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Wisconsin Energy Corporation (NYSE:WEC)

Q2 2009 Earnings Call

July 30, 2009 2:00 pm ET

Executives

Gale E. Klappa - CEO

Allen L. Leverett - CFO

Analysts

Greg Gordon - Morgan Stanley

Paul Ridzon - Keybanc Capital Markets

Jay Dobson - Wunderlich Securities

Steve Gambuza - Longbow Capital

Neil Kalton - Wells Fargo Securities

Michael Lapides - Goldman Sachs

Operator

Good afternoon. Thank you for holding, ladies and gentlemen, and welcome to Wisconsin Energy's conference call to review our second quarter 2009 results. (Operator Instructions)

Before the conference call begins I will read the forward-looking language:

All statements in this presentation other than historical facts are forward-looking statements that involve risks and uncertainties which are subject to change at any time. Such statements are based on management's expectations at the time they are made. In addition to the assumptions and other factors referred to in connection with the statements, factors described in the company's latest Form 10-K and subsequent reports filed with the Securities and Exchange Commission could cause actual results to differ materially from those contemplated.

During the discussion, reference to earnings per share will be based on diluted earnings per share unless otherwise noted.

After the presentation the conference will be open to analysts for questions and answers.

In conjunction with this call Wisconsin Energy has posted on its website a package of detailed financial information on its' 2009 second quarter results at www.WisconsinEnergy.com.

A replay of our remarks will be available approximately two hours after the conclusion of this call.

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

Gale Klappa

Thank you and good afternoon, everyone. Thank you for joining us on our conference call to review the company's second quarter results.

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

Allen will of course review our financial results in detail in just a moment, but as you saw from our news release this morning, we reported earnings from continuing operations of $0.54 a share for the second quarter of 2009. This compares with $0.49 a share for the same period in 2008.

Now I'd like to spend just a moment on our continuing effort to upgrade the energy infrastructure in Wisconsin. Our power of the future plan is fundamental to the principle of energy self-sufficiency. Key components of our focus on self-sufficiency include investing in two combined cycle gas-fired units at Port Washington, north of Milwaukee, the construction of two supercritical pulverized coal units at Oak Creek, which is south of the city, and building a significant amount of renewable generation.

As we've discussed on previous calls, both units at Port Washington are in service. Construction was completed on time and on budget. The units are among the most efficient in the Midwest market and our customers are now benefiting from the low price of natural gas that fuels these units.

Let's turn now to the status of the two new coal-fired units at Oak Creek. Based on Bechtel's revised schedule, Unit 1 and the common facilities are now more than 97% complete and Unit 2 is approximately 62% complete. I'm pleased to report that we reached a major milestone at Oak Creek on July 23 when the main Unit 1 boiler was fired successfully for the first time using natural gas. This milestone, of course, can only be accomplished after the essential plant systems are built and the instrumentation and controls are in place.

Looking forward at Oak Creek, the critical activities from now to the commercial operation of Unit 1 include blowing steam through the boiler tubes and piping to clean them of all scale and construction debris. These steam blows are scheduled to begin as early as today. After the steam blows are complete the unit will be fired on coal and the generator will be synchronized to the grid. Bechtel will then tune and test the plant up to full load before beginning a series of required performance tests. The performance tests include a 15-day reliability run.

Bechtel continues to target the commercial operation of Unit 1 by the end of December this year. The first fire milestone occurred approximately five and a half weeks later than Bechtel's target schedule; however, Bechtel has developed a plan that if successful would recover that time by making up one week of the schedule between now and first fire on coal and then making up the remainder of the time during fine-tuning and testing. Bechtel also continues to target commercial operation of Unit 2 by the end of August 2010.

Now, as you know, Bechtel filed a formal claim last December seeking relief under the contract. Bechtel cited a number of factors, including weather conditions in the winters of 2006 and 2007, heavy rains in the spring of 2008, and what Bechtel believes to be changes in local labor conditions. The claims for schedule and cost relief related to these factors total $413 million.

Bechtel also stated its belief that the weather events constitute a force majeure.

Now, we simply don't believe there is a contractual basis for some of the claims that Bechtel has submitted. For example, we disagree that Bechtel is entitled to cost or schedule relief as a result of alleged changes in the labor market. Further, we do not believe that Bechtel has complied with the contractual requirements for filing the claims.

