NorthWestern Corporation (NWE) CEO Bob Rowe on Q2 2014 Results - Earnings Call Transcript

Jul.26.14 | About: NorthWestern Corporation (NWE)

NorthWestern Corporation (NYSE:NWE)

Q2 2014 Earnings Conference Call

July 24, 2014 04:00 PM ET

Executives

Travis Meyer - Director of IR

Bob Rowe - President and CEO

Brian Bird - VP and CFO

Heather Grahame - VP and General Counsel

Kendall Kliewer - VP and Controller

John Hines - VP of Energy Supply

Mike Cashell - VP of Transmission

Analysts

Paul Ridzon - KeyBanc Capital Markets

Brian Russo - Ladenburg Thalmann & Company

David Arcaro - Sidoti & Company

Maury May - Wellington Shields

Paul Ridzon - KeyBanc

Operator

Good day, and welcome to the NorthWestern Corporation Second Quarter 2014 Financial Results. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Mr. Travis Meyer. Please go ahead, sir.

Travis Meyer

Thank you, Anna. Good afternoon and thank you for joining us for NorthWestern Corporation’s financial results conference call and webcast for the quarter ended June 30, 2014.

NorthWestern’s results have been released and the release is available on our website at www.northwesternenergy.com. We also released our 10-Q pre-market this morning.

Joining us today on the call are Bob Rowe, President and CEO; Brian Bird, Vice President and Chief Financial Officer; Heather Grahame, Vice President and General Counsel; Kendall Kliewer, Vice President and Controller; John Hines, Vice President of Energy Supply; and Mike Cashell, Vice President of Transmission.

Before I turn the call over for us to begin, please note that the company’s press release, this presentation, comments by presenters and responses to your questions may contain forward-looking statements. As such, I need to remind you of our Safe Harbor language.

During the course of this presentation, there will be forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements often addressed are expected future business results and financial performance and will contain words such as expects, anticipates, intends, plans, believes, seeks or will.

This information in this presentation is based upon our current expectations as of this date hereof unless otherwise noted. Our actual future business and financial performance may differ materially and adversely from our expectations expressed in any forward-looking statements. We undertake no obligation to revise or publicly update our forward-looking statements or this presentation for any reason.

Although our expectations and beliefs are based on reasonable assumptions, actual results may differ materially. The factors that may affect our results are listed in certain of our press releases and disclosed in the company’s 10-Q which we filed with the SEC this morning and other public filings with the SEC.

Following our presentation, those who are joining us by teleconference will be able to ask questions. The archived replay of today’s webcast will be available beginning at 6.00 PM Eastern Time today and can be found on our website at www.northwesternenergy.com under Our Company, Investor Relations, Presentations and Webcasts link. To access the audio replay of the call, dial 888-203-1112, and access code 8886085. Again, that’s 888-203-1112, access code 8886085.

I’ll now turn it over to our President and CEO, Bob Rowe.

Bob Rowe

Thank you very much. Just to start off and give you some flavor for our service territory, we’re joining you today from our Bozeman, Montana division office. Bozeman division is very, very dynamic. It serves obviously the Bozeman area also down into Yellowstone Stone Park across the border in Wyoming. Big Sky, where we are experiencing a lot of growth and demand and great employees during the job. Our Board meeting was primarily about 40 minutes west of here in Three Forks, Montana the historic Sacajawea. And that’s an important place to the company, it’s the headwaters of the Missouri river that flows north through much of our Montana Service territory that of course has the East into the Dakotas, down through South Dakota and ultimately goes by our Yankton, South Dakota operation as well. So it really does tie our whole company together.

As we typically do, we had a good employee meeting this morning. Great community reception in Three Forks two nights ago really I appreciated the support that a very large community from that part of Montana showed for what our employees are doing in all kinds of ways. And as you’d expect a lot of enthusiasm for our proposed hydro acquisition too.

The other thing we did during the Board meeting was to take the Board down to see the Madison dam in the Bear Trap Canyon. Madison is the oldest and one of the smallest facilities that we hope to be acquiring. But the power analysis was absolutely spotless, the employees that we hope to be coming over from PPL, just incredibly proud of their operation and they’ve referred it as the flagship of the entire hydro system. So again it’s been a great couple of days.

Some highlights here. A 3% improvement in gross margin just that’s despite slightly milder weather as compared to the same quarter last year. Concerning our Dave Gates Generating station, as many of you know in April of this year, the FERC finally issued an order affirming a previous FERC Administrative Law Judge’s initial decision in September of 2012 in that regard to cost allocation and DGGS between and retail and wholesale customers on the 19th of this year, we filed a request of rehearing which is pending before the FERC, we will come back and talk about that some more.

On July 18th, just few days ago, we completed a robust and nearly two week regulatory hearing in front of the Montana Public Service Commission, requesting approval of the purchase of the hydro generating assets from PPL is on the side we now have all of the licensed transfers approved from FERC and we will come back and talk about all that in more detail.

And our Board of Directors deferred a quarterly stock dividend of $0.40 per share payable on September 30. And with that I will turn it over to Mr. Bird.

Brian Bird

Thanks Bob. In terms of summary of financial results on page 5, the three months ended June 30, 2014 we showed $7.7 million of net income compared to $14.3 million three end June 30, 2013, on a six month ended June 30, year-to-date numbers we’re at $53.3 million net income this year versus $52.2 million from the prior year. I think I’d say about the second quarter, the second quarter typically contributes the least amount to our annual net income matter of fact from 2011 to 2013. The second quarter contributed about 12% to our total.

