication of that growth is that weather-adjusted electricity sales for residential customers grew by 3.2% for the quarter.

Our synthetic fuel investments reduced our earnings by $0.04 a share in the second quarter of 2006 compared to the same period in 2005. This $0.04 reduction includes impairment charges that we've taken in our syn fuel business. I'll cover the status of our syn fuel business and the outlook for these investments for the remainder of the year in a few minutes.

Finally, higher expenses at the parent company, primarily increased interest costs, reduced our earnings by $0.01 a share.

Turning now to the positive factors. Weather in the second quarter of this year was a positive $0.02 above normal. In addition, the second quarter of 2005 was $0.03 below normal. So these two factors contributed to a $0.05 increase in our earnings over the prior year.

Increased usage by residential customers, as well as economic growth, increased our earnings by $0.02 a share in the second quarter of this year compared with the same period in 2005.

A switch from short-term, or market-based rates, to traditional or long-term tariffs by industrial customers added $0.01 a share to our earnings in the second quarter compared to the prior period in 2005.

Our competitive generation business added $0.02 a share to our earnings. This increase represents the impact of previously announced contracts with co-ops and municipals as well as additional earnings from the Oleander facility and a one-month contribution from the DeSoto acquisition.

So in total we had $0.10 of positive items compared to the second quarter of 2005. Our estimate excluding syn fuel was $0.49 a share so we exceeded our estimate by $0.04 a share. Again, excluding syn fuel, we exceeded our estimate by $0.04 a share.

Before I discuss our earnings estimate for the third quarter, I'd like to update you on some important items that have occurred since our last call in April. Let's start with syn fuel investments.

As you know, we have investments in two entities, Carbontronics and Alabama Fuel Products that produce syn fuel and receive tax credits. The tax credits, however, are subject to phase out, decreasing their value as the price of oil increases. In fact, losses could be recognized if that phase-out reaches a certain level.

As I noted in our January call, Southern Company faced this possibility in 2006 as oil prices continued to rise. However, I also noted that we would take a conservative posture and actively manage this risk. We have, in fact, mitigated our risk as we announced last month by taking a series of actions to reduce any further negative impact that escalating oil prices could have on our synthetic fuel business.

First, Carbontronics suspended production by going to a standby or hot idle condition in May.

Second, we terminated our ownership interest in the Alabama Fuel Products partnership effective July 1. However, we will continue to receive income from services provided at this facility.

Third, we executed a series of financial hedges.

The combined effect of these actions is to significantly reduce our earnings exposure to syn fuel. We expect to report slightly positive earnings from syn fuels in 2006, including the impact of writing off our investment in the amount of $9.5 million, which we recorded in this quarter's results. Additionally, we have still preserved a substantial portion of the potential benefits in 2006 resulting from proposed legislation.

Let's now focus on our storm cost recovery. Since our first quarter earnings call in April, we have made substantial progress in the recovery of storm damage costs at Gulf Power and Mississippi Power. The Florida Public Service Commission has approved a plan to allow Gulf Power to recover retail costs for Hurricanes Dennis and Katrina of $53.5 million. Under the agreement, the storm recovery surcharge currently being collected will continue through June 2009.

Turning now to Mississippi power, the Mississippi Public Service Commission has certified the $302 million in costs from Hurricane Katrina that were submitted by the Company. We expect a timely resolution of this matter.

Our final update concerns the continued growth of our competitive generation business. Since our last call, we've announced a long-term contract with a new customer, the acquisition of two generating units, and a contract for our Franklin 3 unit.

In May, we signed a contract with Energy United, the largest electric membership cooperative in North Carolina. Under this agreement, we will serve their incremental requirements through 2010 and their full requirements from 2011 through 2025. Consequently we reached agreement with Progress Energy to acquire the Rowan generating facility in Salisbury, North Carolina. This facility consists of three simple cycle units and one combined cycle unit, totaling 925 megawatts. We expect to close on this acquisition in September.

On May 31, we closed on the acquisition of the DeSoto plant in Arcadia, Florida, from Progress Energy. The plant consist of two 160 megawatt combustion turbines and is contracted to Florida Power and Light.

Finally, earlier this month we announced an agreement to supply 621 megawatts to Progress Ventures from 2009 through 2015. The capacity for this contract will be provided from Franklin 3, a combined cycle generating unit located in eastern Alabama. As you may remember, Franklin 3 was intended to support a long-term contract to Dynegy which was subsequently terminated in May 2003. Construction work on Franklin 3 was suspended. However, our plan was to recontract the unit when market conditions improved, so we have now met that objective.

On a combined basis, these transactions represent the addition of more than 1800 megawatts of generating capacity while maintaining average coverage ratios of approximately 90% through 2010, and more than 80% through 2015.

All these new initiatives will help our competitive generation business further contribute toward filling the gap between the strong growth in our retail business and our long-term objective of 5% average growth in earnings per share. We are consistently demonstrating an ability to sign long-term contracts with financially solid credit worthy counterparties and to earn a fair return on those contracts.

Turning now to our earnings outlook for the remainder of the year, it is clear that our businesses are continuing to perform well. Until such time that we have a final outcome on syn fuel legislation, I'm going to provide an earnings range without syn fuel earnings included.

Therefore, given the continuing execution of our plan, we are still comfortable with our year end EPS range of $2.03 to $2.08 per share, excluding syn fuel. In terms of providing an estimate for the third quarter, we're projecting to earn $0.94 per share. Again, the estimate excludes any syn fuel earnings. At this point I'll turn things back over to David for his concluding remarks.

