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UniSource Energy Corporation (NYSE:UNS)

Q1 2010 Earnings Call Transcript

April 30, 2010 12:00 pm ET

Executives

Jo Smith – Director, IR

Paul Bonavia – Chairman, President & CEO

Kevin Larson – SVP, CFO and Treasurer

Analysts

Kevin Cole – Credit Suisse

Ryan Rosenthal – Sidoti & Company

Brian Russo – Ladenburg Thalmann

Operator

Thank you, and welcome to the UniSource Energy first quarter 2010 earnings conference call. Today's call will be hosted by Paul J. Bonavia, UniSource Energy Chairman, President, and Chief Executive Officer. All lines have been placed on mute to prevent any background noise. After the speakers remarks, there will be a question and answer session. (Operator Instructions).

Before we begin, I'd like to turn the call over to Ms. Jo Smith, Director of Investor Relations.

Jo Smith

Thank you and I'd like to thank all of you for joining us today as we review UniSource Energy's financial results for the first quarter of 2010. Joining me on the call today are Paul Bonavia, UniSource Energy's Chairman, President, and CEO, and Kevin Larson, UniSource Energy's Chief Financial Officer.

Before I turn the call over to Paul and Kevin, I would like to point out that our earnings Release and supplemental materials are available on UniSource Energy's website. Please refer to these materials for a reconciliation of non-GAAP measures. In addition it is my responsibility to advise you that the forward-looking statements made on this call are based on current expectations and may contain risks and uncertainties.

Significant factors that could cause actual events and results to differ materially from expectations are described in our earnings release, and our 10-K and 10-Q filings. All forward-looking statements are made as of today based on information available to us today and except as required by law, we assume no obligation to update any such statements. A replay of this call will be available on our website, UNS. com for the next 30 days. It will also be available by phone through May 7.

At the end of Paul and Kevin's remarks, we will open the call for Q & A, and now I'll turn the call over to Paul.

Paul Bonavia

Thank you for joining us on the call today, and thanks Jo, for the introduction. I'm pleased to report that UniSource Energy's net income for this first quarter of 2010 was $20 million or $0.52 per diluted share. By contrast in the first quarter of 2009, we reported net income of $5 million or $.14 per diluted share.

The year-over-year improvement was driven primarily by anticipated expense reductions combined with revenues related to Springerville Unit 4. The cost reductions included first a $9 million reduction in Tuscon Electric Power's O&M costs. We anticipated a decline in maintenance cost, compared with the first quarter of 2009 when we replaced a turbine at Springerville Unit 1 and environmental upgrades were made to San Juan Unit 2.

Second factor was lower depreciation rates for TEP's transmission assets as well as the purchase of Sundt Unit 4 in March of this year. Those lead to a reduction in depreciation and amortization expense of $3 million compared with the first quarter of 2009. The completion of Springerville Unit 4 in December of 2009, which is owned by Salt River Project contributed to a $4 million increase in rents and fees we received from Units 3 and 4.

We also recorded revenues of $3.6 million during the first quarter for providing temporary transmission capacity for Unit 4 while repairs were made to one of SRP Substations. TEP's total retail kilowatt hour sales were essentially unchanged, both on an actual and weather adjusted basis for the first quarter of 2000, or from the first quarter of 2009, as higher sales to residential and mining customers offset declining commercial and industrial sales. This

This the first time since the third quarter of 2008 that we did not experience a quarterly year-over-year decline in weather adjusted sales at TEP. According to economists from the University of Arizona, recent data show that the recession in Arizona came to an end as 2010 began. Statewide non-farm unemployment rates have leveled off, and retail sales are growing at a 5% annual rate.

Local economists also indicate that there will be several more months before recovery becomes fully evident, and some components will continue to decline for a few more months. We anticipate that the sluggish economy will continue to put pressure on sales to TEP's commercial and industrial customers through most of this year.

