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Vectren Corporation (NYSE:VVC)

Q4 2011 Earnings Call

February 16, 2012 2:00 PM ET

Executives

Robert Goocher – VP, IR and Treasurer

Carl Chapman – Chairman, President and CEO

Jerome Benkert – EVP, CFO and President, Shared Services

Operator

Good afternoon. My name is Candice, and I will be your conference operator today. At this time, I would like to welcome everyone to the Vectren Corporation 2011 Yearend Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After our speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) Thank you.

Mr. Robert Goocher, Treasurer and VP of Investor Relations, you may begin your call.

Robert Goocher

Thank you, operator. Good afternoon, and thank each of you for joining us on the call to review our 2011 results and 2012 guidance.

This call is being webcast, and shortly following its conclusion, a replay will be available on our website at vectren.com in the Investor Relations section. Late yesterday we released our yearend earnings and this morning we filed our 2011 10-K. Copies of our earnings release, today’s slide presentation and the 10-K can all be found on our website.

As further described in slide two, I would like to remind you that many of the statements made on today’s call will be forward-looking statements. Actual results may differ materially from those discussed in this presentation. Carl Chapman, Vectren’s Chairman, President and CEO, will kick off today’s discussion by providing a few comments on Vectren’s 2011 yearend results, and then discuss our 2012 earnings guidance and supporting strategies.

Then Jerry Benkert, Executive Vice President and CFO, will provide details on the 2012 outlook for our Utility and Nonutility businesses, and will finish with a few summary remarks. Following Jerry’s comments, we will be happy to take your questions. Also joining us on today’s call is Ron Christian, Executive Vice President and Chief Legal and External Affairs Officer.

With that, I’ll turn it over to Carl.

Carl Chapman

Thanks, Robert. I would also like to welcome everyone to today’s call. As always, we appreciate you joining us.

Looking at slide three, I’ll briefly go over our highlights for the year. Overall, we are very pleased with our 2011 results and our earnings growth for the year. Our Utility operations performed very well again this year, supported by the approval of our $28.6 million electric base rate case, which we implemented in early May. While we did not receive authorization and the rate order to proceed with full electric decoupling, we were later granted approvals to expand our efficiency programs for all of our electric customers with the opportunity for lost margin recovery resulting from the implementation of these programs.

On the gas side, we received approval to continue our Indiana natural gas efficiency programs and our decoupling mechanisms for the next four years. And finally, legislation passed in both Indiana and Ohio that is supportive of infrastructure modernization programs. In Indiana, SB251 provides for the recovery of 80% of capital and O&M expenditures associated with federally mandated requirements outside of base rate filings, with the remaining 20% deferred for recovery until next rate case.

In Ohio, the legislation only applies the capital expenditures, but is much broader in terms of the types of capital expenditures that are covered. On February 3, we initiated a filing under this HB95 for about $25 million of our 2012 Ohio gas expenditures seeking deferral authority for post in-service depreciation, ongoing deferral of carrying costs and property taxes until a future rate case filing.

On the Nonutility side, as you’ll recall, at the beginning of 2011 we outlined our strategy for our Nonutility portfolio businesses, which included a focus on growing our infrastructure services and energy services businesses in order to reduce the reliance on earnings growth from our commodity sensitive businesses.

Consistent with that strategy, in late March we announced the acquisition of Minnesota Limited, a complementary addition to Miller Pipeline in our Infrastructure Services segment. The addition of Minnesota Limited contributed $0.11 per share, well above our initial expectations of $0.02 to $0.04 of EPS. I’ll discuss this further in just a few minutes.

To close the year, we sold Vectren Source, our retail gas marketing company, for proceeds of approximately $84 million and an estimated gain of $12.4 million net of all tax effects. Both amounts are subject to final adjustment for working capital. We believe this is the right time to move forward with the sale of Vectren Source and realize the value in this business that was built from the ground up over the last several years. We found a logical buyer in Direct Energy that is already an active participant in the retail energy markets and is willing to put additional capital to work to continue to grow the business.

