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Pinnacle West Capital (NYSE:PNW)

Q3 2007 Earnings Call

October 25, 2007, 1:30 pm ET

Executives

Rebecca Hickman - Investor Relations

Bill Post - Chairman and Chief Executive Officer

Don Brandt - Executive Vice President and Chief FinancialOfficer

Jack Davis - President and Chief Operating Officer

Analysts

John Kiani - Deutsche Bank

Greg Gordon - Citigroup

Dan Eggers - Credit Suisse

Paul Patterson - Glenrock Associates

David Thickens - Deephaven Capital Management

Andrew Levi - Brencourt Advisors

David Grumhaus - Copia Capital

Shalini Mahajan - UBS

Danielle Seitz - Dahlman Rose and Company

Reza Hatefi - Polygon Investment Partners

Operator

Good afternoon. My name is Andrea, and I will be yourconference operator today. At this time, I would like to welcome everyone tothe Pinnacle West Third Quarter Earnings Conference Call. All lines have beenplaced on mute to prevent any background noise. After the speaker's remarksthere will be a question-and-answer session (Operator Instructions).

Thank you. Ms. Hickman, you may begin your conference.

Rebecca Hickman

Thank you, Andrea. I would like to thank everyone forparticipating in this conference call to review our third quarter earnings,recent developments and operating performance.

Today, I have with me Bill Post, our Chairman and CEO, JackDavis, who is our President and Chief Operating Officer, and also CEO ofArizona Public Service, and Don Brandt, who is Executive Vice President and CFOof Pinnacle West and also President of APS.

Before I turn the call over to our speakers, I need to covera few details with you. First, I encourage you to check the quarterlystatistics section of our website. It contains extensive supplementalinformation on our earnings experiences and quarterly operating statistics.

Second, please note that all of our references today to pershare amounts will be after income taxes and based on diluted sharesoutstanding. Is it my responsible to advise you that this call will containforward-looking statements based on current expectations and the companyassumes no obligations to update these statements.

Because actual results may differ materially fromexpectations, we caution you not to place undue reliance on these statements.

Please refer to the caption entitled forward-lookingstatements contained in the MD&A and our second quarter 2007 Form 10-Q andthe risk factors in our 2006 Form 10-K, each of which identifies some importantfactors that could cause actual results to differ materially from thosecontained in our forward-looking statements.

A replay of this call will be available on our website www.pinnaclewest.com for the next 30 days.It will also be available by telephone through November 1st.

Finally, this call and webcast are the property of PinnacleWest Capital Corporation and any copying, transcription, redistribution,retransmission or rebroadcast of this call in whole or in part without PinnacleWest written consent is prohibited.

At this time, I will turn the call over to Bill.

Bill Post

Thank you. And I would like to thank you for taking yourtime to join us today. I’ll highlight several issues and then turn the callover to Don and Jack to discuss details of our financial results, ourregulatory developments and our operations.

First, I would like to address our management changes. Lastweek Jack announced his plan to retire next March, completing a very successful35-year career with the company. Throughout his career, Jack has focused onmeeting the demands of the remarkable growth that our company, throughexcellence and resource additions, customer service and operations.

Through his leadership Jack successfully maneuvered ourcompany through periods of record growth and significant industry turmoil,including the western energy crisis.

Although we intend to take advantage of Jack's expertiseduring his remaining time with us, we know he has built a strong team that willcarry on his commitment to excellence. And since he is here with us today, Iwould like to say, publicly, Jack, thank you for all of your contributions. Youwill be missed.

Our success in planning has been in place and as you knowDon Brandt was named President of APS last December. Upon Jack's retirementnext March, Don will take the helm as APS' President and CEO.

Don's commitment to our customers and investors isexceptional. Further, he is keenly aware of APS' challenges and opportunitiesand we look to him to continue emphasizing excellence in customer service andall of our operations.

As we described to you earlier, we have been taking a hardfocused look at our organization for opportunities to be more effective andefficient and maintain a steadfast focus on our customers and to ensure that wehave clear lines of accountability for results.

With that in mind, we also recently made a number ofadditional internal management changes that we believe will streamline andstrengthen our organization, and Don Brandt will discuss them a little bitlater on.

Growth in our service territory has slowed from its paceabout a year ago, but still remains strong versus industry averages. APS'customer base grew 3.2% in the third quarter of this year, compared with a yearago and we expect to end the year with customer growth of about 3% over 2006.

On our last conference call, I outlined a multiple-stepprogram to address the issues of growth and the pressure it places on ourcompany. All facets of the program are currently underway and I will brieflysummarize the key aspects.

As I said, we are reviewing our capital and operating coststo ensure that we are as efficient as possible. However, we will not reduce ourlevels of safety, reliability or service. We expect to complete our cost reviewby the end of the year.