This particular quarter if you take the contribution here against the midpoint of our guidance particularly on adjusted basis will be contributed 10% and you add that with kind of our strong first quarter, we expect to be around 53% of our midpoint year-to-date results. And typically over the last three years through the first and second quarter, we are at about 50%. So little bit ahead of where plans are typically to the first half of the year and though we had a mid weather quarter, as Bob pointed out and results we’d like to have been stronger, we’re still on track where we need to be on a full year basis.

Another thing I would like point here on this particular slide, you can see at the top of the page and you look at gross margin, you can see the three months compare to the year-to-date numbers significantly less that than, but when you look operating expenses they’re very-very close to half the three months versus the six months. So in another words, our volume metric business we have very strong first and fourth quarters, but operating expenses are pretty constant throughout the and thus another reason why our operating income is lower after three months that you would have seen in the first quarter. Lastly, think I would like to point out just to reiterate, we are on track from our perspective the second quarter came in relatively close to our plans and again we’re on target to get our year end guidance.

Moving onto the next page, just to focus directly on the second quarter itself, pretax basis we’re off about $7.5 million and I really summarize that under five different things. If you take a look at the gas production business, the margin from that business less the production cost, we’re up about $2.2 million on a quarter-over-quarter basis. Offsetting that favorable impact really four negative, first and foremost from a Hydro expense standpoint $2.8 million negative variance on year-over-year, $900,000 of that shows in operating expense and 1.9 million shows up in interest expense.

That added to bad debt expense of $2.2 million and then lastly the fourth-and fifth-item are expense items that you would expect to see in the growing company, depreciation expense up $3 million on a year-over-year basis and property taxes up $2.2 million. So in the grand scheme of things, that pretty much breaks up the quarter on the pretax basis. On an after taxes basis, we did have a $900,000 favorable variance on income taxes for the quarter.

Moving forward, speaking directly to gross margin, we do see as we utilize more of our gas business from a volumetric perspective we do an improvement in natural gas production. We did see a $5.1 million improvement on a year-over-year basis. Obviously, the addition of South Bear Paw in the fourth quarter of last year certainly on a year-over-year basis is a big drive for that improvement in the second quarter year-over-year.

Next, we point out from a demand side management perspective of loss revenue recovery that’s primarily a timing issue again year-over-year regarding natural gas retail volumes 900,000 unfavorable we did have a milder second quarter than we did have the prior year. One thing I would point out there is little more color there, our use of customer dropped by over 6% during the quarter. Our customer growth rate slightly under of 1% which results in that volumetric change if you will with slightly less than a 6% decrease on a year-over-year basis.

So gas business was down about almost $1 million of negative variance there. And on the electric side of our business because of the mild weather, we were flat there instead of being slightly up as we would have expected for the quarter.

Moving forward on operating expenses, so operating expenses were up $12.2 million regarding the OG&A or operating, general, administrative expenses were $7 million, or 10% of those in the first and foremost is natural gas production of course again offsetting that against the $5.1 million margin I talked about was end of that net $2.2 million of improvement year-over-year. The second increase was in bad debt expenses and primarily that bad debt expense is from two items.

First, we did have a certainly a colder fourth quarter of ’13 and first quarter of ’14 and collection as you will -- excuse me, revenues as results are higher and thus you expect some additional bad debt expense. But secondly, we had an implementation of a new CIS system. As a result of that, we had some delays in terms of collections and some implementations we needed to work through and that is also resulted in us having higher bad debt reserves than we would typically would. And by the way, it’s additional color there what we do is we put anything over 90 days have to do goes into a bad debt reserve. So as we continue to make enhancements to the system and we continue to do that here in the third quarter. Our expectation is we may see bad debt expense go up for period of time but we do expect to get a recovery of some of those bad debt reserves before the end of the year.

The third item here is non-employee Director’s deferred compensation. Certainly those folks who have covered the call many how long time and for some time understand an increase here from an operating expense perspective is offset in total in the other income and I’ll talk about that in a minute, so that has no impact if you will on the P&L as a full. Another item is hydro transaction costs. Again these are the think of the legal and other advisor cost that either incur from your operating expense perspective we also have what I’ll point out in a minute $1.9 million of additional interest expense associated with the hydro transaction.

The other areas of increase from operating expenses, property taxes and depreciation and included in depreciation by the way is depletion and other incremental cost if you will from having our natural gas businesses. And I pointed out earlier both the production costs and the depletion will stay relatively constant quarter over quarter in a particular year if you will quarter to quarter in a particular year and throughout the year it’s the actually volume metrics of that business are going to better in the first and fourth quarter and those quarters when we typically have higher volumes for our business.

Moving forward in terms of items below operating income and operating income we were down about $7.6 million on a year-over-year basis. Interest expense is up about $2 million but that’s primarily related to the $1.9 million of expense associated with our credit facility or bridge for the hydro transaction that's in place below that as a favorable income associated with other income of about $2.1 million and that’s primarily driven by the $1.5 million gain on deferred compensation we talked about in operations, operating expenses, the other part of that variance is in improvements in AFUDC and that’s getting back to kind of around the $7.5 unfavorable pretax variance.

And as I pointed out on we did have lower pretax that did benefiting a $900,000 favorable income tax benefit but we did see slightly lower while we did see lower flow through items in the second quarter that had we expected to see favorable variance to be slightly higher. We do expect for full year basis our flow through benefits to be in line to continue to provide our guidance of 14% to 16% from an income tax rate. All in all net income again $7.7 million compared to $14.3 million from the prior year quarter a variance of $6.6 million negative.