Bechtel also filed a $72 million claim for the alleged affects of changes and delays prior to the issuance of the full notice to proceed back in July of 2005. We believe this claim is without merit and that Bechtel was fully compensated for any and all impacts of the delayed start.

Finally, Bechtel has asked for six months' of relief from liquidated damages beyond the September 29, 2009 guaranteed date for Unit 1 and three months' of relief from liquidated damages beyond the September 29, 2010 guaranteed date for Unit 2.

As we've mentioned to you in the past, we expect the claims to be resolved through the contract's formal dispute resolution process. We were unable to resolve our differences with Bechtel in non-binding mediation, so we recently initiated binding arbitration, which is the final stage of the dispute process. The arbitration is likely to be completed some time in 2010.

As we assess these developments, I believe there are several key points to keep in mind. First, we are still recovering carrying costs associated with the construction of these units under the terms of the lease agreements between Wisconsin Electric and We Power. We are recovering, based on a mix of debt and equity, our capital carrying costs as construction continues on the Oak Creek project. We're allowed to recover our carrying costs up to the total budget for the project that has been approved by the Wisconsin Commission, so we believe our ability to recover cash carry costs should be largely unaffected by a slight change in the construction schedule.

I would also like to reiterate an important point about the ultimate recovery of any potential cost increases. We believe we have several layers of protection for recovery of our costs.

To conclude, for example, that an additional cost is not ultimately recoverable you would have to believe that the cost will not qualify for recovery under at least four opportunities - first, that any remaining contingency in the project is not sufficient to offset the cost; second, that the cost would fall outside the 5% ban that the Commission has deemed reasonable for prudent costs above the approved amount for the project; third, that the cost was not caused by a force majeure event as defined by the lease agreements; and finally, after an opportunity to demonstrate prudency, that the cost would be ultimately deemed imprudent.

One more important point before we move on. Liquidated damage payments will be due from Bechtel on Unit 1 unless it is determined that any days granted for schedule relief are equal to or exceed the delay in the schedule. Of course, as we move forward we'll provide you with updates on any major developments to our SEC filings and on our scheduled calls.

Now turning to renewables, the State of Wisconsin has a renewable portfolio standard that increases from 5% in 2010 to 10% in 2015 at a statewide level. The standard sets targets for each of Wisconsin's utilities using an historical baseline. Using that baseline, approximately 8.5% of our retail electricity sales must come from renewable sources in the year 2015. Meeting that aggressive 2015 target will require a mix of additional projects and short-term purchased power agreements.

Of course, with the completion of our Blue Sky Green Field Wind Farm last year, we took a major step toward meeting Wisconsin's goal to reduce its carbon footprint. With a total of 88 turbines, each with the capacity of 1.65 megawatts, Blue Sky Green Field is the largest wind farm to date in Wisconsin. It was completed under budget and ahead of schedule.

Last summer as you might recall we also completed the purchase from FPL Energy of a new wind farm development site in East Central Wisconsin. This site is called the Glacier Hills Wind Park. In October of 2008 we filed for approval to build on the site and our application was deemed complete in January of this year. That started a 360-day review process by the Wisconsin Public Service Commission.

In May we also announced a conditional agreement with Vestas Wind Systems for turbines capable of producing approximately 162 megawatts at an attractive price. Then just a few days ago the Wisconsin Commission issued a draft environmental impact statement for the project. Public hearings are now expected to be held in late October or early November of this year, and a final decision by the Commission on our request for a Certificate of Public Convenience and Necessity should be made in January of 2010. Assuming Commission approval, the first full year of operation for Glacier Hills is expected to be 2012.

We're also developing proposals to build between 50 and 100 megawatts of new biomass generation. We're fortunate to be close to significant forest lands that can be harvested in a sustainable manner and are producing large amounts of wood waste which we can purchase to fuel these plants. As compared to wind, the benefit from an operational standpoint of biomass generation is that we can dispatch these plants. We're now in the final stage of completing our feasibility review and I expect we will make an announcement regarding our biomass plans in the very near future.

Construction is also under way on a major upgrade of the air quality controls at the existing coal-fired units at Oak Creek. We expect the cost of this new environmental facility will be $960 million. That includes allowance for funds used during construction for the installation of wet flue gas to sulphurisation and selective catalytic reduction facilities. These controls are scheduled to be completed in 2012.