David Ratcliffe

Thank you Tom. As Tom has just outlined, our businesses are performing well as we execute our plan. I'd like to conclude the call today with an update on an important regulatory matter that recently concluded in Georgia. On June the 15th, the Georgia Public Service Commission approved a new fuel rate for Georgia Power. The order will allow the recovery of approximately $720 million of under recovered fuel costs from customers in the original Georgia Power territory over the next 35 months, and approximately $78 million from customers in the former Savannah Electric territory over the next 41 months.

The Company is now required to file for a new fuel cost recovery rate on a semi-annual basis beginning September 30. The order also establishes a merger transaction adjustment, which applies to the base rates for customers in the former Savannah Electric territory until the conclusion of the next rate case in December 2007. Amounts collected are credited to the customers in the original Georgia Power service area.

Finally, in a separate order, Georgia Power has been allowed to defer pre-construction and licensing costs for new nuclear plants in Georgia. Georgia Power expects to invest approximately $51 million in licensing and pre-construction costs to potentially build two new units near Augusta. The order does not commit Georgia Power to build and requires a prudence review of all costs before they are put into retail rates.

At this point Tom and I will be happy to take any questions you might have, and Courtney, we'll now take the first question.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Keri St. Louis - Fidelity.

Keri St. Louis - Fidelity

I had a couple questions. First, I think there were some changes to your CapEx forecast and operating cash flow forecast. Just some slight changes, maybe a little bit more financing needs?

Tom Fanning

Yes, a little bit. What that was intended to do was -- remember in the last earnings call we talked about this foreshadowing of some significant purchases associated with Rowan and DeSoto, and ultimately Franklin 3. So what we did here in this presentation was reflect those changes in the cap budget.

Essentially what you see is an incremental change associated with the purchase of Rowan, DeSoto, the continued construction now, or resumed construction of Franklin 3, and then everything else was kind of held constant. Then some other corresponding changes.

Keri St. Louis - Fidelity

Is there still a placeholder for unannounced, unregulated generation in there?

Tom Fanning

Yes.

Keri St. Louis - Fidelity

Do you know how much that?

Tom Fanning

Well, we typically think about $250 million a year as a reasonable placeholder. But that's what it is, a placeholder.

Keri St. Louis - Fidelity

Just regarding your financing, some utilities have been contemplating these hybrid issuances, and I was just curious if that is something that you've been looking at?

Tom Fanning

Yes. A line I like to use with people here at Southern, we're pretty conservative in the way we think about and just about everything we do, including capitalizing the business. Not to say that all these new ideas are flawed or anything, but there's lots of tricks in finance but there's no magic.

A lot of the hybrid securities sometimes look like deeply subordinated debt. We use our own internal risk metrics to evaluate all kinds of new ideas. So irrespective even of what the rating agencies say, we have our own point of view on these types of securities. We'll evaluate each one independently.

Keri St. Louis - Fidelity

Thank you.

Operator

Your next question comes from the line of Greg Gordon - Citigroup.

Greg Gordon - Citigroup

Thanks. Keri asked my primary question, which was on CapEx. There was obviously a fairly detailed article in The New York Times magazine recently on your nuclear ambitions. Can you give us an update on where you stand in terms of the process for moving forward on potentially building your nuclear plants? And an update on the time horizon in terms of when real capital might actually get deployed in that process?

David Ratcliffe

The plan right now would have us filing for an early site permit, hopefully next month. That's the track we're on for the Vogle 3 unit, and possibly a fourth unit. That will put us into the NRC process, totally unknown as to how long that would take, but hopefully sometime next year we would get approval on that.

We would also begin next year the certification process that we have to go through in the State of Georgia to allow the Georgia Public Service Commission to engage in a decision around how to meet base load needs for the Georgia jurisdiction in the 2015 timeframe.

Our plan would be to submit the possible nuclear addition as an alternative in that certification process. I suspect that if we are successful and the Public Service Commission actually certifies the technology at the end of 2007, and we begin more earnest detailed engineering design, I think we're in a 2008-2009 timeframe before we commit significant capital. Probably 2009.

Greg Gordon - Citigroup

Thank you very much.

Operator

Your next question comes from the line of Nathan Judge - Atlantic Equities.

Nathan Judge - Atlantic Equities

I just wanted to walk through syn fuels just a little bit more. Could you give us an update on a bill that is in Congress? What are the prospects looking like for passage of that bill? Then if oil prices were to fall in 2007, what would that represent what could happen with your syn fuel earnings in 2007?

David Ratcliffe

Well, let me start, and I'll try to deal with political situation, and Tom can speak more specifically to the financial situation. What is being attempted in Congress is some modification to how you calculate the oil price for purposes of determining tax credit. If we are successful, then that would be attached to legislation that hopefully would move most likely the pension bill. If you read the paper, depending on what time of day you read it, there's great optimism or great pessimism.

From my standpoint -- and we have a raging debate around this table on whether we think it is going to get passed -- having watched the legislative process for a long period of time, I think the fact that they are continuing to talk and have daily meetings, meaning plural, I think there's a good possibility that something gets passed. We're pretty comfortable that if something gets passed, that the rider associated with the syn fuel tax calculation would be a part of that bill. So I remain the optimist in the crowd.

Tom Fanning

Let me finish off the rest of that. Nathan, you referred to what potential economics may occur in 2007. So let's assume that in fact, there are credits available. In other words, the legislation may provide you don't have credits available, it's ended, but let's assume they are. Remember, we have two projects, and the Carbontronics project is the one where we've gone to the hot idle.