On the bright side, the housing market in the TEP area continues to improve. Data from March show home sales up 30% and new properties under contract up 76%, compared with March of 2009, and copper prices are strong as Kevin will discuss later. Although overall sales trends in the first quarter of 2010 showed some signs of improvement, we have not diverted our attention from capturing all the opportunities we can to lower costs and increase revenue.

We have carefully evaluated our O&M budgets and will take steps to make reductions as we did last year if sales fall below our forecast. Our historic O&M growth rate that has averaged 3% per year to 4% per year reflects our historic sales growth rate. In a lower growth environment, that rate is not acceptable nor is it necessary to operate our business soundly.

We are focused on effectively managing our business and meeting financial targets without compromising safety or service. We have kept a strong hand on O&M in the past, and achieve strong results. That is exactly what we intend to do now and in the future.

While we've had a good start to the year, we are maintaining our 2010 earnings guidance range of $2.75 to $3 per diluted share. With the strongest sales months still ahead of us, the range continues to reflect the uncertainties with respect to the level of energy usage that we may experience.

Turning to the regulatory front, the Arizona Corporation Commission approved an average base rate increase for UNS Gas of $3.4 million, which is below the $9.5 million we requested. The rates became effective on April 1. That's not the outcome we were hoping for, but it provides us with some rate relief while we evaluate the need for and timing of the future rate case.

UNS Electric's rate case is still pending before the ACC. We requested an average base rate increase of $13.5 million while the ACC staff recommended an increase of approximately $8 million. The hearing concluded in February, and we expect a decision by the ACC in the next several months.

Later this year, the ACC is expected to vote on the adoption of energy efficiency standards. These standards are designed to implement the achievement of cost effective demand side Management programs, a surcharge would be added to the customers bills to fund the program. If approved, the rules would be certified by the Arizona Attorney General before the standard can take effect.

The ACC is also exploring the use of decoupling as a mechanism to encourage energy efficiency efforts. We support renewable energy DSM and improved energy efficiency, and have been an active participant in the workshops held by the Commission. We are advocating a balanced effective and sustainable approach to all of those issues.

Earlier this month, the ACC approved TEP's 2010 renewable energy or RAFT implementation plan. One component of the plan includes the purchase of about 30 megawatts of solar energy under long-term agreements that also give us options to acquire those resources. With Commission approval in hand, we are moving ahead under those agreements.

Another component that the ACC considered to be appropriate is the construction of two Arizona-based solar projects totaling 3.4 megawatts that would be owned by TEP. The funding mechanism for these projects was not considered by the ACC in that proceeding, but is scheduled to be addressed at the Commissions May 13th meeting.

Our funding proposal which is supported by the ACC staff would bridge the gap between rate cases by allowing cost recovery for the proposed company-owned solar projects through the REST adjustor. Recovery of O&M, depreciation, property taxes and return on investment would be funded through the REST mechanism until these costs would be recovered as part of TEP's next rate case. We are prepared to move forward with these projects upon receipt of Commission approval.

As part of our effort to not only expand Arizona's solar economy, but to make solar energy more accessible to all our customers, TEP has proposed a Community Solar program. This innovative program would allow customers on a voluntary basis to meet some or all of their needs with solar power. Customers could claim a stake in the new 1.6-megawatt Community Solar array by signing up to purchase blocks of solar energy.

The Community Solar program would extend the benefits of solar powers to customers at utility scale prices without the upfront cost or complexities of installing their own PV systems. We expect the Commission to approve the Community Solar program in the June timeframe. These solar power initiatives are part of our plan to take Arizona's tremendous solar resource from potential to reality.

They share three characteristics First, they're doable now. They use proven technologies, usable sites in our communities and short lead times. Second, they are competitively priced for the benefit of our customers and third, they would be billed under a constructive set of rules that would enable our companies to invest capital in solar power to the benefit of consumers, shareholders, and the development of Arizona's solar economy.