Regarding the balance sheet on page 10, not a lot to point out here since is over the last six months. I do want just to pay attention to on the ratio to debt to total capitalization. We typically see that that over six months we see that number come down from the 55% something lower than that. One thing we do want to point out we did issue from an some data associated with new market tax credits associated with our new general office in Butte approximately 28 million and that ultimately closed on July 1. But from an accounting perspective we did book that 28 million to long term debt during the end of the second quarter, and the cash that we’ll show up and restricted cash will not show up into the third quarter. So if you remove that $28 million from our long term borrowings our total debt to cap as of the end of June 30, 2014 would be 54.3%.

Moving forward to the cash flow statement. Cash provided by operating activities is approximately $5 million less than it was for the six months ended June 30, 2013. The primary variance there is working capital changes and the biggest difference really from working capital was more a function of under collection on our supply costs than it was on from receivables. We have been doing a better job in the second quarter and collecting receivables but we still had a bit of work to do by the end of the year in that regard.

In terms of investing activities we are investing certainly more from a PP&E on a year-over-year basis $112 million versus approximately $89 million. But on the financing side proceeds from issuance of common stock through the first six months of this year are down versus the prior six months of 2013. The reason being is we finished up our dribble program in 2014 the last issuance in the first half of this year. So that facility is now done. As a result of all of that activity at the end of the day we actually borrowed approximately $5 million versus paying down $58 million debt last year.

Moving forward to adjusted EPS schedule. I would point out on a diluted basis 2014 GAAP EPS of $0.20 versus $0.37 from the second quarter of 2013. We did make from an adjusted standpoint two items from non-GAAP adjustments first being we added back a penny from weather perspective and we added back $0.04 associated with hydro transaction cost. And as you can see looking at slide 12 that $0.04 in the second quarter very similar to the $0.04 we added in the first quarter. That got us to an adjusted $0.25 for the quarter versus $0.35 for adjusted 2013 and there was a weather impact actually it’s a weather in the second quarter of 2013 that was adjusted and net-net, a decline if you will of $0.10 from an EPS perspective year-over-year. If you look at the charts just below that from a GAAP year-to-date we had about 1.38 to down to 1.37, just under a 1% decrease but with the adjustments I just spoke about and adjustments that we also had in the first quarter of 2014. Using adjusted EPS from a $1.36 in 2013 $1.41 in 2014, just under a 4% increase.

Lastly on this page, we pointed out in the red box at the bottom. I also mentioned earlier on the call, we are typically about 50% of our earnings if you will through the first half of the year and right now we said about 53% of mid-point of our guidance. So we are right in line with what our expectations for the year. In terms of as a result of that moving to slide 13, we are reaffirming our 2014 guidance of 2.60 to 2.75. We do have listed below some assumption associated with that one that’s highlighted and above here was related to the hydro transaction. We are incurring fees of course during the year but even if we are to receive approval in the transaction and we are able to close on that before year end. We are excluding any fees or any potential income in our guidance for the year.

And with that, I will hand it back over to Bob.

Bob Rowe

Thank you, Brian and I will give you an update on several of the item as we do talk about quarter-to-quarter. First of all Dave Gates Generating Station, as most of you know, some of you may not, this is essentially a transmission reliability resource. The very thing about using the powerpoints is we have been doing now for a number of quarters, is the ability that we show you what we are talking about. You see the plant in the photo off the right, it’s three units which provides us one operating reserve just swinging in and out as needed for example when I get it to take it down for repairs or maintenance and simply to manage the operation.

We have responsibilities to both the retail and wholesale customers. We operate at very large balancing authority out of our Montana system and DGGS was designed to allow us to meet this important obligation. Montana public service commission has the consistently integrated job around working with us approving the plant in advance as clarity to what policy would be there. We bought the plant in $20 million under budget in December 2010 and that’s been operating very well now.

Separately then we had filed in 2010 or 2011, an application for recovery on the federal side as well. As many of you, then we went through way contested case proceeding at the Federal Energy Regulatory Commission. Notably prudency and there costs were an issue there, it was really the question of allocating cost recovery jurisdictionally. And unfortunately the FERC ALJ took a very different view of allocation than what occurred at Montana or our view different from what FERC President would have suggested.

So we received what we consider to be a very unfavorable decision from the Administrative Law Judge in September of ’12. We requested reconsideration in front of the full commission. During that time, we’ve been recognizing revenue consistent with the Administrative Law Judge’s initial decision and so as a result, reserved $27.3 million subject to refund through the end of June of this year.

In late April of this year about 3.5 years after the plant completion, 20 months after the ALJ decision, FERC did issue summary or affirming the initial decision. Subsequently in May, we filed a request for rehearing which remains pending. Under the FERC decision, we were required to refund within 30 days included in our rehearing request, we requested that refunds not be ordered until after a final -- until after the substance of the rehearing request had been addressed and the FERC did reverse or revise its initial position and just asked to refund.

So we will all refunds if at all 30 days after for a quarter on rehearing. If the rehearing unsuccessful, we may appeal to the United States Court of Appeals. The timeline would depend most particularly on when the FERC issues a rehearing request but ultimately could extend the 2016 or beyond. Parallel to that, we are looking at actively developing I should say a number of options on the FERC side in terms of other filings really can’t say more about that right now you will have more clarity about that by the time we will get there at the end of the next quarter.