If we resume production, we could earn potentially somewhere around $25 million. Now that assumes full credit for syn fuels. We think the phase-out ranges are somewhere around $63 to $79 in 2007, so you have to adjust that number depending on wherever oil prices may be.

The other project we have, Alabama Fuel Products, we still receive fees from that. Let's assume that that continued to go for the full year and we received a full annual fee collection. That would be somewhere around $20 million. So at the outside you're talking about $45 million in '07, should people allow credits to be earned during that year.

Nathan Judge - Atlantic Equities

Great. Thank you very much for that detail. There's been a lot of talk about economic activity slowing throughout the United States. Clearly the 3.2% residential and consumer growth, organic growth that you were talking about is very robust. David, I know you're on the Federal Reserve Board of Georgia. Could you just talk generally what you're seeing throughout your region?

David Ratcliffe

I’ll start out with that 3.2% number. Again, that's indicative of continuing positive customer growth. That is people moving into the territory. It also indicates a higher usage per customer, meaning people are plugging in more stuff, whether it's plasma TV's, or new Game Boys, or whatever, we're seeing both the customer growth. The number of customers and the usage is increasing, and that's good for us and our business.

There are lots of other indicators in the southeast and the Georgia jurisdiction, the unemployment rate is below 5%, or around 4.5%, which is very low, we continue to see the housing market, while it is moderating, it still is at a very positive pace in the southeast. I think when we talk about a moderating economy, we've got to remember that we've been in a very robust economy for an extended period of time, and when people start talking about it slowing down, they're not talking about it going negative, they're talking about it slowing down but remaining positive.

So there's a lot of good news in our jurisdiction about added jobs and growth in our region. So I'm pretty bullish on us.

Nathan Judge - Atlantic Equities

Fantastic. Just lastly, there have been some changes at the FERC commission. Several new commissioners have actually been appointed and are sworn in now. If you have any broad concepts or ideas of what and how the FERC is going to act now versus perhaps compared to what has happened in the past that would be very helpful. Thank you.

David Ratcliffe

You're not asking us that question. Can somebody else on the call answer it? I think, Nathan, obviously we're excited about having three new commissioners to fill out the commission. We've just got to wait and see how that dynamic works out. I think Commissioner Kelliher is very articulate and very deliberate in his leadership of the commission and I think that will continue; I think these people will be good new members.

Nathan Judge - Atlantic Equities

Thank you very much.

David Ratcliffe

I was hoping somebody else would answer that for us.

Operator

Your next question comes from the line of Leslie Rich - Columbia Management.

Leslie Rich - Columbia Management

Hi. Tom, I wondered if you could walk through now that you have 1800 megawatts of unregulated generation, very highly contracted, if you could walk through an earnings implication. I know some of those contracts don't start until 2010 et cetera, but how should we think about the compounded annual growth rate in that business?

Tom Fanning

Compound annual growth rate -- Leslie, I'll have to get back to you. I just don't have that off the top of my head.

I'll tell what you I do have, it's kind of an interesting statistic. Long term, these transactions, taken together, because we don't like to say about each project, right? That could convey some competitive information. But taken together, and let's put in the 2011 to 2013 timeframe, along that timeframe. Remember, too, that when I say things like these, there's two pieces to every kind of every bilateral contract we do. One piece is associated with capacity, and generally speaking, our profits associated with capacity are relatively fixed over a period of time.

The second piece is associated with energy, and that's largely fuel, and some variable O&M. Remember that's just about a pass-through. We typically don't take fuel risk, and there's very small moderate upsides potentially on the energy side of these deals. So when I quote this number I'm about to give you, it's associated largely with the capacity side, which is relatively fixed over a period of time.

Taken together, Rowan, DeSoto, Franklin 3, in the kind of 2011 to 2013 timeframe just about give us a profit contribution that looks about half of Mississippi Power. It's in the $30 million to $35 million range. It's a pretty significant contributor in that timeframe and beyond.

Leslie Rich - Columbia Management

And in the period between 2007 to 2010? I know you have a target of $300 million in '07, which it looks like you'll handily beat. So if I can get any sense from you if there are pieces that layer in prior to 2011.

Tom Fanning

Well, there are. As you can see, we've got a lot of coverage in that timeframe. Yes, they're pretty well spoken for already in the plan. Let me attack it this way. Our original plan for this year called for about $285 million in profit associated with competitive gen. We're going to do a little better than that. We hope we'll hit $300 million this year, we'll see. We're doing pretty well right now. Beyond that, we really haven't set a target.

Now, know that the way we think about our competitive generation earnings contribution is that we first measure what our retail regulated business will contribute to our 5% earnings per share target. Those businesses we believe now over the next three to five years will be kind of in the 4% out of the 5% range. So therefore, we're looking for a contribution by our competitive gen to get to the 5%. That's kind of the way we're thinking about it.

So what you ought to view is that between now and say the next three to five years, we're making very good progress to filling the gap between the 4% and the 5%,. Assuming the 4%, as soon as we get continued good performance on our rate cases and a variety of things that lay in front of us, so I would just say at this point that we're looking good to preserve the 5% earnings per share target.

If you want me to put a range of numbers it would be somewhere between, I don't know, $15 million and $30 million as it ramps up over the next five years.

Leslie Rich - Columbia Management

That's what I wanted, Tom. Thank you.

Tom Fanning

Thanks, Leslie. Appreciate you calling in.

Operator

Your next question comes from the line of Ashar Khan - SAC Capital.

Ashar Khan - SAC Capital

Tom what is the comparable number without syn fuel for the third quarter of 2005?