The sale of Source coupled with the acquisition of Minnesota Limited has helped to reduce our earnings exposure to the more volatile commodities markets, again consistent with the strategy we discussed at the beginning of 2011. In addition, it demonstrates Vectren’s disciplined approach to regularly assessing each of our Nonutility businesses to determine whether they continue to be a strategic fit for Vectren.

We also highlighted a couple of specific items beyond normal growth expected in our various businesses to help offset the loss of the Source earning stream for 2012 and beyond. 2011 also saw the ramp-up of production at our new Oaktown 1 mine, which produced 2.7 million tons of coal for the year and is approaching its full capacity of approximately 3 million tons. In addition, we continued the development of the second Oaktown mine, with a targeted startup in the third quarter of 2012 depending upon demand.

Turning to slide four, other highlights for the year include an increase in our annual dividends paid for the 52nd consecutive year, a record matched by few companies, and the successful placement of $250 million of long-term debt at an average rate of just over 5%, which will help drive 2012 interest expense lower by about $8 million.

Turning to slide five for a bit more detail behind our 2011 results, reported net income for 2011 was $142 million, or $1.73 per share, compared to net income of $134 million, or $1.65 per share in 2010. We’re obviously pleased with this year-over-year increase in consolidated earnings.

Utility earnings were $123 million, or $1.50 per share, in 2011 compared to $124 million, or $1.53 per share, in 2010. Some of the key items impacting year-over-year results were the electric rate increase implemented in May, which paid for an increase in planned generation outage maintenance activities. However, a cooler summer in 2011 compared to the extreme summer weather in 2010 lowered year-over-year earnings $4.4 million. The negative impact from the revaluation of utility-related deferred tax as a result of the sale of Vectren Source lowered results by $2.8 million.

Nonutility earnings were $23.8 million compared to $9.8 million in 2010. The operating businesses of Infrastructure Services, Energy Services and Coal Mining earned $38.2 million in 2011 compared to $21.4 million in 2010. Note in particular the strong 2011 performance of our Infrastructure Services segment I referred to earlier, reflecting very good results for both Miller Pipeline and Minnesota Limited. In addition, our Coal Mining business also had a great year, reflecting the ramp-up of production levels at our new Oaktown 1 mine.

And finally, note that fourth quarter and year-to-date 2011 results were impacted by a few unique items. First, the gain that I mentioned earlier from the sales of Source. Second, after-tax charges totaling $9.2 million related to legacy real estate investments. And third, a $6 million contribution to the Vectren Foundation, which is currently expected to sustain its giving program for the next three years, resulting in a $3.9 million charge after-tax decrease in 2011 earnings.

Turning to slide six, we’re initiating our 2012 earnings guidance, including an expected loss of ProLiance in the range of $1.75 to $1.95 per share. We anticipate the Utility operations will demonstrate earnings growth within a range of $1.60 to $1.70 per share. Our Nonutility portfolio, excluding the results from ProLiance, is projected to add earnings in the range of $0.30 to $.40 per share.

Expectations for ProLiance, while obviously still nowhere near where we want them to be, are for a marked improvement in 2012 over 2011. ProLiance losses are projected to be in the range of a loss of $0.10 to $0.20 per share, as the business results reflect significant reductions in fixed demand costs in 2012 and improved seasonal spreads. The table in the lower part of this slide gives you a comparison of the 2012 guidance midpoints to the reported 2011 results as adjusted for the unusual items we discussed in our review of slide five. In a few minutes Jerry will provide you a little more insight as to the drivers and assumptions supporting our expectations for the various businesses in 2012.

As we look at slide seven and think about the items driving value for Vectren, we would remind you that in our view, valuation multiples applied to consolidated EPS that include ProLiance at a loss, will not accurately capture Vectren’s long-term value. Those losses, although disappointing, are not expected to continue indefinitely.