Turning to the environmental compliance, a Big Stone and Neal we have been talking about these for a long time. Both of these important and successful projects. The Neal plants in which we own a much smaller interest, coal plant in North West Iowa was potentially we did last year ahead of schedule and is in service. The Big Stone project is expected to be completed by the April 26, compliance deadline and again as the work project we’re pleased with the status. We’ve talked a lot about our natural gas reserve opportunities and this is something particularly in the way that we’re doing it is really quite unique.

In the Montana operation, we have an extensive natural gas transmission storage and gathering system adjacent to that system in north central Montana or extensive traditional gas production assets. So our approach, as many of you know has been to acquire natural gas production and dedicate that exclusively to serve our customers, manage those assets and provide gas based on the cost of production.

Our customer saw great value of that I think over this last year winter when multiple cold weather excursions your have had a lot of over last couple of weeks really drove price quite high and you were able to help buffer that for our customers. We’ve made three purchases so far certainly we’re out examining opportunities now taking a conservative but we think appropriate approach, goal could be to own up the 50% of our retail supply first perhaps another 50% of what we would need to provide fuel at the Dave Gates Generating Station and then at our leased Basin Creek facility.

As you know natural gas production depletes, so we do have to factor in depletion as well and this is something we’re very happy to be able to do and we think provides our customer an awful lot of long term benefit. Lots and lots going on in our transmission and distribution systems as we pay attention to the essential infrastructure that serves all of our customers, the Montana distribution system infrastructure project we discussed every quarter focused on reversing the trend at aging infrastructure, maintaining reliability, managing safety, building capacity where it’s needed, and making our network ready for the deployment of new technology.

Both gas and electric project complicated project in terms of the number elements geographically dispersed over a period of time. The Bozeman employees I mentioned at the start of the call are very much and I think of this and they are working very very hard. We are pleased with the progress we made so far. Our employees certainly report that they are seeing the results in the field. So we’re again quite happy with that. It’s a good time to point out during the Board meeting, Board members made the comment that with the intense focus we’ve had on the Hydro project really for several years certainly for the last several months it was a real reflection on the breadth and depth of this company that we were able to move ahead on so many other fronts as well. And I think that was very wise observation on their part.

Turning to Hydro, we are obviously very focused on projects that are consistent with our vision that go with success we work through our project screen this the Hydro project is one we think provides great long-term value for our customer, our communities certainly for our employees and you are our investors as well. One of the really striking things within the company is although we’ve been in Montana for a number of years, a T&D company primarily and have it operated the Hydro in a number of year. We’ve got quite a few folks who refer themselves as the river rats. If you are working Hydro operation you are a river rat and the experience that they have brought to the project to due diligence and will provide to operating these facilities is just extraordinary.

Turning to Page 19 little bit more detail on the process. The overall effort again two years really nine months is the clock that the Montana public service commission is working on, culminating in almost two full weeks of hearings. We put on ultimately 18 witnesses including addressing some issues we had anticipated initially particularly including transmission access for our choice customer. If you have a chance to listen to parts of the hearing, it is available on-line and I think you will see it particularly, if you have the opportunity to listen to some of our operational folks Henry was outstanding and whatever perspective that you would I make find ourselves very impressed by John Hines and the operational people who lead the due diligence team and we’ll manage the spreads out of assets so post hearing briefs new August 1st for us just contains for the intervenors and then our final brief on August 25th September 16th would be the final day for the commission to issue an order the commission could extend that deadline if it determines their extraordinary circumstances. With the case as large and consequential as this is that commission really has done an extraordinary job in keeping the schedule really right to the day. This is we believe is a obviously a clearly correct answer but also completely recognize just how fundamentally important this case is to us at NorthWestern but to our customers and really to the State of Montana.

If you listen to the or watch the Friday morning hearing this last Friday morning I think you will see the Montana Commission had its very finest and particularly Chairman Bill Gallagher who did an outstanding job running the hearing and it’s just been very-very thoughtful about this entire matter. So if we receive the satisfactory approach from Montana Commission we will be seeking authority from the Federal Energy Regulatory Commission to issue securities in connection with the transaction. We anticipate a FERC approval to take 30 to 60 days after the Montana Commission approval FERC denote that because of the size of this transaction a key aspect of our request but the Montana Commission is to approve financing and then the FERC ultimately decided that it needed to see Montana Commission decision before it would approve financing as well.

There were a series of FERC approvals that we needed they have now other than the Sector 204 approval for financing they’ve all now been received and that specifically in foods the license transfer has just happened a hour ago for this call started we received that we had received the final license transfer approval. So we are very-very excited about that. If we receive both MPSC and FERC approvals we plan to close into permanent financing of up to $540 million of debt and up to $400 million of equity and up to $50 million of free cash flow as capital market access is limited we do have the option of closing into the $900 million committed bridge facility was Credit Suisse and Bank of America Merrill Lynch lots of additional information available on our updates.

And with that I will stop talking. And we look forward to discussion and questions.

Question-And-Answer Session

Operator

(Operator Instructions) We’ll move first to Paul Ridzon with KeyBanc.

Paul Ridzon - KeyBanc Capital Markets

Good afternoon. Can you just give an update where the -- not the DSIP, but the TSIP, kind of you have a parallel program for the natural gas system, kind of where the thoughts are on that?

Bob Rowe

Actually TSIP refers to transmission DSIP does include gas and electric elements. What we are doing is really trying to take a comprehensive view of all of our infrastructure assets, transmission, distribution, substations and we’ll be developing we’ve done a lot of work developing options in terms of priorities scope of investment and timing. And we’re looking forward to discussing those plans with our commissions over the coming six months or so. Mike Cashell, our Vice President for Transmission is here. Mike do you want to add anything to that?