Tom Fanning

$0.94.

Ashar Khan - SAC Capital

You're expecting earnings to be flat quarter over quarter in the third?

Tom Fanning

Well, yes, remember, though that we had really good weather in the third quarter of '05. Then we had some other kind of extraordinary things going on there. For example, we had the hurricanes go in. We had all kinds of activity. So to say it's flat from quarter to quarter, there's a lot of moving pieces in there. But on the surface, yes, we're looking for $0.94 relative to last year.

Ashar Khan - SAC Capital

Then could I just ask, on a broader scale, how are you looking at M&A versus competitive generation to increase earnings growth as part of a strategy?

Tom Fanning

Well, just like M&A broadly, we look all the time. The southeast is an interesting place to do business because, as David covered in his comments on the economy, we continue to see a robust environment down here, where the United States has had slowing the southeast has generally performed a bit better. And where we have downturns, we tend to recover a bit faster. So it's a good place to do business.

What you see around the southeast is more and more the different regions, say our own territory, Florida, coming into equilibrium from a supply and demand standpoint. That means our reserve margins now are being met, and excess capacity is being used up.

So, therefore, there's lots of opportunities, we think, in our target area. We look at all sorts of places to add resources to meet the potential growing needs of our customer bases, both from a retail standpoint and a wholesale standpoint. Remember too, as we structured these recent transactions with Energy United and then consequently with Rowan, we seek to get revenue first and get long-term contracts with creditworthy parties, where we don't take fuel risk. Then and only then do we add resources. So we'll consider acquiring things, we'll consider greenfield development, whatever makes sense.

Ashar Khan - SAC Capital

Tom, just going back, what about corporate M&A? Is that more on the back burner?

Tom Fanning

No, it's always kind of been in the same spot. It's something that we've looked at for the longest time. We continue to work. We continue to have the same goals in mind, and that is contribute to our EPS growth targets, 4% to 6% is our target, and our long-term objective is 5%.

We want it to be accretive in a short period of time. We want it to be credit neutral. We believe that Southern Company trades as much on its low risk profile as it does its attractive returns. And of course, we wanted to be consistent with our strategy. We maintain those objectives and continue to look hard. It's hard to get these deals to work and to make sense, but it's something we've looked at for a long time and we'll continue to do so.

Ashar Khan - SAC Capital

Thank you.

Operator

Your next question comes from the line of Scott Engstrom - Satellite Asset Management.

Scott Engstrom - Satellite Asset Management

A question for you on the operating side. Georgia plus Savannah had nice growth in the quarter. Alabama, Gulf, Mississippi were actually flat to downish. Anything in particular going on at Georgia or not going on? It looked to me weather was good across the service territory. Anything in particular going on there?

Tom Fanning

Well, you have a number of things. If you look at our Advantage package you will see those relationships displayed. I think what we're seeing, particularly for example in Alabama, a lot of the increase in revenues is associated with our clauses.

For example, we show a 15.1% increase in revenue. Excluding fuel that goes down to about 7.2% -- and remember also we have an Alabama purchase power clause, an eco clause for environmental spending, storms. So when you recast the revenues from that standpoint, ex all these clauses, we have a picture that looks more consistent from, say what our revenue picture is to what our net income picture is.

That's what I would say there. The other thing that we continue to see, and we've been very consistent with over a long period of time, is Southern's operating companies have a great track record of continuing to invest in our transmission and distribution systems. Certainly we've had some reasonable weather here recently. We've been able to meet those loads effectively. We always do that with the long-term interest of our customers at heart. We continue to do that.

Scott Engstrom - Satellite Asset Management

Just the delta net income had Georgia and the other net incomes being flat to down. You talk about consolidated growth rates. Is it more concentrated in Georgia and the other subs aren't participating as much, or is this just a one quarter variance where these things wash out over a year?

Tom Fanning

I don't think there's anything particular, long term going on at Georgia than there is in Alabama, for example. I would argue that a lot of it is probably O&M, is up in Alabama a bit. I know in the first quarter they spent a good bit on some fossil hydro plants, a variety of things like that. What you are seeing is probably a quarter to quarter variance in O&M.

Scott Engstrom - Satellite Asset Management

Question on the parent company expense line that you guys break out, this year a drag of 26 versus a drag of $1 million, that's year to date. Is there something changed in the run rate there? Or, again, is this quarter to quarter variances that will wash out over time?

Tom Fanning

Quarter to quarter variance, and when we say interest rates, it's really the quantum of short-term debt we're carrying, plus a small increase in the cost of debt.

Scott Engstrom - Satellite Asset Management

Then sort of related to that, and picking up on Ashar's question about third quarter '05, you had a particularly large parent company net income number there as well. So if you back that out I assume that was a little bit anomaly. Last year I think it was a $27 million drag in the quarter last year.

It looks like maybe you're saying, excluding that hit, that earnings might be down year to year, excluding the syn fuel. I assume that's due to your using normal weather this year as opposed to abnormal weather last year.

Tom Fanning

Exactly.

Scott Engstrom - Satellite Asset Management

The experience in July has been more like last year or more like normal?

Tom Fanning

Last year we had $0.03 positive weather in September. So far we've had a reasonably good July.

Scott Engstrom - Satellite Asset Management

Okay. Great. Thanks for walking through that stuff.

Tom Fanning

You bet. Thank you. Appreciate you calling in.

Operator

Your next question comes from the line of Vidula Merke - Tribeca Global Management.