We realize that you have your own perspectives on the value of ProLiance, but we don’t believe that multiplying a P/E ratio times our guidance will yield an appropriate result. Our view is the combined EPS guidance excluding ProLiance of $2 at midpoint is the proper foundation for determining value. Vectren’s primary valuation driver continues to be our core utility operations, which are projected to grow nicely and generate between 80% to 85% of Vectren’s consolidated earnings in 2012 when setting aside the net loss currently expected for ProLiance. This is up from 75% in 2011.

Vectren’s Nonutility portfolio is diversified, yet still linked to the core utility and offers nice additional upside earnings opportunities that, excluding the ProLiance loss, are expected to contribute 15% to 20% of Vectren’s consolidated earnings in 2012.

In addition, given the expansion of our Infrastructure Services segment through the acquisition of Minnesota Limited in 2011 and its strong growth prospects, coupled with the sales of Vectren Source, future Nonutility earnings are expected to be less volatile. Including our dividend with the current yield of just under 5%, Vectren targets an attractive total shareholder return over the long term of about 8% to 10% annually. We believe our strong core utility operations, complemented by the improving business mix within our Nonutility portfolio and our attractive dividend record and current yields, are the key items that will drive long-term value.

Let’s move on to slide eight and look ahead to our strategies for 2012 and beyond. On the Utility front, which clearly represents Vectren’s core operations, our focus remains on executing strategies that will help us consistently achieve our annual Utility earnings growth target of 3%. For 2012 compared to 2011 the midpoint of EPS growth is closer to 8%, as we implement a full year of our new electric rate relief and realize the first year of the long-term benefits of our refinancing efforts. Over the long term, to grow earnings at the 3% rate, we need to earn our allowed returns and be disciplined in our spending.

On the first strategy of earning our allowed returns we have three key elements. One, implement electric utility lost margin recovery mechanisms. We made our initial filing recently to recover lost margins from the implementation of residential and small commercial customer programs. Two, earn current returns on infrastructure modernization investments as provided by existing trackers and recently passed state legislation. And three, aggressively manage our operational costs through performance management and strategic sourcing initiatives.

Our second strategy revolves around disciplined spending and staying focused on our goal of allocating capital in order to operate our utilities at cash flow neutral. This will include reinvestment of earnings to support necessary rate base growth and reducing the need for additional external financing, which at the same time should protect our strong A minus credit ratings.

On the Nonutility side, we look to continue to grow and enhance the profitability of our existing portfolio of businesses. As we did in 2011, we’ll focus on investing in our Infrastructure and Energy Services businesses to drive our long-term earnings growth.

We still look to open Oaktown 2 in the third quarter as demand dictates and would expect a ramp-up to near full production in 2013. Finally, we’ll continue to focus on improving the profitability prospects at ProLiance, primarily through continued reductions in our cost structure and growth in number of customers, while managing the portfolio take advantage of market changes, like the improved seasonal spreads for the winter of 2012-2013.

Before I turn it over to Jerry for more in-depth discussion of our outlook, I wanted to share a few final thoughts on ProLiance. We continue to be disappointed in the performance of ProLiance, but are committed to working with their management team as they execute the turnaround plan.

They have been successful to-date in significantly improving those things they can control, but similar to other wholesale marketers, their margins continue to be squeezed as a result of continued unfavorable market conditions. However, during our prepared remarks and in the Q&A discussion today, we do not believe it’s appropriate, and thus do not plan to comment regarding any specific long-term strategy regarding whether Vectren will be a long-term investor in ProLiance or exit this line of business.

What we will say is we have a very disciplined evaluation process and that we regularly review our investment in ProLiance, along with our investments in each of our nine utility businesses, and evaluate various strategic options for each business. Over time, we evaluate whether each of those businesses remains a strategic fit for our Nonutility portfolio, and whether it’s capable of providing reasonable returns on the capital invested.