Mike Cashell

I think that you covered it fully Bob. The plans are pretty well developed as far as what we intend to do on both electric and gas side excluding substations and they need some more stakeholder involvement and that sort of thing and then also will be kind of molding those into our five year plan as we go through the budget season.

Bob Rowe

Couple of comments I’d make in addition to that between Curtis Pohl, Vice President for Distribution and Mike the level of coordination between T&D in terms of longer planning and various key initiatives is great. So I think we are as a company more able than ever before to really look at the entire system. And I think that’s just obviously in our customer’s best interest. And we do have the ability again to stage investments as it makes sense. And we are taking obviously hydro with a long term commitment that we’re making to our customers and our focus on transmission and distribution is exactly the same as the long term commitment on the supply side.

Paul Ridzon - KeyBanc Capital Markets

And just on the bad debt, is this a function of people not getting their bills or just not paying them?

Brian Bird

No, it’s not a function of that; it’s a number of things Paul. One of the things is from a budget building perspective we had to do some adjustments to our system for that particular issue which resulted in our inability to change people’s bills in a more time fashion in terms of adjusting as accordingly to the higher amount of sales if you want the first quarter. That’s a portion of it. But it’s a function of corrections we had made at that system here in the third quarter, but we continue to see as people are going past the 90 day, real estate if you are seeing that even in July but we did make a correct to the system, we believe that’s going to correct that on a going forward basis and thus, we expect to see an improvement in the second half of the year.

Bob Rowe

Just one more word on the system itself. We’ve talked about this a little bit previously. Our number of utilities have been going through these CIS conversions over the last year or so. We like the results we are getting from our system, we like the fact that we’ve used as much in-house work as we did and so collecting just a lot more hands on experience and so we’re further ahead than our many companies that have gone through these conversions. They are always tough, but like where we’re getting. And to your initial question, the customers’ effect that actually include quite a few, I’d say, very high quality customers. So I think we will manager through we’re putting the resources on it. But it’s going to get probably a little bit worser before it gets before.

Brian Bird

The other thing I’d add Paul is two things. One, when we implemented this system it was labor day at last year and as a result of cutting over to that new system, we did stop collections for a one month period and that does, if you will push everyone out if you will, pretty much in 30-day perspective, that certainly continues to be an impact particularly as we went into a very cold season where we had difficulties with disconnects in the likes. So that had an impact on this as well. And I think from -- as Bob pointed out, we continue to be focused on this, we continue to see some issue potentially in the third quarter, but again expectation of some of it whatever reversal in by the end of the year.

Operator

(Operator Instructions). We’ll move to Brian Russo with Ladenburg Thalmann.

Brian Russo - Ladenburg Thalmann & Company

The David Gates -- if the FERC declines your request for rehearing, would that be the trigger to cause an impairment and a write-off?

Bob Rowe

We’ll be evaluating the need for the impairment on quarterly basis certainly at that point but that would not necessarily be a trigger.

Brian Russo - Ladenburg Thalmann & Company

Okay. And can you just talk a little bit more on other options for the under-collected capacity at David Gates, kind of integrating it into your system or portfolio and did the hydros kind of give you another opportunity to find alternative use for that if, indeed, you'll be under-recovering on the FERC side?

Bob Rowe

Two points and then Mike or John may want to speak to this as well. First we are providing a service that we are required really as a matter of federal law and policy to provide. It’s an essential service on the system. We face penalties if we don’t provide it and if we don’t meet the performance standards. So we have no choice but to provide the service. This is the right asset, the best asset with which to provide that service and that’s why I know many of you have been puzzled and frustrated along with us by these with the strange FERC outcomes. So it’s the right asset to provide this necessary. Secondly though, we are -- if we receive a favorable decision from the Montana Commission concerning the hydro project, we are eager to look at ways to optimize and the entire system to operate it as efficiently as we can for both our retail and wholesale customers. I think the Montana Commission had a lot of interest in those opportunities for again overall system optimization. Mike or John?

John Hines

This is John. Just to add that with the addition of the hydros we will have control of over 60% of our power supply in Montana as opposed relying primarily on power purchase arrangements, which will give us a lot more tools if you will to optimize including the use of Dave Gates in alternative ways. It is premature for us to identify those at this point in time but I can say that we are looking at providing at providing different alternatives.

Mike Cashell

This is Mike Cashell. I would simply say to Bob’s point of the potential for additional filings with the FERC, an emphasize that we are providing the service and our intention is to show FERC in a different way that the customers are providing very important service whether you call it regulation or something else. And that’s kind of the theme around potential future filings.

Brian Russo - Ladenburg Thalmann & Company

Okay and the year-over-year EPS drag on the depletion of the gas reserves this quarter, what was it exactly, embedded in the depreciation in depletion?

Bob Rowe

The deprecation depletion total was 3 million; 1.2 million was depletion for the quarter.

Brian Russo - Ladenburg Thalmann & Company

Okay. And we should expect that to recur in the second -- in the third and the fourth quarter as an earnings headwind?

Bob Rowe

Yes, I would look at this way Brian. Think of the gas production itself and the depletion itself to be relatively constant quarter-to-quarter, but the margin will obviously be higher in the first and fourth quarter that when we’re selling more throughputs during those quarters than we certainly are doing second and third quarters.

Brian Russo - Ladenburg Thalmann & Company

Okay. And is bad debt recoverable in a general rate case?