Vidula Merke - Tribeca Global Management

Good afternoon. I was wondering if you can discuss a little bit about where your current thoughts are on CO2 emissions, environmental issues at this point and where you're seeing now trends going in terms of global warming, congress, that type of thing?

Also, can you talk a little bit about any activity that you may be doing in renewables or any mandates or proposals in your jurisdictions on that front?

David Ratcliffe

Let me take the last one first. We don't have any initiatives at this point around renewables from a regulatory standpoint. We have maintained an active position to investigate all of those technologies: solar, wind, biomass, for application in our service territory.

We used to have a very extensive solar program, but it never really worked very well, and we abandoned that. We continue to stay in touch with the technology. We are currently looking at, in fact, expect to receive, a report from a project that we're doing in conjunction with the Georgia Institute of Technology here in Atlanta to review the possibility of a wind generation capability off the coast of Georgia. We should have that report in the next couple of months.

We are also looking at onshore wind, although not very optimistic about having the wind velocities that would allow us to apply wind technology here. The most likely renewable source that we see right now would be some form of biomass where we would actually grow something, harvest it, and combust it either through gasification technology or just a direct combustion technology.

Still looking at those technologies, as the most promising for us, with regard to the question about climate change, obviously the rhetoric continues to grow, and the emotion around the issue of climate change continues to grow, the political debate also continues to expand.

I think that there's a growing sense in the Congress that perhaps some action needs to be taken, although there are lots of details that have to be worked out. We have taken a very clear position that we do not believe that imposition of taxes or mandates in the form of some reductions are appropriate.

Rather, what we have said is that the smartest thing that we can do for climate change not just in the United States, but globally, is to develop the technology that will allow us to produce electricity with less of a CO2 footprint.

For example, IGCC, which has about a 25% less footprint for CO2, which we are building a unit -- not just talking about it. We're building a unit in Orlando, in conjunction with Orlando Utilities of the DOE. In addition to that Future Gen, which we are actively engaged in, one of our executives actually chairs the Future Gen project, if you’ve read in the recent day or so they've announced a narrowing down to the sites that we will move forward to along with nine or ten other parties to build next-generation capability, to burn coal with little or no environmental footprint. Then in addition to that, looking at carbon capture and sequestration technologies.

Fourth, certainly not least, is moving forward with a new nuclear capability in this country. Those are the tangible things that will allow us to actually reduce carbon rather than simply imposing taxes on this economy. It will take us probably ten years to deliver that technology to the commercial marketplace, and that's the track that we are on.

We're actually investing a lot of money, not just talking about the theory, but investing a lot of money and producing the technology. We think that's the right path. Not to impose taxes and mandates and forms of reduction.

Vidula Merke - Tribeca Global Management

Thank you very much.

Tom Fanning

Thank you.

Operator

Your next question comes from Darin Conti - Wachovia Securities.

Darin Conti - Wachovia Securities

Hi, gentlemen.

Tom Fanning

Hey, Darin.

Darin Conti - Wachovia Securities

I just want to follow-up on an earlier question with regard to interest expense. I wanted to know, do you expect the trend that we've seen in Q1 and Q2 year-over-year to continue? And also, how is that baked into your guidance?

Tom Fanning

Well, I mean, up, there's two pieces to it, right? One is what level of interest rates are there, and the other piece is what's our working capital requirements? We actually feel good about our pace of recovery of unrecovered fuel balances and other working capital requirement issues. So I think we continue to make progress there. We'll just see how that evolves. But I think so far our track record has been good, our guidance certainly takes all those factors into account.

Darin Conti - Wachovia Securities

Okay. Thank you.

Tom Fanning

Sure. Thank you.

Operator

Your next question comes from the line of Dan Eggers - Credit Suisse.

Dan Eggers - Credit Suisse

Good afternoon, guys.

Tom Fanning

Hello, Dan.

Dan Eggers - Credit Suisse

Quick follow-up on Vidula's question first, on the environmental side, and thinking about ten years out for this new technology to be viable. Do you guys see this being a replace old coal plants, old equipment with entirely new over a generation's worth of time, or is this all going to be supplemental?

David Ratcliffe

I think it will be a combination of both, depending on the particular asset that you are looking at. I think what you've got do is to look at an asset and decide what do you think the useful life remaining on the asset is, to determine whether or not you would retrofit some technology versus just change out the technology at a certain point in time, and that's a very complex decision depending on the technology available and its cost obviously. But I think it will be a combination of those things.

Tom Fanning

Those are things we do all the time. We call those internal asset retirement studies and those are an ongoing effort. I will say that, especially when you look at our cost position relative to the kind of United States averages, things like that, our coal fleet is a very economically attractive portfolio of assets that our customers benefit from every day. And so we always want to keep our customers in front of us in terms of what the economic impact of any alternatives are.

David Ratcliffe

But it is a function of an annual, rigorous planning process that looks at every one of those options.

Dan Eggers - Credit Suisse

Structurally as we look at these options or develop these technologies is there long term -- obviously this is beyond any sort of modeling perspective -- but is there an acceleration of rate-based growth over time as these new technologies are introduced?

Tom Fanning

Well, let's think about that. The pace of change that you see in our CapEx budget is kind of a reasonable thing to expect over a decent period of time. That is, we're spending %1.1 billion a year on T&D. That looks like a trend that is reasonable in the long term. When you think about environmental, we're spending a little over $1 billion a year on that over the next three years. That's kind of a reasonable trend.

Of course, that one depends on what, as David has mentioned before, what future regulations may be and a whole host of variables related to the cost of labor and commodity prices and a site specific engineering requirement. So we'll just see how that evolves.