The lower expected loss for 2012 demonstrates that ProLiance’s management is focused on and has made progress toward moving the business to eventually achieve return hurdles. However, given our disciplined approach, if those hurdles can’t be achieved, then various exit strategies are considered, along with their potential impacts on the consolidated enterprise.

I’ll now ask Jerry to provide more insights into our various businesses for 2012 and beyond.

Jerome Benkert

Thanks, Carl. Turning to slide nine, the midpoint of our 2012 Utility net income guidance range is $135 million. The increase over 2011 is driven in part by full year of the new electric base rates, which were first implemented in early May of 2011 for an annualized increase in rates of $28.6 million.

The other key driver for Utility earnings growth in 2012 is lower interest expense, which is driven by the refinancing opportunities we took advantage of in 2011 related to a total of $250 million long-term debt. As a result of these factors, we expect the consolidated Utility Group to show strong growth over 2011 and to earn at or near our authorized returns in 2012.

On slide 10 we continue the Utility outlook with a review of our forecasted Utility CapEx for the next three years. As Carl mentioned earlier, our guiding principle is to reinvest earnings for needed infrastructure improvement projects across our utilities, while targeting free cash flow neutral.

We have listed on slide 10 four areas of investment that have mechanisms at either the state or federal level that are expected to provide our utilities with the reasonable opportunity to defer cost and/or recover the investments in a timely manner and offset earnings attrition related to making those investments.

The newest area will be increased spending planned for gas infrastructure modernization in response to new federal legislation. Examples include such things as installation of remote shutoff valves on transmission lines and increased inspections of more miles of transmission lines, as the classifications for high consequence areas are expanded to include additional existing pipelines.

As we look forward from 2012, we believe that modest rate base growth combined with supportive regulatory recovery mechanisms and along with diligent management of our operating costs through performance management and strategic sourcing initiatives, should position us to generate a sustainable 3% earnings per share growth and earn near our allowed Utility returns without the need for additional gas or electric base rate relief over the next few years.

Turning to slide 11, we move to our Nonutility guidance and outlook. Focusing for a moment on only Infrastructure Services, Energy Services and Coal Mining, 2011 was an outstanding year. While we don’t expect to match it in 2012, in total we do expect to see very good two-year growth from these businesses, growing from earnings of $21.4 million in 2010 to $29.5 million in 2012, a two-year growth rate of over 17%. Though I’ll go into more detail on each business in a few minutes, let me go ahead and note a few things impacting 2012 results for these businesses versus 2011.

For our Infrastructure Services segment, it’s really a matter of timing on the acquisition of the Minnesota Limited in 2011. Because we acquired Minnesota Limited March 31 of 2011, the typical seasonal first quarter loss would show up in 2012, whereas it was not in the last year. In addition, we saw much stronger earnings in 2011 from Infrastructure Services, particularly in the third quarter than we had expected, given strong demand for our services coupled with excellent weather and other favorable conditions impacting construction. As a result, we’re tempering our 2012 earnings expectations slightly to a level that should be more sustainable.

For Energy Services, the lack of growth in earnings that we expect in 2012 reflects the long sales cycle for new personnel in the performance contracting business, as we continue to invest in this business by hiring sales and engineering talent to significantly grow the business. We expect to continue our ramp-up of additional personnel through 2014.

For our Coal Mining business, margins will be somewhat compressed in 2012 compared to 2011, and closer to the lower end of the $5 to $6 range that we gave on our third quarter call in November. The current softer market price for new coal sales and the exploration in 2012 of some older higher priced contracts will limit our expected Coal Mining earnings contribution for the year compared to our strong 2011 performance.

For 2012, we are expecting ProLiance to significantly reduce its losses year-over-year, as they continues to execute on its performance improvement plans. Reductions in the fixed demand cost will drive the expected improved results. While continued focus on controlling G&A expense, the growth in commercial and industrial and power generation customers will also help. I’ll expand a bit more on these improvements in just a few minutes.