Turning now to the rate reviews that we have under way, on March 13 we filed a general rate case on our normal cycle for our Wisconsin Energy and Wisconsin Gas utilities. The filing included a request for a $76 million or 2.8% increase to support electric operations, a $39 million or 4.6% increase for Wisconsin Gas operations, a $22 million or 3.6% increase for Wisconsin Energy gas operations, and a $2.7 million increase for our two steam utilities.

Since we filed the case in March our forecasted electric sales for the 2010 test year have declined. To reflect this updated data we filed supplemental testimony in early July that increased our request from $76 million to $126 million. So the previous rate increase request of 2.8% for our retail Wisconsin customers has now risen to 3.9%. This new amount also reflects an increase in available Point Beach bill credits in light of lower sales expectations. We did not change our requests for our gas or our steam utilities.

A schedule was set by the Commission for the case at a prehearing conference on June 25. The next milestone will be the filing of direct testimony by Commission staff and interveners, and that is due on September 3rd. Technical and public hearings are likely to be held in the fall and we expect new rates will be in effect in January of 2010.

We also filed this month for an electric rate increase of $42 million in Wisconsin Electric's Michigan jurisdiction. This request is driven primarily by the need to recover our investment and our operational costs associated with the new Oak Creek units.

We're proposing to implement this request in three phases. The first phase is for approximately $22 million and primarily reflects the commercial operation of the first Oak Creek unit. This increase would be expected to occur in conjunction with the commercial operation of Unit 1. The second phase would occur when the Michigan Commission issues its decision for the 2010 test year. That is anticipated to be in July of 2010. Assuming our request is approved, this amounts to an additional $16 million. Finally, if our request is approved when the second Oak Creek unit enters commercial service, the final amount - approximately $4 million - would become effective. In Michigan, of course, any amounts that we would self-implement are subject to refund with interest at the cost of equity.

The Michigan Commission has not yet set a schedule for hearing our requests, but under Michigan law the Commission must act within a year of the filing or the rates would become effective as filed.

And now I'll turn the call over to Allen, who'll give you more details on our financial performance for the second quarter. Allen?

Allen L. Leverett

Thank you, Gale.

Now, as Gale mentioned earlier, our second quarter 2009 earnings from continuing operations were $0.54 per share. I'll focus on operating income by segment and then touch on other income statement items. I will also discuss cash flows for the first six months and discuss our earnings guidance for 2009.

Our consolidated operating income was $119 million as compared to $108 million in the second quarter of 2008, for an increase of $11 million. Operating income in our Utility Energy segment totaled $90 million, which is comparable with the second quarter of 2008.

On the positive side, we had a $10 million reversal of a charge that we took in the first quarter related to revenue sufficiency guarantee credits from MISO, which I will expand upon later.

Our utility non-fuel O&M costs are $12 million lower than last year in the second quarter as we took action in response to economic conditions. These actions included a hiring freeze.

In addition, while we experienced an unseasonably cool June, it was closer to normal than last year. More favorable weather resulted in a $4 million increase in operating income as compared to the prior year.

We also had fuel recoveries that were $2 million better than in 2008.

Partially offsetting these factors was a $23 million decline attributable to lower retail sales as a result of the downturn in the economy.

Our utility depreciation expense is $4 million higher as a result of higher plant balances.

When we net all other factors together, we come to flat utility operating income as compared to the second quarter of 2008.

Now I wanted to briefly discuss the $10 million reversal of the first quarter charge related to MISO credits. In the first quarter we told you that we took a $10 million charge because the Wisconsin Commission had ordered us to refund $10 million of MISO-related credits that we hoped to receive later this year. At that time we expected to be neutral for the year if the credits came through; however, because of the uncertainty associated with the credits, our policy is to recognize them only when they are received.

In May the FERC issued rulings that significantly reduced the amount of MISO credits that we were to receive. As a result of the FERC rulings we requested the deferral letter that would allow us to recover from customers any refunds that we gave them that were not ultimately covered by credits from MISO. The Wisconsin Commission granted the deferral and based on this we were able to reverse the first quarter charge.

In summary, on the first quarter conference call we told you that we expected the first quarter charge to reverse by the end of the year as the MISO credits were received. Now, with the deferral, the charge was reversed at the end of the second quarter.

As expected, our non-utility operating income was up $11 million. The key drivers of this increase relate to a full quarter's earnings contribution from Unit 2 at Port Washington, which was placed into service in late May of 2008, and the water intake system at Oak Creek that was placed into service in January of this year. We do not expect to see this large of an increase in the third and fourth quarters as the earnings from Unit 2 at Port Washington will be comparable for these quarters.