David Ratcliffe

I think Tom mentioned it, but I want to highlight it. The regulatory landscape with regard to existing technology is still very uncertain. When you look at phase 2 of the Clean Air Act and the conversations around mercury and what the actual final regulations will be there, then you go to a question of PM 3.5 and the fine particulates regulations that must involve; and there's a whole list of regulatory initiatives that are still in play and have to be finalized.

That is not a near term, short term kind of process. Those things have a long-term horizon. They have huge potential impacts on the decision-making that we just talked about in terms of do you continue to operate an asset and simply retrofit the technology? Or do you change out the technology in some fashion? That's why it has to be a part of our annual business planning to the extent we can see that future from a regulatory standpoint. And it is quite uncertain.

Tom Fanning

I will say what helps us a bit, that is there are only a few states in the United States that have environmental mechanisms within their rate structures, and certainly we have those mechanisms in place in Alabama, Mississippi, and in Florida, frankly the nature of regulation in Georgia Power allows us to contemplate during the period of the accounting orders forward spends in environmental. So we're at least benefited in that respect.

Dan Eggers - Credit Suisse

Okay. I guess one other question. With gas prices down a bit, and even year-over-year, you guys have been able to backfill a lot of earnings with wholesale sales. How are those looking this year from a comparable earnings contribution basis as we look at the third quarter?

Tom Fanning

Yes. What's interesting is, we've had weather, and we've had lower gas prices, and there's been a lot of interesting effects there. One of the things is that we have seen -- let's just talk about the second quarter, because I'll bet you it's going to be like that this third quarter coming up.

We saw demand up about 2.5 million megawatt hours, and you may know that we have had just a dearth of rainfall. So our hydro production was down 47% in the second quarter. What you saw was, we had terrific performance out of our coal fleet. In fact, when you look at our peak season equivalent forced outage rates, it's 1.3%. The fleet is running as well as it ever has.

But what's picking up more generation is gas. Our gas production is up about 2.3 million megawatt hours, about 50%. Capacity factors on our combined cycles are up from 13% to about 26%. So you're seeing a lot more demand.

Remember the way we work here at Southern is that the cheap energy goes to serve our native retail load customers first, so, therefore, because demand is up, there's less cheap energy available on the margin to meet wholesale margins in the southeast. So demand is up, bottom of stack is up also, and so therefore margins are squeezed a bit relative to last year. Data there would be $12.50 per megawatt hour relative to this quarter, this year, $9.50.

So margins are squeezed a bit. So we have some opportunities to sell. Margins are down a bit, and that's because demand is up. My view is the amount of money we are talking about on the margin is just not that much. When you think about total trading profits from opportunity sales, we're only talking about somewhere the difference between $10 million and $11 million.

Remember that the vast lion's share of our profits on competitive generation are due to long-term contracts. The relationship for that in the second quarter was 81% long-term contracts relative to 16% from what we call the trading floor. So I would argue opportunity sales kind of flattish year to year. We're making more money on the long term side. I would expect that trend to continue.

Dan Eggers - Credit Suisse

Got it. Thank you.

Operator

Your next question comes from the line of Paul Patterson - Glenrock Associates.

Paul Patterson - Glenrock Associates

Good afternoon. Most of my questions have been answered. Just really briefly, and I apologize for missing this, on the syn fuel you mentioned that you expect a bill to pass soon. I guess it's a pension bill, and that this will be included. Did I understand that correctly?

David Ratcliffe

Let me be very clear. I said I was the resident optimist in that regard. To say that I expect it to pass would be a bit of a stretch. I'm optimistic. It is [inaudible] still being made, not necessarily from a syn fuel standpoint, but just from a pension bill standpoint. But I think the fact that they continue to talk about it gives me some hope.

Paul Patterson - Glenrock Associates

When do you think we'll actually get word as to whether or not it's included in the bill or not? I think it's a conference report that comes out or something. Do you know when that will happen? If you don't, that's okay. I just was wondering if you had heard anything.

David Ratcliffe

I think we have a high degree of confidence that it will be included in the bill.

Paul Patterson - Glenrock Associates

You said it would add, you think $45 million in 2007? Is that correct? I apologize again. I got distracted. Is that correct?

Tom Fanning

Let's be clear on what we think the legislation may be. That's the first point. That is, as I understand the legislation that's being proposed right now would not provide for any tax credits in 2007 that what you're going to be able to do, instead of the reference price, the price of oil in 2005 to be used to calculate credits in 2006. In return for that you give up the credits in '07.

The question we answered before was, should credits be allowed in '07 what would be the profit picture given all the actions we have taken. At a maximum.

Paul Patterson - Glenrock Associates

I appreciate the clarification. And then finally, I just was thinking you're doing so much with respect to competitive generation in the southeast. Are there any thoughts of maybe leaving the southeast or expanding your footprint or do you just still see lots of opportunity there? Is there any limitation to that either from a market concentration perspective or just in general?

Tom Fanning

Sure. The Southern dogma has been for awhile now, the business we know, the place we know, the customers we know. We think that's worked very well with us. We think we've been able to execute that effectively. We think that the target market that we've identified, VACAR, our own territory, Florida, will continue to provide us lots of opportunity that will support all the financial objectives that we lay out for you all.

Would we consider something else? We always look, but we think right now that our current strategy fits our needs very well.

Paul Patterson - Glenrock Associates

So when you guys are looking outside the area, you don't see anything that's compelling? Because there have been several opportunities that have come up, and I mean, the pull to the southeast is so attractive to you, considering your position that what you see out there just doesn't interest you guys at all? Is that correct?