Now at this point I'll turn the call over to Kevin Larson who will provide more details regarding our first quarter results, and outlook for the remainder of the year. Kevin?

Kevin Larson

Thank you, Paul, and thanks to everyone for joining us today. Let me get into a few of the key drivers for UniSource Energy's performance, and then I'll talk about our outlook for the balance of the year. If you want to follow on, please refer to page two of the slides that were posted online this morning.

On a quarter-over-quarter drivers, the $0.38 increase in diluted earnings per share is comprised of the following items

UniSource consolidated base O&M of 63 million was $9 million below last year, which contributed $.14 to the quarter-over-quarter increase. Most of the decrease was a result of $6.2 million reduction in generating plant maintenance.

As Paul mentioned, TEP had major outages at its Springerville and San Juan plants in the first quarter of last year. Other factors include lower ALJ and pension expense, compared with the first quarter of 2009. Also, Springerville Unit 3 and 4 operating synergies were $4 million higher in the first quarter of 2010 related primarily to the start of commercial operation of Springerville 4 in December of 2009.

In February, we estimated that Springerville Unit 4 would generate pretax benefits in 2010 of about $8 million. Based on changes in cost allocations, we expect the full year benefit from Springerville Unit 4 to be closer to 10 million. In total Springerville 3 and 4 contributed an incremental $.06 per diluted share to the quarter.

TEP transmissions revenues were 3.6 million higher than last year. During the first quarter, TEP provided temporary transmission service for Springerville Unit 4. This result in an increase in income of $.06 per diluted share. We also have a change on UniSource depreciation and amortization was $3 million below last year due primarily to lower transmission depreciations rates at TEP as well as the extension of lease hold improvements Sundt Unit 4. The lower depreciation and amortization benefit of earnings per share by $.05 per diluted share.

Retail gross margins across TEP, UNS Gas and UNS Electric increased by $3 million. $2.2 million of the increase came at UNS Gas and Electric as a result of cold winter weather and higher electricity used by UNS Electric's industrial and mining customers. TEP's retail gross margin increased $800,000 due to higher residential sales. In total, the higher retail gross margin contributed $0.05 per diluted share for the quarter-over-quarter improvement.

TEP's wholesale margins were also slightly above 2009 levels, and contributed approximately a penny to our diluted earnings per share. Turning to Slide 3, TEP's quarter-over-quarter total resale sales were flat as Paul mentioned.

Looking at each of the customer classes in a little more detail, residential sales were up 3.8% compared, with the first quarter of 2009. On a weather-adjusted basis, we estimate kWh sales increased by about 3%, compared to the first quarter of last year. In the first quarter of 2010, Heating degree days; Heating degrees were slightly higher than the 10 year average; however because of the timing of the cooler weather, we estimate the impact in residential sales was minimal.

January, which is a very weather sensitive month, was warmer than usual this year, while March, which is not a very weather sensitive month, was much cooler. Therefore, we don't think weather impacted Q1 sales this year. Weather did have an impact on sales in the first quarter of 2009 when Heating degree days were 20% below the 10 year average. This accounted for less than 1% of the total 3.8% increase in kWh sales.

Commercial and industrial sales decreased by 2.3% and 3.2% respectively, an indication that our local economy continues or remains sluggish. Commercial building vacancies lead to lower sales and sales to large retail stores and TEP's small industrial customers are down.

On the cost side, mining sales increased by 0.009% [ph] due to strong copper prices. In the first three months of 2010, copper prices averaged over $3.50 to a pound, compared with the $1.75 last year. Mining sales should remain strong for the balance of the year if copper prices continue to hold the current pricing. Now let me briefly cover our financing activity.

In March, we closed on the purchase of Sundt Unit 4. We paid $52 million for the equity interest in the plant and redeemed the remaining $5 million of outstanding lease debt. To help fund the transaction, TEP entered into a $30 million secured loan, secured term loan. The facility expires in September 2011, and carries an interest rate of LIBOR plus 2.