Bob Rowe

Yes. I think from our perspective, I want to keep make sure people understand that these are not right offs, these are increases in reserves. And so at the end of the day, it will what is your bad debt expense in a particular test year that would you ultimately ask for the recovery. As a company, we have extremely low bad debt as a percentage of revenues and our expectation is continue to make adjustments to the implementations of our new CIS program. We are going to continue to keep that very little level of bad debt expense and so again there is an expectation we’re going to get recovery of these reserves at some point in the future.

Brian Bird

And just as to reinforce that again we have both Montana, South Dakota, Nebraska gas and electric among the lowest bad debt ratios of any utility in the country.

Brian Russo - Ladenburg Thalmann & Company

Okay. And the last question -- Brian, based on your comments earlier on the guidance and the percentage of earnings that you’ve achieved year-to-date, you’re comfortable with the midpoint of your guidance?

Brian Bird

Brian, we don’t speak to where we sit in the guidance. The percentages that I gave were of the midpoint. The guidance is the range of total of 2.60 to 2.70.

Operator

We’ll now take the question from David Arcaro with Sidoti & Company.

David Arcaro - Sidoti & Company

Could you talk a little bit about what the main drivers are of gross margin growth in the second half of the year, this year?

Bob Rowe

I think as you would expect demand -- when you say gross margin growth, I continue to see customer growth and volumetric growth as a result of that. I don’t see in terms of any projects coming on line that we’d incremental margin growth from that. Obviously, you’re going to continue to have gas production in the second half of year that’s going to be higher than 2013 because remember we didn’t put Bear Paw South into our earnings till December of 13. Other than that we have seen some improvement in OASIS revenues for the year. Those are things David that are jumping out of me at this point in time.

David Arcaro - Sidoti & Company

Got it. Thanks. Also had a question about timing of financing for the hydro acquisition -- wondering if you could help me understand the timeline. So, if you were to get approval from the Montana Commission mid-September, that would start the countdown for FERC approval. But would you then tap into the bridge basically bridge loans, mid-September? Or would you wait for FERC approval before doing any kind of financing?

Brian Bird

That’s good question David. I think once we receive MPSC approval, there was expectation of 36 days from FERC. And the way that the PSC has written is we required to close than 20 business days after we get all of approvals. So we don’t have to draw on the bridge financing. Our expectation is we hope to receive MPSC approval and then within 36 days when we with hope to receive the FERC approval, we would quickly upon receiving those get to the capital markets and we have lot of sometime to do that as it pointed out. And so to your point of mid September, our hope is we could do something maybe after 30 days maybe late October if you will, but potentially could go into November as well in terms of coming to the capital markets.

Bob Rowe

We are very eager to get out just in New York minute as quickly as we can. Right now, we could deliver long-term very loss cost debt. Brian has a little vote of candle and picture of Janet Yellen on his desk. We want to get out and do that and we would be able to provide an overall ROR probably lower than anything the Montana Commission has seen. So the quality of the assets, the attractiveness of financing right now walking in long-term debt while these plants deprecate out, it’s just a wonderful time to be doing what we think is a great deal. I think I should have said a Montana minute.

David Arcaro - Sidoti & Company

Bob, question for you actually regarding the hydro hearings. You had mentioned during the hearing, or you described it as a little bit acrimonious. Or that might have been a quote from someone else. But I was wondering what your thoughts are about how you might be able to improve the communications or improve the process between NorthWestern and the other parties when it comes to hearings like this and processes like this.

Bob Rowe

Actually well look like it go back to the previous question first of and another reason we’re eager to get out and wrap up the financing is because our operational folks that I mentioned earlier are basically ready to go as of August 1st. So as soon as we get the deal put together if we do we’ll be ready to start operating these plans dedicated to serve our customers. In terms of process it was in this case extraordinarily thorough reams and reams of information I think every stone was looked under and that’s totally appropriate we have so many people working very-very hard to provide all the information to get the job done.

The point of concern I had and I tried to raise in a respectful way on the second of the last phase of hearing just has to do with the what I think was the key the important role in Montana and the Montana regulatory process so the Montana Consumer Counsel that’s a constitutional body plays an important role representing the public interest representing customers as you hear us talk about constantly we really do put customers and the public interest first and talk about that alignment of interest. We’ve tried to reach out to and actually often are able to work very well with the consumer counsel on a range of things including often on for example our gas production acquisition. We need to have a good relationship there and there just deems to be respects among ourselves and them, but also the witnesses.

And honestly we had some we very directly had some real concerns about positions that one of the consumer counsel witnesses took and about statements that were made during the hearing. And honestly there is almost an expectation that the consumer counsel that witnesses will be speak in fact fully and a real respect for the consumer counsel positions in Montana so it’s important that they be factual be constructive and that we’ll be able to work with one another. So I did point that out during the hearing on I actually pointed it out in my rebuttle testimony as we well. We respect the consumer counsel as an institution certainly respect the individual who heads the consumer counsel but it’s just so important for us to be able to work together.

And in this case again because the size of the transaction its importance to Montana and the risk that was associated with timing and that was another real concern for us. We as a matter of law needed the Montana Commission’s approval before financing and then found out that actually we needed the Montana Commission’s approval as a prerequisite for FERC approval too. During that time the market did not moved, debt prices did not go up but they certainly could and it would have been a tragedy if we had lost our ability to finance on those effective terms. So it’s something and there is supposed to be some institutional tension but it’s something we sure as a company are committed to addressing and sometimes it’s best to address that outside of a congested case.