Corporate and other affiliates had an operating loss of $2 million in 2009 and in 2008. Taking the changes for each of these segments together brings you back to the $11 million increase in operating income for this quarter.

During the second quarter of 2009 earnings from our investment in the American Transmission Company increased $2 million and all other income was relatively level.

Interest expense increased $5 million because of interest expense associated with Unit 2 at Port Washington as well as additional long-term debt issued during the fourth quarter of 2008.

Consolidated income tax expense increased by approximately $2 million, primarily because of higher pre-tax earnings. I expect that our annual effective tax rate in 2009 will be approximately 37%.

Combining all of these items brings you to $64 million of net income from continuing operations for the second quarter of 2009 or earnings of $0.54 per share.

During the first six months of 2009 we generated $232 million of cash from operations on a GAAP basis, which is down $341 million from the same period in 2008. While our cash earnings were up, there were two large factors that reduced our cash from operations.

First, we contributed $289 million to our benefit plans in January of 2009, of which $270 million went to fund our pension plan. In the first six months of last year our contributions to benefit plans totaled $48 million.

The second factor which reduced cash from operations related to working capital items primarily associated with inventory balances.

On an adjusted basis, our cash from operations totaled $335 million as compared to $728 million in the first six months of 2008. The adjusted number includes $103 million of cash impact from the bill credits in 2009 and $154 million in 2008. Under GAAP, the cash from the bill credits is reflected in the change in restricted cash, which GAAP defines as an investing activity. From a management standpoint we consider this a source of cash as it relates directly to the bill credits and the one-time amortization.

Our total capital expenditures were approximately $365 million in the first six months of 2009, which is down from $642 million in the first six months of 2008. On an annual basis, we expect our capital expenditures to be about $275 million lower than 2008 capital expenditures as we move closer to the completion of our power of the future construction program.

On a GAAP basis, our debt-to-capital ratio was 58.2% as of June 30, and we were at 55.2% on an adjusted basis. This is essentially flat compared to our December 31, 2008 levels, even when considering the $289 million contribution to our benefit plans in January of this year. I would expect our debt-to-capital ratio to increase slightly by the end of this year as compared to last year. Our goal is to maintain our adjusted debt-to-capital ratio at no more than 60% during the period we are constructing our new coal-fired generation.

We're using cash to satisfy any shares required for our 401(k) plan, options and other programs. Going forward, we do not expect to issue any additional shares.

In the second quarter we continued to see the economic recession impact our electric sales. Generally, our service territory has a well-diversified industrial and commercial mix that helps mitigate the impact of economic downturns; however, in this economy we are seeing four sectors dramatically affected. They include iron ore minor, paper production, primary metals and the automotive part sector.

Our electricity sales to large commercial and industrial customers dropped by 21.8% in the second quarter as compared to the second quarter of 2008. Excluding sales to our largest customer, the iron ore mines, our large commercial and industrial sales were down 16.2%. Electricity used by small commercial and industrial customers declined by 5.4%. Consumption of electricity by residential customers was up 0.2%.

Over the past several weeks we have seen strong anecdotal evidence that industrial production and economic output are stabilizing. Several sectors have held up well in this economic downturn. The health care and food products segments have remained constant in their energy usage when compared to last year, and most of the other segments have leveled out after a double-digit drop in sales.

During our first quarter call we provided new guidance on our electric sales forecast for 2009. I would like to comment on where we see our annual sales in light of the second quarter results. Our second quarter sales came in slightly lower than our May forecast. On a weather-normalized basis, retail sales came in about 11% less than the second quarter of 2008. We had expected a 9% decline. The majority of the decline came from the large commercial and industrial class, which had a decline of 22% versus a forecasted decline of 16%.

Taking into account the results of the second quarter, we are adjusting our overall annual sales outlook slightly. Our previous outlook for electric sales called for an 8.1% decline in kilowatt hour sales in 2009 as compared to 2008. We now estimate the decline will be approximately 8.5%. However, based on what we've seen in the detailed sales mix by customer class, we are not changing our gross margin or our annual earnings estimates.

Our earnings guidance for 2009 remains in the range of $3.05 to $3.15 per share. Our first six months came in stronger than we expected because of cold winter weather, favorable fuel collections, and cost reductions across every segment of our business. As we mentioned in the first quarter call, we expect the favorable fuel collections to partially reverse in the second half of the year; however, I still expect that we will be in a positive fuel recovery position of approximately $20 million for calendar year 2009.