In the regulatory area, our efforts include a FERCtransmission rate case and the associated processes to implement result inrates at both the wholesale and retail level.

Retail rate setting options to be presented to the ACC thisyear to address growth, who should pay for it and how should pay for it andalternative resource plans also to be presented to the ACC by year-end for baseload peaking, renewable and energy efficiency resources to meet future loadgrowth. Jack will provide some more detail on the regulatory initiatives.

Finally, we are assessing our need for additional raterelief. The elements of the multi-step program just described will obviouslyhave impacts on APS's revenue requirements and all of these items will be consideredand incorporated into future rate funds.

Turning to financial issues, we understand the importance ofdividends to our shareholders as a component of total return. We also believeour dividend is essential to maintaining our shareholder base and attractingcapital to support our large capital expenditure program and to serve ourcustomers' growing energy needs.

Last week we declared a quarterly dividend of $52.05 pershare payable on December 3rd. This represents an indicated annual dividendrate of $2.10 per share. Our dividend policy has been that future dividendlevels in growth will be dependent on a number of factors such as free cashflow, payout ratios and industry trends.

Historically, our board has considered our annual dividendlevel in October and for more than a decade we grew our dividend at a rate wellabove the industry average. After considering all facets of our currentcircumstances, we held the dividend at its current level.

Finally, this morning we updated our earnings outlook for2007. Currently we expect our consolidated earnings for 2007 will be within areasonable range of $2.90 per share, which is an increase of $0.35 per sharefrom our previous guidance.

Let me now turn it over to Don, who will give you moredetails on the guidance and other financial updates.

Don Brandt

Thanks, Bill. As Bill said, our consolidated earningsguidance is a reasonable range around $2.90 per share. As part of this guidancewe estimate the APS's earnings will be about $2.70 per share, which willproduce an earned rate return of about 8.25% for the year.

SunCor's earnings are currently expected to be approximately$20 million for the year. The consolidated guidance we provided in July was anestimate of a reasonable range around $2.55 per share.

The primary differences between our current guidance and theprevious guidance are as follows. First, hotter than normal weather during thisyear's third quarter improved our estimate by $0.14 per share and I will talk alittle more about the details of just how hot it was this summer in a fewminutes.

Tax benefits related to prior years but resolved during 2007increased our estimate by about $0.13 per share. Deteriorating credit marketconditions in the second half of 2007 have lowered our earnings expectationsfor SunCor by about $0.10 per share.

The decline at SunCor is essentially attributable to threerelatively large commercial and partial transactions that we do not now expectto close in 2007. The net effect of numerous relatively minor factors combinedimproved our estimate by $0.18 per share.

These factors include such items as, lower effective incometax rate, higher than expected retail sales and lower than projected interestexpense. Let me emphasize that not one of these numerous items is notable on astand-alone basis and that some of them are clearly one-time items, whileothers are the result of our cost management efforts, and those efforts willcontinue.

Turning to our third quarter results, for the third quarterof 2007 we reported consolidated net income of $209 million or $2.07 per share,compared with $184 million or $1.84 per share in the prior year quarter.

Two factors dominated the quarter-to-quarter comparison.Extraordinarily hot weather in this year's third quarter and tax benefitsrelated to prior years but recorded in this quarter. First, extreme weatherincreased our earnings by $0.16 per share.

This year's third quarter was very hot even by Arizonastandards. We set some summer weather milestones. We had temperatures at orabove 110 degrees on 32 days in the Phoenix metropolitan area. This compareswith a norm of 10, 110-degree days in a typical summer. We also had the hottestAugust on record.

Another key factor was the tax benefits related to prioryears that were recorded in this year’s third quarter. These tax benefitsimproved earnings by $0.10 per share. The other principal factors that affectedthe quarterly comparison were increased retail sales volumes related tocustomer growth added $0.10 per share.

APS's July 1st retail rate increase improved earnings by$0.10 per share. The components of this increase are $0.07 per share as aresult of lower 90/10 sharing under the PSA due to the higher base fuel rateand $0.03 per share for non-fuel rate increases.

Higher O&M expense cost decreased earnings $0.09 pershare. These costs increases were largely driven by customer service andregulatory program costs, as well as higher generation costs including PaloVerde’s performance improvement programs.

Increase depreciation, property taxes and interest costprimarily related to higher APS plant balances in capital spending reducedearnings by $0.07 per share. SunCor earnings of were down $0.11 per sharechiefly related to lower sales of residential property and parcel salescompared to the prior year.

These reductions are consistent with the slow down in thewestern real estate markets we discussed earlier this year, but they wereexacerbated by the rapid deterioration in credit market conditions during thethird quarter.