In addition, as you see in the footnote at the bottom of the slide, we’re disappointed in the charges that were necessary to be recorded in both 2010 and 2011 from some of our investments in old legacy businesses that preceded the formation of Vectren and are no longer part of our core Nonutility portfolio. However, we do believe that we are well-positioned now, such that if there are any future charges required as we continue to even exit these businesses, they should not be material. As you will note, the total investments primarily in real estate, net of deferred tax impacts, is now about $20 million. This is down from $50 million as recently as the end of 2009.

Moving on to slide 12, I’ll provide additional detail on our 2012 expectations for Infrastructure Services and the Energy Services. We do anticipate another great year in 2012 from our Infrastructure Services business, with earnings of approximately $12.5 million. We continue to see strong demand for pipeline construction both in the repair and replacement segment due to safety concerns of aging natural gas and oil pipelines, as well as new federal pipeline safety regulations. And additionally, new opportunities related to the development of oil and natural gas infrastructure near the Bakken and Marcellus shale formations.

As I noted earlier, historically difficult weather conditions in the first quarter hampered construction activity and our ability to turn to profit. And though the weather so far this year has been better than normal through mid-February, we recognize that a few months of potentially difficult working conditions remain in our primary markets. At a high level, Miller and Minnesota are committed to maintaining their focus on building and sustaining their long-term customer relationships through ongoing delivery of quality pipe construction and great customer service.

As Carl mentioned earlier, the Infrastructure Services business is a cornerstone of our Nonutility portfolio, and we will remain focused on growing the business organically and we will also consider additional strategic acquisitions.

Turning to the Energy Services segment. Energy Services Group has been a solid earnings contributor to Vectren for many years. Earnings of about $6 million are projected for 2012. This includes, as compared to 2011, an expected roughly $4 million to be generated from tax credits for planned renewable projects. Going the other way in 2012 will be incremental personnel cost associated with adding the staffing levels in 2011 and 2012, as we continue to invest in order to position the company for long-term earnings growth.

With this investment in personnel and the nation’s focus on energy efficiency, we believe that long term contributions to earnings from this business should be significantly higher. The performance contracting segment of ESG’s business continues to focus on its market niche of serving hospitals, universities, governments and schools, where ESG adds value through the design and build phase of energy savings projects, and often enters into longer-term agreements to actually operate some of the larger energy facilities.

The backlog of performance contracting projects remains strong, sitting at $82 million as of 12/31/2011, even though that is down from 2010 levels. In 2011, ESG also made further progress in the renewable energy sector as we won design and build contracts for landfill projects and began construction on three anaerobic digester projects to covert animal waste to power at dairy farms in Wisconsin. The first of these projects will begin production later this month. After this new line of renewable business for ESG grows, these projects will complement our expertise in other areas of renewable energy, such as facilities that convert landfill gas to power or to pipeline quality gas.

Slide 13 provides our outlook for the Coal Mining Group and for ProLiance. We look for Vectren Fuels to contribute approximately $11 million to Nonutility net income in 2012, down from $16.6 million in 2010. Fuels is expected to increase its coal production and sales to about 6 million tons this year from just over 5 million tons in 2011, primarily as a result of the opening of our second Oaktown mine, which is anticipated in the third quarter of 2012.

Approximately 75% of 2012 expected production has been sold, which includes sales of about 1.8 million tons to Vectren’s electric utility. Expected margin for 2012 is about $5 per ton excluding freight, compared to roughly $7 per ton in 2011. Even though we expect a decrease in the cost per ton in 2012, we expect a decrease also in revenue per ton compared to 2011, which is due primarily to the expiration of some older, higher priced contracts in 2012 that are being re-priced at lower current market prices.

For 2012, less than 1 million tons of coal sales to Vectren remain at the higher 2008 contract prices. Those higher price contracts will end this year. As I mentioned earlier, we expect to mine 1 million additional tons in 2012, which will help drive our expected cost per ton down, since these additional tons will come from our lower cost Oaktown mine and we will be able to allocate our fixed cost over even more tons produced.