In addition temperatures in July have been well below normal and cooling demand has been low. Our current forecast for earnings in the third quarter is $0.46 to $0.51 per share. This projection is below our earnings in the third quarter of 2008 largely because of the timing of electric fuel cost recovery as compared to last year as well as the cool July weather.

So with that I'll turn things back over to Gale.

Gale Klappa

Allen, thank you very much.

I would just like to add - before we open up for questions I'd like to add some additional perspective on the downturn in industrial energy use across our region.

The numbers clearly show weak production levels and there has been a significant loss of manufacturing jobs throughout our service area; however, the overall unemployment rate in Wisconsin remains better than the national average at 9.2%, and while many manufacturers have eliminated second and third shift operations and all weekend work, we are not experiencing a significant number of new plant closures. As Allen said a bit earlier, we've seen over the past few weeks strong anecdotal evidence that energy demand from our large commercial and industrial customers is stabilizing.

On another positive note, a modest amount of customer growth is continuing in our region. At the end of June we were serving nearly 3,400 more electric customers and approximately 2,300 more natural gas customers than a year ago. Overall we're on track and focused on delivering value for our customers and our stockholders.

Question-and-Answer Session

Operator

And now we would like to take your questions. (Operator Instructions)

Your first question comes from Greg Gordon - Morgan Stanley.

Greg Gordon - Morgan Stanley

You've made the update to the rate case based on what you're seeing in terms of the evolving expectations for electricity demand. Is that the only adjustment you'll be able to make? I know you said you think you're seeing a stabilization of demand, but if you were to see a significant change in demand between now and, let's say, November and December, would you be able to make another adjustment or would it be too late in the rate case cycle?

Gale Klappa

Greg, very good question. Essentially the way the process works in Wisconsin is up until the time that we filed additional direct testimony we had a window to update our data and we were able to do that. Pretty much now, as we work our way between today and the decision by the Commission, the sales data and the sales forecast is about locked in.

What we will, though, have an opportunity to update is fuel. But the historic practice of the Wisconsin Commission is to take a look at the November strip for natural gas, for example, and update the fuel forecast numbers very late in the process so that they have a pretty good up-to-date look at what our fuel costs are going to be before the final decision.

So no additional update, we would not expect at all, on the sales forecast, but we would expect very updated and current fuel numbers to factor into the decision in December.

Greg Gordon - Morgan Stanley

And in the interim really your earnings power at the utility on an ongoing basis, I'm presuming, will be predicated on, one, economic conditions hopefully being comparable to what's in the filing and you getting consistent rate-making treatment, but in the short run is it fair to say that, to summarize what you've said on the call, anyway, you're offsetting the softness of sales partly through the benefit of how steeply fuel has dropped and the way your fuel adjustment clause works and partly through temporary cost reductions?

Gale Klappa

Correct. You're absolutely right, Greg. In the near term probably the single biggest impact on our earnings will be the weather.

Greg Gordon - Morgan Stanley

When I look at your CapEx budget, the last time I checked you gave a forecast out through 2011. There's a little over $400 million in there for renewables. Which projects does that include? Does that include a placeholder for any of these biomass or not-yet-announced additions that you need to meet that mandate?

Allen L. Leverett

Well, the expenditures that we had certainly for 2009, 2010, 2011, that would be more related to wind projects, primarily to Glacier Hills, so that would just be wind projects. Longer term, as Gale talked about with biomass, there certainly could be expenditures past 2011 for biomass, but in that three-year outlook from '09 to '11 we didn't include any capital expenditures for biomass.

Greg Gordon - Morgan Stanley

So any incremental renewable projects that you enter into to meet your mandate above and beyond what you've explicitly announced would be additional CapEx? I just wanted to make sure there wasn't some amount in that '11 number that was sort of notional for future projects.

Allen L. Leverett

I don't view any of the '09 to '11 numbers as notional; however, as Gale talked about, we're still in the midst of the approval process with the Commission, so although we expect a good result there, we haven't brought that to completion yet.

Greg Gordon - Morgan Stanley

The environmental spending is for the Oak Creek project, for which the last year is '12?

Gale Klappa

That is correct. And all of the environmental spend that you see or virtually 100% of the environmental spend you see in the breakdown of our capital projections is for this huge environmental upgrade at the existing Oak Creek units.