Tom Fanning

I shouldn't say it doesn't interest us at all. Again, one of the things that I think a strength of Southern is, is that we have a diversity of opinion that we draw on and have good healthy arguments among each other. Certainly there are people that would love to expand our horizons but you must know that we are conservative in our execution, and we really like to deliver results that are regular, predictable, sustainable.

So therefore, we believe right now this mantra of business we know, place we know, customers we know, the southeast, suits us quite well. Don't say never, but that's our focus for now.

Paul Patterson - Glenrock Associates

Thanks a lot, guys.

Tom Fanning

You bet.

Operator

Your next question comes from the line of Shalini Mahajan - UBS.

Shalini Mahajan - UBS

Hi. I just had one question on syn fuel earnings. Tom, you indicated that you, based on the actions that you have taken, could end up having slightly positive earnings from syn fuel this year. I was wondering if you could quantify that?

Tom Fanning

In the event -- let me give two states of nature. In the event no legislation passes, we think we've limited our downside to the point where $0.01 or so of earnings from syn fuel. In the event legislation passes, and now you step into a whole host of assumptions, so this is a highly variable estimate I'm about to give you.

But based on a host of assumptions, based on something happening relatively soon, based on an estimate of oil prices, we think we have preserved the ability to earn this year somewhere in $0.07 to $0.09 out of the $0.12 you would normally see.

Shalini Mahajan - UBS

If there was no legislation and 100% phase-out, could you quantify the losses that you might have to take?

Tom Fanning

Zero. In other words, we think we'll have about, and again, there's a little variability around here, but about $0.01 positive this year; including impairments, including everything.

Shalini Mahajan - UBS

All right. That's all, thanks.

Operator

Your next question comes from the line of Margaret Jones - Citigroup.

Margaret Jones - Citigroup

I had a follow-up question to a couple of things that I wasn't clear on. The first one, the question about nuclear construction in the future, were you saying that there might be significant expenditures in the '08, '09 timeframe?

Tom Fanning

If you want to think about it, what we just had the Georgia Public Service Commission pass before us is our best estimate of what we think we might spend in order to create the option to build two units at plant Vogtle. That's about $51 million between now and 2009.

Margaret Jones - Citigroup

The second question that I had was again on the syn fuel. The potential attachment to the pension bill. Were you explaining that that would include something for '07 as well as the numbers that you just went through for '06?

Tom Fanning

Obviously this is highly speculative, but what we understand, the proposal is, is that the legislation would provide for the reference price for oil which is used to calculate the value of syn fuel tax credits, would be set at the '05 price level, which would provide for 100% recognition of syn fuel tax credits.

David Ratcliffe

Let me stop right there just a minute. I hope you understand, if you think about what you're doing, from a Federal Government standpoint, you're giving significant tax reductions there. Now go to the rest of it.

Tom Fanning

In return for that, you would forgo the ability to earn Section 29 syn fuel credit for '07. So if the legislation passes, as I've described, there would be no net income in 2007.

Margaret Jones - Citigroup

Thank you.

David Ratcliffe

Because what the Congress is trying to do is to balance those two, and in exchange for a more favorable calculation looking backwards, they would require us to give up the potential in '07. That's how they balance.

Margaret Jones - Citigroup

Thank you.

Tom Fanning

You bet. Thanks for calling in.

Operator

Your next question comes from the line of Jay Yannello - Pali Capital.

Jay Yannello - Pali Capital

I bet you guys can't wait until you don't have to answer any more syn fuel questions.

Tom Fanning

No, man we love it, we love it.

Jay Yannello - Pali Capital

It's late here, but let me just dive in really quickly. Your fleet profile is obviously better than in many other areas of the country where rates have gone up a lot. But I'm just curious, as you pass on the higher rates can you give us a little flavor what are your residential rates going up on average, or commercial rates, and how might that impact demand going forward? What sort of usage, weather normalized usage per customer do you have in your growth forecast going forward? Just any insights on that would be helpful. Thanks.

Tom Fanning

Let's start out with a couple ways to attack that thing. We have done a lot of work on this. If you look at the pace of increase, price pressures, if you will, that we see: and that's fuel, environmental, storm recovery, and base increases necessary to meet growth, particularly in T&D, those are the price pressures we see.

Then what we try and do is evaluate strategically, how does Southern compare to the rest of the industry? That takes into account not only what price increases we actually see, but also a framework around perhaps what price increases they need to see but have been deferred in their own jurisdiction.

Taking a long-term view, we believe that our price position is actually the same or improving relative to other jurisdictions. So we feel good about that. In terms of what your question went to, elasticity of demand.

Jay Yannello - Pali Capital

Exactly.

Tom Fanning

Our view is, and, in fact, the quarter here bears it out, certainly we're doing everything we can to hold prices down here, and the 70% or so mix of energy that comes from coal and the good performance we've had out of nuclear keeps our prices down but still we've seen some fuel increases throughout our four-state region.

We still see numbers like weather adjusted residential sales this quarter over last year up 3.2%. So from an elasticity evaluation, you must say that the economy itself is supporting, at least, an increased consumption, at least on a residential level, of electricity.

When you look at demand from an industrial standpoint, just about all of our sectors look good. Automotive has been great for us, paper, primary metals, we've seen an expansion announced here at AirTran in the south, Chevron potentially at Mississippi. They have been chatting about that a bit, a growth of data centers down here. Hewlett-Packard announced a consolidation of two data centers in Atlanta. We continue to see growth.