Additionally, contributing to the expected cost decrease year-over-year 2012 compared to 2011 are productivity improvements. We expect that we will be very near or at full production at Oaktown 1 in 2012 and produce 2.9 million to 3 million tons. Mine productivity improvements in 2012 include that all three of the continuous mining units in Oaktown 1 have now been cleared by MSHA used deep cuts, allowing the continuous miners to mine about 36 feet before they have to pull out to allow for roof building and other mining supporting activities to proceed. Previously, two of the mining units were only cleared for mining 20 feet and 30 feet, respectively.

In addition, at both Prosperity and Oaktown much more of the mining in 2012 within the room and pillar approach will be in certain sections located off the mains called panels, where mining productivity is much greater than in the main entryways of the mines. Beginning in 2013, we expect to mine approximately 7.5 million tons per year, which will equate to all three mines being at or near full production. Approximately 40% of the 2013 production is sold, of which we expect 2.1 million to 2.5 million tons to be sold to Vectren’s electric utility.

Substantially more coal sales are under contract, but we did not count them as sold due to price reopeners contained in the contracts. I mentioned earlier the tons sold at Vectren will all be at lower prices more reflective of current market conditions. And finally, with the sale of our retail gas marketing subsidiary, Vectren Source, the Energy Marketing segment now consists solely of our equity investment in ProLiance.

In 2012, we expect our share of ProLiance’s results to reflect an after-tax loss of approximately $12.5 million, or an improvement in excess of $10 million over 2011 results. Driving the year-over-year improvement are reductions in firm transportation and storage costs, which result in 2012 cost of approximately $55 million at ProLiance level compared to $73 million in 2011. Also of note, in the fourth quarter of 2010, ProLiance took advantage of substantial improvement in seasonal spreads for natural gas, and they executed a hedge that has essentially locked in roughly 75% of their seasonal spread opportunity for the year.

In addition to these improvements, ProLiance will continue to pursue the renegotiation of pipeline and storage contracts, in addition to taking a hard look at dropping contracts that expire by 2013. Those contracts represent another $18 million of fixed cost.

In closing, let’s turn to slide 14. This afternoon we have provided quite a bit of detail around our various businesses and how we expect them to perform in 2012. Let me move back to the 50,000 foot level and summarize some of the key factors that we believe support Vectren’s attractive investment profile.

We are, first and foremost, a utility company, but we have a diversified portfolio of complementary nonutility businesses. The quality of our earnings is strong and improving, with the lion’s share coming from our utility operations that operate in constructive regulatory environments. We have a strong balance sheet with corresponding strong A minus credit ratings. We have a dividend record of consistent increases year after year that few companies can match.

Our Nonutility businesses provide enhanced earnings growth opportunities and our business mix continues to improve, with less emphasis on earnings growth expected from the more volatile commodity sensitive businesses and more emphasis on those that can generate solid earnings growth with much less period-over-period volatility.

In a nutshell, those are some of the unique things about Vectren that we believe position us for future success. Although we won’t cover them in today’s call, I will call your attention to the Appendix section of the slides, which, as usual, contain some of the key metrics for each of our Nonutility businesses. We take great pride in being very transparent and we believe that part of that transparency is providing detailed key metrics on each of our businesses.

Operator, that concludes our prepared remarks and we’re now ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And we have no questions at this time. I’ll turn the call back to our presenters.

Robert Goocher

Okay. Thank you, operator. We’d like to thank everyone for joining us on our call today. On behalf of our entire team, we appreciate your continued interest in Vectren and invite you to please contact us if you have any follow-up questions. For those of you located in the Northeast, next week we will be hosting lunch meetings in New York on Tuesday and Boston on Wednesday, and hope to see many of you there. With that, we’ll conclude our call for today. Thanks again for your participation.

Operator

This concludes today’s conference call. You may now disconnect.

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