Operator

Your next question comes from Paul Ridzon - Keybanc Capital Markets.

Paul Ridzon - Keybanc Capital Markets

The $11 million from the construction projects, can you break that out between Port Washington and the water intake?

Allen L. Leverett

Sure. The $11 million I would say that roughly - well, let me talk about it in terms of maybe the first half. I think $16 million in the first half of the year was from Port Washington No. 2, so that gives it to you for the first half. Then of the roughly $11 million within the quarter I would say that probably $1.5 million was the water system and the balance was Port Washington.

Paul Ridzon - Keybanc Capital Markets

And then what was the absolute fuel over or under recovery in the quarter?

Allen L. Leverett

Sure, let me just go through that. And maybe in terms of the quarter, the absolute for the quarter was a $4.4 million under recovery for the quarter, second quarter. And that's about, I mean, if you compare, Paul, to the second quarter of 2008, that's about a $1.5 million swing positive, meaning that we were about $5.9 million under recovered in the second quarter of 2008 and then the second quarter of this year, $4.4 million under recovered for a positive swing of $1.5 million.

Paul Ridzon - Keybanc Capital Markets

I thought we had a month of still very strong over recoveries in the quarter. How did we switch to getting negative?

Allen L. Leverett

Well, in the second quarter, you remember, we had the fuel rate refund - excuse me, the reduction in the fuel rate. And so what we're collecting now is lower than what we had in the past.

Gale Klappa

We had one, April, was a positive month; then new fuel recovery rates when into effect in very early May, so you see May and June being slightly lower.

Paul Ridzon - Keybanc Capital Markets

But you're under recovered, so did fuel move between the time you set your new rates to the time you started buying gas?

Gale Klappa

No, Paul, but remember, April is a shoulder month with very low demand, so you're not going to see huge swings in fuel one way or another in the month of April and we didn't. But now we have the lower fuel rate in effect, and I think what really Allen is telling you is that we think we will be reasonably recovered, maybe a slight slip in the second half in terms of actual fuel costs for the second half compared to fuel recovery rate. We might see a $4 slip in the second half, but we expect to be pretty close to fully recovered with a new fuel recovery rate in the second half.

Allen L. Leverett

For the year, Paul, just to be clear, so for the first half of the year we were about $24.2 million in a positive recovery situation on fuel, so that's for the first half of the year. And then as Gale mentioned, we for the second half of the year would expect to be under recovered about $4.2 million. So for the year we would expect to be in a $20 million positive recovery position on fuel.

Paul Ridzon - Keybanc Capital Markets

Can you just update us on how bad debt is tracking and remind us of recovery mechanisms?

Gale Klappa

Allen and I can both handle it. Actually, we're doing reasonably well and surprisingly well on bad debt. Essentially, arrears greater than 60 days are only about $7 million higher than a year ago and essentially we have protection for arrears greater than what is in rates, what is being collected in rates on the residential side of the business, where we can escrow essentially bad debt write-offs above what is being collected in rates for residential customers. So we're really hanging in there just fine at the moment, Paul.

Operator

(Operator Instructions) Your next question comes from Jay Dobson - Wunderlich Securities.

Jay Dobson - Wunderlich Securities

Gale or Allen, I was hoping to get a little more granularity on the O&M cuts - I think, Allen, you cited a $12 million impact in the quarter - just to understand how much if any of that is sort of ongoing. And when I think ongoing I think sort of full year '10 versus '09, and then maybe you can think about the last two quarters of this year.

Gale Klappa

Both Allen and I will give you our views.

First of all, you are correct. Our ongoing operation and maintenance expenses in the second quarter of this year were $12 million less than Q2 of a year ago. Probably the biggest driver is the hiring freeze.

We began really to take action on very specific initiatives to reduce costs even lower really in the third quarter of last year. We began to see some troubling signs in demand and with the economy, and we really started to take action, I think, quite early. So we've had a hiring freeze in place for many months now and that is the biggest single driver of the reduction in O&M.

But, Jay, we've got literally hundreds of initiatives - cost reduction, cost control initiatives - going on all across this enterprise, many of them very little things like completely re-thinking the number of copiers we need in the offices. But it just gives you an idea of the depth to which we're looking at efficiency and cost.

And I might add, if you look back for a little bit longer look, our full-time equivalent headcount is 11% lower or about 590 people lower than it was at the end of December, 2004, and that is even in view of the fact that we've added about $1.2 billion of generation-related assets that have to be managed with new people. So I'm very pleased with what we're seeing in terms of our employees focusing on costs and the results that we're seeing from cost reduction.