David Arcaro - Sidoti & Company

Great. Thanks for that. That's all I had.

Bob Rowe

Thank you.

Operator

We’ll now take a question from Jonathan Reeder with Wells Fargo.

Jonathan Reeder - Wells Fargo Securities

Just a couple follow-ups. Were there any issues raised during the hearings that you hadn't anticipated? Or was everything pretty much in line with your expectations?

Bob Rowe

I would say two points we knew that cost of capital would be an issue Brian in particular done a nice job addressing that in our initial testimony we did bring in a dependent cost of capital witness in rebuttle and then secondly the transmission related to issues obviously there is concern for customers mainly industrial institutional take service from now from PPO so whether it over our transmission system that they would continue to have access. And Mike Cashell ended up providing live testimony and we think we did a good job addressing those questions.

I think we were all surprised by some of the proposals that consumer counsel’s independent expert Dr. Wilson offered in their round of testimony and that again lead to some of the discussion back and forth. Third issue some of the concerns around Kerr which is as those of you who are following it know is a facility that under condition of its FERC license has the potential to revert to the Confederated tribes next year and there is a lot more clarity provided around that process after we had entered into our purchase and sale agreement, we had to -- we actually really stepped up and worked through that issue end up pretty well. John, anything else?

John Hines

I guess the one issue that I thought was a little bit surprising when you are acquiring and asset that’s going to be around probably another century was the extreme focus on very short term comparison between these assets and the market.

Bob Rowe

And that really is foundational. We take seriously but we have an obligation. Under Montana law, one, to look long-term and two, to assess risk and we think we did that very well.

Jonathan Reeder - Wells Fargo Securities

Okay. And so now that you have the hearings and kind of the public comment opportunities in the rear-view, do you feel like the court of public opinion has been swayed at all? Or, you've talked about a lot of support within Montana from not just customers but also legislatures and everyone else up and down the line. Is that still consistent?

Bob Rowe

I think so. And again credit to the commission out for going out and holding almost 20 public hearings and I was a great, educational opportunity in a low of different ways. The commission, the consumer council and we had the opportunity to educate customers and citizens, but it was opportunity then for the commission to -- and for the commissioners to educate themselves about what the public was thinking. We as a company, we really do emphasize talking and we did pretty substantively with our customers and community leaders. So we are always doing that and certainly on something as important as this that was our goal.

Jonathan Reeder - Wells Fargo Securities

Okay. And then last question -- is reaching a settlement on the hydro deal, is that even a possibility or anything you're working towards, or now that we've kind of seen the opinions and everything we should expect fully litigated?

Bob Rowe

The Chairman Gallagher made a statement, its matter of public record. Friday afternoon, after the hearing closed, he testified to the legislative interim committee and legislative interim committee on telecommunications and energy and we reported on the hearing generally and made the statement that NorthWestern Energy had started at around 128 million and through a number of adjustments came down to a 117 million and the consumer council was at a 114 million. So if that was reasonable to expect to settlement and if that would then allow the commission to issue an order in early September. So from our side, settlement negotiations are confidential but we have been actually working trying to reach out since March and April and we think it’s a sensible thing to do. The way to think about it and we’ve talked about this in some detail at the hearing, $900 million purchase price we will write a check, we got the opportunity to write that check for $900 million. After announcing this transaction and we got clarity on the terms of the arbitration results between PPL and the confederate service and scrutiny drives.

As a result of that then we know that essentially that the price for us is $30 million, so that will get sorted out after about a year at the time of the transfer. So we were able then to move from 900 million to 870 million rate base amount by basic we fore going and either return on or return off Kerr during the time that we operated it. There was some discussion about various other specific adjustments and to walk through those at a very high level, we agree to take the first year yields tax obligation which is lower we expect than ours will be as a retail utility.

We spoke -- we’ve also then agreed to move from 40 year to 50 year depreciation which actually -- which is a pretty significant net present value I want to say about 16 million? In the first year or two to our customers and again over the life, very significant net present value. There were concerns about capital forecast, we are very comfortable with the first six years of capital forecast and although Montana has an historical test year we were willing to commit to live within those capital forecast again based on the experience our due diligence team and the quality of their work and then fundamentally focusing on capital structure, cost of debt, cost of equity. As you know, we are willing to take on still a little bit more leverage in the capital structure than a lot of companies. And again the amazing thing is that depending on if the Commission does print out a positive order and if we are able go out and finance that long-term, the stability we could provider customers for that set of assets really is remarkable. Brian, John -- add?

Brian Bird

No, I think Bob, you pointed out again the $11 million in revenue requirements that company offered during the case and some of those have ability to reduce cost and the reduction debt cost would be one of those, but again I think to your point we’re trying to do what we can to help into move this right hope to.

Jonathan Reeder - Wells Fargo Securities

Just a follow-up on that, So, Bob, you mentioned the MCC. I guess their revenue requirement was at $114 million. Was that in their pre-trial testimony on the assumption that the deal, I guess, kind of gets approved? Or where is that kind of coming from?

Bob Rowe

There are three pieces and it gets complicated for at least for simply guy like me. They had two witnesses, Dr. Wilson and then Mr. Al Park. Mr. Park was the accounting witness see you could say. He proposed couple of adjustments deprecation life and then the return on and off that we expected. Kendall Kliewer accepted in his rebuttal testimony. And that moves to the 114 in addition in propose a generational inequity not in equity, but inequity adjustment that had some discussion of the hearing. And then what was very troubling for us were series of rate base adjustments if you will that Dr. Wilson proposed and those are things that we just had a hard time understanding on one level and again I think form in accounting perspective would have caused huge-huge concern. So what we asked for ultimately again after we have the clarity around Kerr was 870 million in rate base and that’s based on our obviously our best effort to reach an appropriate price with a seller who was under no obligation to sell at and certainly didn’t need to see to us for a set of asset that we think provide a whole range of long-term values.