The only place where we have seen a retraction in industrial growth really has kind of been in the kind of low end of textiles. That would be apparel manufacturing, yarn manufacturing, even in textiles we've seen some bright spots. The high-end stuff, I would say carpet has been a real bright spot, as has polymers. So from a residential standpoint, we haven't seen elasticity take effect to where consumption is starting to go down. Rather, we're seeing usage continues to go up, even in spite of the price increases.

Jay Yannello - Pali Capital

I did note that originally in the original comments. I'm just wondering prospectively going forward, within the next year or so do you think your rates all-in will be going up 10%? 15%? 20%? Do you have any kind of ballpark figure?

The reason I'm asking it is, obviously consumers were whacked with big natural gas bills. They're now continuing to get whacked with big gasoline bills, and though clearly, in your service territory the rate increases won't be that much. In other areas they're starting to get whacked with notable increases in electricity bills.

I'm just wondering, as all this starts snowballing, I think you're in a much better competitive position. I was just trying to get a little insight. Are we talking a 10% increase within the next 10, 15 months in your area?

Tom Fanning

Gosh, I would just really be loathe to offer a guess on that one. What you ought to just think about is the rate of increase associated with environmental spending and T&D and balance that against growth. That would be the simple way I'd look at it.

Jay Yannello - Pali Capital

All right. Thank you.

Operator

Your next question comes from the line of Paul Ridzon - Keybanc.

Paul Ridzon - Keybanc

Good afternoon. Just wondering what you're thinking about with regard to whether you've put any hedges in place for 2007? Just given your view of what legislation might look like, whether that would be worth it?

Tom Fanning

We have not.

Paul Ridzon - Keybanc

Thank you.

Tom Fanning

You bet.

Operator

Your next question comes from the line of Dan Jenkins - State of Wisconsin Investment Board.

Dan Jenkins - State of Wisconsin Investment Board

I have just a few questions related to the growth in your service territory. You mentioned in your release that customers grew by 1.3% year-over-year. That's a little lower than your long-term projection of 1.8%.

Tom Fanning

Yes.

Dan Jenkins - State of Wisconsin Investment Board

I was curious -- are there differences regionally? Why is that below average? Does it have to do with the hurricane at all?

Tom Fanning

You're all over it. It is due to the hurricane. If you adjust the hurricane effect, remember, there's all kinds of interesting data around that we could cover later, if you're interested in that, the hurricane effect makes our customer growth look more like about 1.7% for the quarter year-over-year. So it's right on the money.

Dan Jenkins - State of Wisconsin Investment Board

So it would have been 1.7%.

Tom Fanning

Ex-hurricane, right.

Dan Jenkins - State of Wisconsin Investment Board

I assume that's also reflected, then, in why the Mississippi Power numbers look particularly weaker than the other regions.

Tom Fanning

That's right. We think, frankly, under the leadership of Haley Barbour, and like I said, the political structure, they have been doing a great job in creating an environment to carry that region forward. It's been a real model of success.

Dan Jenkins - State of Wisconsin Investment Board

I was curious if you could give me what the nuclear capacity factors have been so far, either in the quarter or year-to-date?

Tom Fanning

Sure can. Just a second. Here they are. Nuclear. Equipment, forced outage rate for the current quarter was around 4.3%. If I had to compare that year-to-date, 5.5%. Yes, capacity factor for the second quarter of '06 was around 88.4. We had had a refueling outage that held that down a bit, associated with Farley 1 that went from April 8, to the end of May.

Dan Jenkins - State of Wisconsin Investment Board

Was that pretty much the time of that as planned?

Tom Fanning

Yes, I think it went just a bit longer. They decided to take care of some things while they were already there, but, yes, it might have gone ten days or so, two weeks longer. Then for the rest of the year, any more outages to budget? I don't think so. Not the end of this year. I think the next outage that I'm aware of is this fall, Vogtle 1 will be out on refueling September 17, through October 26. And that's it for the rest of the year. The rest of them come in, in '07.

Dan Jenkins - State of Wisconsin Investment Board

I was just curious on the CapEx budget, numbers that you show on page 6 there, does that include the acquisition cost for these like the DeSoto acquisition?

Tom Fanning

That's exactly right.

Dan Jenkins - State of Wisconsin Investment Board

So that's included in the CapEx.

Tom Fanning

Sure is.

Dan Jenkins - State of Wisconsin Investment Board

I assume those acquisitions, is that in the competitive generation CapEx?

Tom Fanning

Yes.

Dan Jenkins - State of Wisconsin Investment Board

So would that number that you show there, the '06 through '08, primarily be front end loaded? How much of that is subsequent to '06, then, given those acquisitions?

Tom Fanning

Well, if I think about it, competitive gen is a little front end loaded. ‘06 looks like ‘07, and it goes down a bit in '08, but remember what we see in ‘07 and ‘08, and really for the balance of this years, are some placeholders. So it's all estimates.

Dan Jenkins - State of Wisconsin Investment Board

Right. Okay. That's all the questions I had had.

Tom Fanning

Thanks for calling in.

Dan Jenkins - State of Wisconsin Investment Board

Sure. Thanks.

Operator

Mr. Ratcliffe, at this time we have no further questions. You may proceed with your closing comments.

David Ratcliffe

Thanks everybody for joining us, and we appreciate the questions. We look forward to next quarter's call. Thank you very much.

Tom Fanning

Thank you.

Operator

This concludes today's Southern Company second quarter 2006 earnings conference call. At this time, you may now disconnect.

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Source: Southern Company Q2 2006 Earnings Conference Call Transcript (SO)
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