And then, Jay, to your question about will we continue to see some benefit from cost reduction in the second half, I think the answer is yes in large part because the initiatives we have under way will continue and so will the hiring freeze.

Allen?

Allen L. Leverett

Although - and Gale mentioned this, Jay - you remember we really started seeing the benefits of that hiring freeze in the second half of this year, so I don't think it would be appropriate to say all right, well, we started that in the second half of '08; you already had started those initiatives. So incremental I wouldn't expect to see yet again the sort of impacts that we saw in the first half of the year.

Gale Klappa

Percentages.

Allen L. Leverett

A lot of those [inaudible] in the second half.

Jay Dobson - Wunderlich Securities

Is my recollection right? I thought you had described first quarter O&M as flat, so if these initiatives were under way I'm a little confused as to why we didn't see much of it in the first quarter, now we're seeing it in the second quarter. Is there some lack of predictability to it given it's driven by a hiring freeze?

Allen L. Leverett

Yes, there's one other item related to amortizations in the rate case. There were $15 million of regulatory amortizations that we had to take in the first quarter of this year that did not occur in the first quarter of 2008, and I think that was about $15 million. So that $15 million of costs went through the income statement in the first quarter.

Gale Klappa

And it masked some of the underlying O&M savings.

Jay Dobson - Wunderlich Securities

Last question, on the Bechtel dispute, now that you've gone to binding arbitration, how transparent is that process going to be? I know we got an update last quarter, now we get one here. Will there be updates throughout that process or does now it sort of go behind closed doors and sort of pop out when we get a final decision in '10?

Gale Klappa

A very good question, Jay. Under the contract that we have with Bechtel, the binding arbitration process is supposed to be confidential. If there are any material developments, though, obviously we would announce those developments. But day-to-day back-and-forth, what schedule is being followed, that is all under confidentiality per the contract.

Jay Dobson - Wunderlich Securities

And now that you're in binding arbitration I assume settlement sort of happens if it's going to occur at the 11th hour. There's certainly no incentive for either party to sort of go to settlement prior to that.

Gale Klappa

Jay, it's very hard to make that decision or really comment on that because it really depends upon, I think, how motivated Bechtel might be as the hearing process and testimony process really unfolds.

But, again, I think we feel like we have a very strong case here.

Operator

Your next question comes from Steve Gambuza - Longbow Capital.

Steve Gambuza - Longbow Capital

Your coal and transport needs for the new coal units, have they been contracted yet or are they yet to be contracted?

Gale Klappa

For the new Oak Creek units?

Steve Gambuza - Longbow Capital

Yes.

Allen L. Leverett

We've got coal on the ground right now and we have delivery scheduled.

Gale Klappa

And rail contracts in place.

Steve Gambuza - Longbow Capital

You mentioned that you're going to have the opportunity to kind of put in a new fuel forecast for the 2010 rate year and so the numbers you quoted at the beginning of the call - a 3.9% rate increase  is that the full rate including your forecast of fuel and purchased power at the time or is that just the base rate increase?

Gale Klappa

No, that would include any fuel forecast changes, so the 3.9% across the retail group of customers is a net, basically, of base rate increases and fuel changes.

Steve Gambuza - Longbow Capital

And what was the vintage of the fuel and power forecast determining that 3.9% increase?

Gale Klappa

Well, we filed in March and I don't think we changed anything but the sales forecast with our July testimony, so that would have been early first quarter.

Steve Gambuza - Longbow Capital

I'm just curious if you were to kind of mark your open position for fuel and purchased power, to mark it based on a decline in gas prices and the big drop in power prices, if you've got any sense for what that - if you were to do that forecast today if it might be a little bit less than 3.9% or potentially flat?

Gale Klappa

I don't think it would be flat in part because we have a very big percentage of our power supply coming from coal-fired units and our purchased power agreement from Point Beach for the nuclear generation. And those costs, I mean, we have long-term coal contract costs, we have a long-term cost-specific purchased power agreement with FPL, so those costs are not subject to huge change.

The big swing, if there is a swing, would be in the portion of our generation from gas-fired generation or MISO purchases.

Steve, it's just things move around so much day-to-day and we'll just have to see as we get closer to December. But I do think it's a positive the way the Wisconsin Commission updates its fuel forecast numbers to make as accurate a decision as they can.