Jonathan Reeder - Wells Fargo Securities

Okay. So the $114 million is based on $870 million rate base and excludes kind of those more extreme adjustments that the witnesses threw out?

Bob Rowe

That’s true.

Jonathan Reeder - Wells Fargo Securities

Okay. All right. Well, we'll be watching this closely and good luck getting it across the finish line.

Operator

We’ll now move to Maury May with Wellington Shields.

Maury May - Wellington Shields

Just another quick question on Kerr. I think I understand the issue. But if all goes right, you're going to own this asset for about a year and it produces about 1 million megawatt hours per year. And so, if there is any profit on it, does that just get returned to rate payers as credits?

Bob Rowe

We hope have Kerr for about nine months and yes that would flow back as credits.

Maury May - Wellington Shields

Okay. Okay. And my second question really is on dividend policy. Can you review your dividend policy and payout ratio?

Brian Bird

Sure, our payout ratio is 60% to 70% Maury, but we are at the low end of that ratio and we publically noted that several years now that we plan to be at lower end of that percentage as long as we go large capital commitments in front of us. If there is some point whatever reason rate base growth percentage is even that rate of growth would slow, our expectation is we have more cash to be able to pay a larger dividend. We'd probably move up within that range, but we’re very comfortable being at the low end of our stated 60% to 70% range this time.

Maury May - Wellington Shields

Okay and now in recent year you have increased the dividend in the first quarter of each year, and did you do that -- do you apply the payout ratio to the prospective year or the previous year?

Bob Rowe

We look at what our plans would be. We come out with our dividend usually in line of time we come out with our guidance for the upcoming years. So it is on a perspective basis.

Operator

(Operator Instructions) We will take a follow-up from Paul Ridzon with KeyBanc.

Paul Ridzon - KeyBanc

Along the lines that Brian has a pinup poster of Janet Yellen in his office, have you put any treasury locks in?

Bob Rowe

That’s a great question Paul and what we have done in discussions with commission staff about this issue sometime ago, the concern is when you put in a treasury lock or even consider doing a forward, if you will, on your stock, it certainly gives the perception that you’re going to get this thing approve and we certainly didn’t want get ahead of our skies in that regard. I have to tell you in hindsight it certainly was a wise decision. We would have locked interest rates at the time that we had filed for this particular case that would have locked into to high across if they will from the both debt perspective and of course their stock price is up since that time as well I think I would put it in this context if in fact we were to have a settlement with the MCC and companies in terms of that this transaction could close and comfort based on feedback we received from the commission about liking us to lock in we would certainly want to do a treasury lock at that point in time. But until there is clarity around that we just feel uncomfortable doing it. And in the meantime I’ll continue to monitor what Ms. Yellen is doing.

Bob Rowe

And we’re lighting a lot of candles I feel I am going to be in so much trouble for showing that secret to Brian as soon as we’re off this call.

Paul Ridzon - KeyBanc Capital Markets

And when we think about the permanent financing I assume we should be thinking about 870 million, not 900 million. And I don't know if you'll just carry the 30 million on your revolver of some sort. Or is that the right way to think about it?

Brian Bird

Paul, you’ve nailed it. I think if think of it this way the 400 million of equity associate with the 870 million, this of 450 million of debt on the 870 million and then 20 million of free cash flows. On the 30 million that for the total if you will to get to 870 million and the 30 million associated with Kerr as Bob pointed out it’s an asset we’re going to own for nine months or so. Our thought process is it’s a short term asset that we’ll own we’ll finance that if we will with a draw on your revolving credit facility.

Paul Ridzon - KeyBanc Capital Markets

Is there any thought about, in light of the fact that there is more gas users out there, just coming to the capital markets once and maybe clean up some potential equity you might need?

Bob Rowe

It’s fair question Paul I think we’d like to keep our financing raise here particularly since the hydro transaction is such a significant transaction we’d like to kind of keep that totally tied to that transaction. Obviously if there are other tools if in fact we understand there is opportunities on our gas reserves of transaction of that size we’ve used the dribble program in the past for small equity needs that maybe a tool we would consider getting in the future.

Paul Ridzon - KeyBanc Capital Markets

Okay, that makes sense. Thanks again.

Operator

We’ll now move back to Brian Russo with Ladenburg Thalmann.

Brian Russo - Ladenburg Thalmann & Company

I just want to clarify, in the 10-Q I mean it says that average first-year rate base is 839 million, down from 866 million, but you guys are discussing an 870 million.

Bob Rowe

I think that one of the issues there you have to take in consideration the impact of Kerr and then deferred taxes has an impact on that amount as well.

Brian Russo - Ladenburg Thalmann & Company

Okay, so the 839 million is the number we should use?

Bob Rowe

Yes.

Brian Russo - Ladenburg Thalmann & Company

Okay, great. Thank you.

Operator

And it appears there are no further questions.

Bob Rowe

Great. Well, again thank you all for your interest and support over the quarter. I hope we’ll be seeing some of you over the next several months and I think our next quarterly call will be from Mitchell, South Dakota in October. And that concludes the call.

Operator

And once again that does conclude today’s conference and we thank you all for your participation.

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