We also have various credit agreements that expire in August 2011. As I mentioned on the last call, we are working with our lead banks in monitoring the capital markets to be in the position to refinance these facilities later this year. So, since the beginning of the year we have seen bank pricing drop approximately 50 basis points and the markets continue to improve.

Regarding our outlook, we are maintaining our 2010 earnings guidance range of $2.75 to $3 per diluted share. As you know, the summer months are key drivers in terms of TEP sales volumes and ultimately the earnings performance of UniSource Energy. As we indicated when we issued 2010 guidance in February, we expect sales at TEP for the year to be in line with 2009 levels.

We still believe this is a reasonable expectation. Also keep in mind that a 1% change in TEP annual sales equates to approximately $0.08 change in earnings per share.

Regarding O&M, O&M expense for the full-year should be approximately $275 million which is about $5 million higher than last year. The increase is due primarily to higher labor costs resulting in part from new bargaining unit contract and system and regulatory compliance cost.

As Paul stated, we are closely monitoring our O&M, and are positioned to make adjustments as needed. With that I will turn it back over to Paul.

Question-and-Answer Session

Paul Bonavia

Do we have questions?

Operator

Your first question comes from the line of Dan Eggers with Credit Suisse. Your line is open.

Kevin Cole – Credit Suisse

This is actually Kevin Cole. How are you guys approaching the decoupling conversation with the ACC? Are you guys actively pursuing the per customer decoupling and what the good timeframe is for that?

Paul Bonavia

Yeah, we're trying to be active. We know from the leadership of the Commission that they are taking this very seriously and they intend to try and get to some resolution on decoupling. So, we jumped in very actively to the workshop and what we're saying is if the Commission wants to get to the level of energy efficiency reductions they are proposing, which would be a national leader in terms of the strength of the standard, then you really do have to get to a per customer decoupling to make that work. Effective energy efficiency plans have to have effective regulatory models and business models around them, so that's the tone of our comments.

Kevin Cole – Credit Suisse

Do you think this will be a 2010 event?

Paul Bonavia

I think they will get to some further action in the workshop and some resolution of that in 2010, but there will still be implementation to be done afterwards. It will come down to implementing in the next round of rate cases and they might even propose a rule at some point in the future as well to supplement what's already out there.

Kevin Cole – Credit Suisse

Okay, can you help me think through the growth opportunity for the timeframe for executing the utility scale solar project? Meaning that if the RES project or see it what like mechanisms are approved this summer. Would that give you enough time to build large scale or 25 megawatts project for 2011 timeframe?

Paul Bonavia

Yeah, the 25-megawatt project that we've got in which the Commission is already approved is a PPA. They will be moving ahead with that and I would expect we would probably start receiving power from that energy from that next year in 2011. The owned projects which total up to 3.4 megawatts are, the funding mechanism is currently pending for approval. The Commission has approved the concept of the projects. If they act on that, according to their schedule on May 13th, we'll start construction this Summer and we expect to have them in service by the end of the year. That means we would put them in our renewable energy standard compliance plan for 2011 that we file this year and we would expect to start getting our cost recovery through the rest in 2011.

Kevin Cole – Credit Suisse

Okay so that 25-megawatt plan under PPA, do you have an option to purchase at the end?

Paul Bonavia

We do. Well not at the end. We have options that kick in at different points during the 20 year contract, the first one being year 6. You have to make sure that they have been able to use the full effectiveness of the grant or the ITC, so year 6 would be the first trigger point.

Kevin Cole – Credit Suisse

Okay, and then with O&M with the $9 million reduction in the first quarter, given that it was due to major maintenance, what other major maintenance you have planned and I would guess the fourth quarter of this year in order to true up your full year estimate to the guided flat year-on-year?