Now let me cover APS's PSA deferrals and fuel hedgepositions. As of September 30th, APS had $150 million of accumulated PSAdeferrals. We expect to recover these deferrals through annual PSA adjustersand surcharges by the end of 2008.

During this third quarter, we deferred $69 million andrecovered $58 million through various PSA adjusters and surcharges. As youknow, the deferral recovery positively impacts cash flow, but does not affectearnings, because the amount recovered grew revenue also is amortize as fuelexpense.

With respect to managing fuel and purchase power cost, ourhedge program substantially mitigates natural gas and purchase power pricevolatility for our customers. As of today, we have hedged about 85% of ourremaining 2007 exposure to fuel price risk for negative load requirements.

Similarly we have hedged 85% of our 2008 price risk and 50%of our 2009 price risk. These hedge positions are at prices generally in linewith current forward market prices.

Finally, I would like to make a few comments on themanagement changes Bill mentioned. We have realigned our executive managementorganization to enhance our focus on customers and to sharpen roles andresponsibilities so as to improve accountability and overall performance.

While each of the management changes are significant forAPS, there are three changes I believe should be of particular interest to ourinvestors.

First, Don Robinson was promoted to Senior Vice President,Planning and Administration. Second, Tammy McLeod has been named Vice Presidentand Chief Customer Officer. And third, Jeff Guldner has been named VicePresident Rates and Regulation.

Many of you have met Don Robinson in our offices and on afew investor road shows. Don is a solid experienced executive and in a numberof administrative functions has been centralized under Don, along withimportantly our all of our planning functions including resource planning andenergy procurement.

Tammy McLeod is Wharton graduate who joined APS in 1995. Shehas a solid background in customer service programs, marketing and T&Doperations. Her responsibilities include system-wide customer service,corporate communications and community development. Essentially every aspect ofAPS that touches our customers and the communities we serve is under Tammy'sdirection.

Jeff Guldner, formerly a law partner at Snell & Wilmerhere in Phoenix, with an expertise in energy and regulatory law, joined APSabout three years ago to run our compliance programs and manage federal regulatorymatters. His responsibilities now include all aspects of APS's Arizona andfederal rate and regulatory activities.

I have every confidence that these three executives alongwith the entire APS officer team will lead APS to deliver outstanding service andvalue to our customers and create value for our shareholders in the many yearsto come.

I’ll now turn the call over to Jack.

Jack Davis

Thanks, Don. Today, I will update you on recent regulatorydevelopments and operational performance. Although this maybe one of theshortest regulatory updates I have given you in recent past, we continue to bevery focused on regulatory issues.

On last quarter's call I outlined the key provisions of theACC June decision on APS -- on the APS rate case. That decision closed asignificant proceeding in our regulatory history. A preceding that lasted some20 months and resolved a number of significant issues. Principally timelyrecovery of our fuel and purchase power costs yet other issues continue.

The formula for kilowatt hour PSA adjustment that tookeffect on February 1st of this year will remain in effect as long as necessaryafter January 31st of 2008 to collect an additional $46 million of 2007 costsdeferred under the PSA as a result of the mid-year implementation of the newbase fuel rate. We estimate this adjustment will remain in effect through mid2008.

Effective July 1st, APS began collecting through a PSAsurcharge of approximately $34 million including a crude interest of PSA costdeferrals led to the 2005 replacement power cost for Palo Verde outages. Thistemporary rate increase will be in effect for a 12-month period.

Regarding 2006 Palo Verde related PSA deferrals, APSdeferred $79 million under the PSA related to 2006 replacement power cost forPalo Verde outages. Virtually all of those referrals were associated with theunit one vibration issue.

The ACC directed its staff to conduct a prudent review ofthe outage costs. Earlier this month the ACC staff filed a report with the ACCconcluding that the APS' response to the unit one vibration was reasonable andprudent.

We have been recovering those referrals and will continue todo so through the PSA. On August 7, APS submitted to the ACC a plan to meetingthe five years -- a five-year plan of Arizona renewable energy standard.

In addition to projects already in operation or undercontract, the plan calls for APS to acquire around 2000 gigawatt-hours ofrenewable energy between 2008 and 2012. And also I’ll outlines significantincreases to APS distributed energy program, which pays customers to installtheir own renewable generation sources such as solar electric systems or solarwater heaters. The ACC staff is currently reviewing this plan and will file areport with the ACC.

As Bill mentioned we are continuing to work on regulatoryinitiatives related to growth in our state. The ACC commissioners haveexpressed concerns about how to support the vitality of our state and itsremarkable growth. It will also expressed concerns about who should pay forgrowth and how.

Paying for growth will require some innovation in our ratemaking policies -- in our rate setting policies. We were developingalternatives to address growth from a regulatory perspective and plan to takethem to the ACC this year.