Steve Gambuza - Longbow Capital

Can you just remind what portion of your generation output at [WeCo] is kind of tied to gas prices?

Gale Klappa

Less than 15% in terms of just our own generation.

Steve Gambuza - Longbow Capital

So I guess it's that piece plus whatever purchased power you have that would really be moving?

Gale Klappa

Yes. And Rick is saying it will shift a lot next year as we bring the Oak Creek units on, but you're right, it's two pieces - it's our own gas-fired generation and then the affect of gas on the margin in MISO for purchased power.

Operator

Your next question comes from Neil Kalton - Wells Fargo Securities.

Neil Kalton - Wells Fargo Securities

Just a quick question on the rate case. I understand that staff testimony is due, I think, September 3rd, but have you had any indication or input as to how the recent higher revenue request has been received in the state?

Gale Klappa

We had one front-page story in the Milwaukee paper, probably a dozen customer calls, and really that's about it.

I think one of the other factors in play here is that every single Wisconsin utility has filed for a rate case this year, so the five major utilities that operate in Wisconsin all have filed for rate cases, and our 3.9% increase is at the low end of anybody's ask. I think Wisconsin Power and Light is up above 9%; some of the others are in the 5% to 7% range.

And clearly what's driving the lion's share of our request is recovery of the final stages of power of the future, and I think folks have a good understanding that we've had to invest in infrastructure that's going to serve customers here well for the next 50 years.

Neil Kalton - Wells Fargo Securities

And I guess it would be fair to say that the incrementally higher request is probably not a big surprise, right?

Gale Klappa

No. We had signaled that that was likely to happen as we got more economic data and real world experience with what the first several months of our industrial demand looked like.

But, again, if you think about what fundamentally happened, the original ask was a 2.8% increase; it went to 3.9%, so it's not like there was a huge, dramatic change.

Operator

Your next question comes from Michael Lapides - Goldman Sachs.

Michael Lapides - Goldman Sachs

Allen, can you talk about what you think your earnings sensitivity is this year for kind of like every 1% change in your demand forecast for the back half of the year?

Allen L. Leverett

Well, when you say demand, maybe if I could answer it in terms of energy rather than demand, I would guess that for the year if you saw a 1% change in overall sales it's probably on the order of $20 million. If you were then looking for just six months it's probably $10 million. And those numbers are margin figures, Michael, so not total revenues.

Gale Klappa

Pre-tax.

Allen L. Leverett

Yes, so pre-tax gross margin, those are, I think, reasonable numbers - rules of thumb.

Michael Lapides - Goldman Sachs

Okay, I just want to make sure I follow you. So in other words, if actuals deviate from your demand forecast for the rest of the year by 100 basis points for kilowatt hour sales, it's roughly $10 million pre-tax.

Allen L. Leverett

Yes, pre-tax gross margin, right.

Michael Lapides - Goldman Sachs

I know that a number of the other utilities in the state have filed cases. What's kind of the range of ROE and equity layer requests by some of your peers in the state versus what you've asked for?

Gale Klappa

I think, Michael, most of the companies that have filed in the state have essentially asked for the same capital structure going forward as is in place today and the same return on equity.

So, for example, we said that even though we think the cost of capital has been re-priced and risk has been re-priced - and you could make an argument that the cost of equity is higher than two years ago - we would, in light of the economic conditions, just ask for 10-7-5 is our allowed return on equity and roughly a 52% to 53% equity layer in our capital structure, again, unchanged from the prior rate decision.

Michael Lapides - Goldman Sachs

I remember - and it's been a little bit since I've looked at it - is that 52% or 53% based on your GAAP equity layer or is that based on your regulated equity layer and is GAAP likely higher or lower?

Gale Klappa

It's based on the regulated, but I'm not certain whether the GAAP is -

Allen L. Leverett

Meaning it includes some debt equivalents.

Gale Klappa

All right.

Michael Lapides - Goldman Sachs

Okay, I'll take this offline.

Operator

Well, Mr. Klappa, we have no further questions, sir, so I'll turn it back to you.

Gale Klappa

Outstanding. Well, this concludes our conference call for today, ladies and gentlemen. We appreciate you taking part. If you have any other questions, Colleen Henderson will be available in our Investor Relations office and her direct line is 414-221-2592.

Thank you again. Good day.

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Source: Wisconsin Energy Corporation Q2 2009 Earnings Call Transcript
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