Paul Bonavia

Yeah, biggest part of the plant maintenance is now behind us. First Quarter was the heavy season. The reason why that O&M will not just freeze at the $9 million reduction level is simply that some of the components of our O&M schedule are still left to come in. We had other O&M that was deferred, projects where we pushed them back a little bit, so the full $9 million benefit will reduce down over the course of the year.

Kevin Cole – Credit Suisse

Okay, thank you.

Operator

Your next question comes from the line of Ryan Rosenthal with Sidoti & Company. Your line is open.

Ryan Rosenthal – Sidoti & Company

Good afternoon, everyone.

Paul Bonavia

Hi, Ryan, how you doing?

Ryan Rosenthal – Sidoti & Company

I'm doing well, thanks. I wanted to inquire about the mining potential, in particular regarding new potential mining customers as well as the existing ones and just some additional color perhaps on what the growth opportunity is for both of them.

Paul Bonavia

Well first of all our existing mining customers are doing very well. Copper prices are high; you've seen them up in the 350s. That bodes very well for everybody. We have already seen ramp up in the Mercator Mine which is the UNS Electric service territory, and that will continue. So, those are miners that are already in service, we're seeing strong performance. As far as new activity, you know that the one that's gotten the most attention has been the proposed Rosemont Mine, a little bit Southeast of Tucson.

They are in the environmental impact statement phase and the lead agency is the U.S Forest Service, we expect them to issue a draft EIS probably in June and you've got somewhere like a year of consideration public comment out there before we see some outcome for that. The Rosemont – we're not mining experts, so we can't predict exactly how this will go. There is community opposition to be sure. There's also a lot of jobs in favorable economic impact for the project. When we hear the Rosemont Mining people make public comments or when we speak to them, they're confident that they will get their mine in service. That's the most we know but it's probably 2012 or 2013 for a timeframe.

Ryan Rosenthal – Sidoti & Company

Great and then turning to your guidance for just a moment, embedded in your guidance currently, is there a benefit from the UNS Electric rate case and can you also discuss your plans or the likely implementation timing of that rate case as well at this stage?

Paul Bonavia

Yeah, we do have an assumption about that rate case in our forecast which underlies the guidance. The Commission will probably decide that case in the second half of the year. By the time we get rates in effect, we'll probably be past a lot of the summer high consumption season. So, there is some effect from our assumption on that in this year but really next year is more strongly affected.

Ryan Rosenthal – Sidoti & Company

Okay, great, so it sounds like it could be the end of the third quarter, is kind of your expected timing at this point?

Paul Bonavia

Yeah, that sounds right.

Ryan Rosenthal – Sidoti & Company

Okay, I'll turn it over. Thanks for your time.

Paul Bonavia

Thank you.

Operator

(Operator Instructions).Your next question comes from the line of Brian Russo with Ladenburg Thalmann. Your line is open.

Brian Russo – Ladenburg Thalmann

Hello.

Paul Bonavia

Hi, Brian.

Brian Russo – Ladenburg Thalmann

Could you just quantify the capital budget for the existing renewable projects, 3 megawatts of solar, and then how can we kind of look at the trend if you get fair treatment from regulators as it looks like you will, how should we look at the ramp up of that post 2011?

Paul Bonavia

Yeah, the 3.4 megawatts would total up to about $14 million in CapEx, so again that revenue requirement that would start to kick in next year is going to be fairly modest but still meaningful. That's round one of the plan. We already have been through a subsequent RFP. We have new PPAs that we are negotiating and finalizing work on right now in order to put those in our next rest compliance filing and if we get a favorable signal for the Commission, we'll be looking to add some additional owned projects in there as well, so Brian, it is going to ramp up.

This is really – we are really in the first year of the new regime right now with the stuff that's pending and this is going to accumulate in order for us to get to the 15% renewable standard and have a little bit of margin to spare on that, we're going to start ramping up considerably and so the revenue requirement both from the PPAs and from the owned projects will accumulate. It will grow year on year.

Brian Russo – Ladenburg Thalmann

Okay, great and is there a way for you to quantify the revenues that may be lost through energy efficiency and demand side management that in the event you get some sort of decoupling, we could see some improvement there?

Paul Bonavia

Yeah, I might, I'll say this is quantifying revenues that are lost as a consequence of energy efficiency programs in particular is something that is a wonderful continuing industry for consultants and lawyers litigating it before the Commission, that which is and you put your finger on the key point, that is exactly why we think the more enlightened environmentalists and why we see decoupling as the answer because you skip over the phase of count dancing angels on the Head of A regulatory pin and you get down to effective implementation of the programs.

The near term effects of the currently proposed energy efficiency standard would be relatively modest but they build quickly and you would see that in our next rate case as additional revenue requirement. If we don't get decoupling and again the difficulty with that is you're always considering it in arrears.

Decoupling allows you to have a regime where you get on with the business of energy efficiency and get the results without that towing along that baggage of litigation over how much savings were realized or how many kilowatt hours of sales were actually lost.

Brian Russo – Ladenburg Thalmann

Okay, thanks and then also given the solid first quarter results, if the remainder of the year is just comparable to what you earned last year, it looks like you guys will be bumping up against the upper end of your 2010 guidance, and I'm just wondering what we should be looking out for maybe on the negative side for the remainder of the year that somehow gets you back down to the mid point of your guidance, or is there a bias towards the upper end of your range given the solid first quarter results?

Paul Bonavia

Well, no question, it's a strong first quarter and we feel very good about that. We're keeping the guidance range intact where it is $2.75 to $3 and the main reason, Brian, is I think gets right at what you're asking about and that is our heavy sales months are still ahead of us.

The summer late Q2 and all of Q3 makes so much difference for us that it would really be pretty mature to come out of the box and say that we had a strong first quarter, therefore we expect year-end results to be above the guidance range, but if you look at sales as they develop that's going be the biggest sensitivity factor and for TEP, a 1% change up or down in sales is about $0.08 or $0.09 a share, so that's going to be the biggest one.

Obviously, O&M is a second factor. Right now we feel very good about our O&M based on everything we know right now, we're saying $275 million of base O&M, we fully expect to achieve that, but what you and we both will be looking for are new developments. What else might happen that could affect that number later in the year, so sales in O&M are the two biggest.

Brian Russo – Ladenburg Thalmann

Okay, and one last question if you don't mind. Kevin, you mentioned earlier that it looks like borrowing costs on the refinancing of your letter of credit and revolver might be less than maybe you previously laid out in last quarters forward-looking earnings drivers, and I'm wondering, are the other earnings drivers, many of them which were negative drivers, are those still intact or are you seeing kind of relief anywhere else on the O&M side or the letters of credit look I mentioned?

Kevin Larson

Well, Brian you're certainly right. The banking market has improved and I think previously we would expect maybe our cost to go up by maybe $6 million to $8 million right now and so our costs are maybe going to go up $5 million related to the financing and again the bank market continues to improve and so maybe it will even come in less than that as we move into 2011. Other factors that are key in the out years that we talked about on the last call primarily relate to sales and again at this point, it's hard to estimate what the sales level will be in 2011 and 2012, and so it's more of a wait and see.

At this point aren't changing what our estimates were for that time period and I think the last component which is Paul has talked about thoroughly is just the O&M and again we're going to continue to monitor O&M and we have indicated that historically our O&M has increased 3% to 4% but that's based on sales increases of 2% to 3% to 4%. Obviously, we're in a different environment today, much lower sales increases and so we're closely monitoring and we'll continue to closely monitor our O&M.

Brian Russo – Ladenburg Thalmann

Great. Thank you very much.

Operator

There are no further questions at this time. I'd turn the call back over to our presenters.

Paul Bonavia

Thank you very much for joining us. We think it was a good quarter and we'll stay tuned for some more. Thanks again.

Operator

Ladies and Gentlemen, this concludes today's conference call. You may now disconnect.

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