Also before year-end we plan to provide the ACC withresource alternatives to meet future load growth. We will also offeralternative proposals that curve peaking and base-load resources, as well as,renewable and energy efficiency options.

Turning to the federal scene issues for a moment. As Idiscussed in our last call, APS filed a on July 10, its first transmission ratecase with the Federal Energy Regulatory Commission since 1996. The filing askedfor a $37 million increase in annual transmission revenues.

The filing also includes a proposal for the FERC to approvea formula rating setting methodology to allow APS to adjust wholesaletransmission rates on June 1st of each year.

On September 21st, the FERC issued an order allowing APSproposed transmission rates to become effective on March 1st of next year. Andthe FERC order also established settlement judge procedures. Initial settlementconference meeting has been held and additional settlement conferences will bescheduled.

However, at this point we do not know where the caseultimately will be settled or go to hearing. It's important to understand atthis point that only about $7 million of the annual increase amount would comefrom wholesale customers and approximately $30 million of increase representscharges for transmission services to serve APS' retail customers.

The ACC approved a transmission cost adjuster mechanism aspart of the 2005 rate case decision. We are currently addressing theappropriate procedure to recover the retail transmission rate changes from ourcustomers.

Now let me discuss growth in our market. Growth in ourservice territory remains solid. Arizona's population grows at three times thenational average. That growth is the foundation for our customer growth, whichwas 3.2% in the third quarter, compared with a same quarter last year.

Customer growth translates into increased sales. APS' thirdquarter retail sales grew about 6.4% compared with the prior year and onweather normalized basis third quarter retail sales grew 1.9%.

Customer growth also translates into peak load growth. OnAugust 13, we set our system peak for 7,545 megawatts. The peak was right inline with our forecast for the year and reflected a 1% decrease from last year.However, on weather normalized basis the peak was approximately 33% higher thanlast year.

Last year we set our peak on a day that reached 118 degreesin Phoenix, which happens only once every 10 years. Most important our systemoperated very well to meet the record peaks.

Now I will discuss our power plant performance. The combinedcapacity factor for Palo Verde nuclear units was slightly better than 89% forthe third quarter this year. Better than the same quarter a year ago. We havetwo scheduled refueling and maintenance outages at Palo Verde each year.

This year's spring outage of unit one was completed on July19th. The fall outage of unit three began last weekend in September -- beganlast week in September. We expect unit three outage to last about 80 daysduring which we will replace the unit steam generators, low-pressure turbinesand core protection calculators.

Unit three will be the final unit to receive the steamgenerators thus replacing -- thus completing the largest replacement program inPalo Verde. We are aggressively addressing our operations at Palo Verde with agoal return the plant to top tier performance as soon as possible. We arecontinuing implementation of a thorough self-evaluation of the plant toidentify and correct any issues.

In addition, we are working closely with the NuclearRegulatory Commission to ensure that our plans and procedures for addressingissues are coordinated. The NRC is in the process of completing a rigorouscomprehensive inspection at Palo Verde. In the four-week inspection the NRC istaking a detailed look at all areas of the plant's operation. By the end of theyear, the NRC expects to issue its inspection report. The NRC findings will beincorporated into our improvement programs.

Our coal fire plants continue to operate superbly. Duringthe third quarter the coal plants posted a 93% capacity factor essentially thesame as their performance a year ago. That concludes my prepared remarks and Iwill turn the call back to Bill.

Bill Post

Thanks, Jack. In summary, we understand what it takes toserve the fastest growing state in the country. Over the years, we haveconsistently met our customer's growing energy needs and we will continue to doso. That concludes our prepared remarks and we would be very happy to answeryour questions.

Question-and-Answer sessions

Operator

(Operator Instructions)

We'll pause for just a moment to compile the Q&A roster.Your first question comes from the line of John Kiani from Deutsche Bank.

John Kiani - Deutsche Bank

Good morning. Can you talk a little bit more about thecomponents of the $0.35 per share guidance increase? I want to just get abetter sense for how much of the items that you highlighted in the 8K arerecurring or will continue beyond '07. If I look at some of the pieces to me itlooks like maybe a subset of the $0.18 other category and then perhaps thehigher retail sales is the portion that we could expect to see as a continuedbenefit. Am I think being that correctly?

Don Brandt

John, this is Don here. To a degree, possibly yes. I hate tobe equivocating on that but some of that is potentially attributable to theweather extremes just how accurate splitting weather from growth might be. Onthat front, but it did surprise us. There was still strong growth there. In myprepared remarks, I just wanted to stress that there -- most of the itemsindividually are not of the recurring type nature. But some of it, about half,or 40% I would put in the category as a result of management efforts.

And those will continue, whether the exact sameopportunities will present themselves again in the future periods. Those exactcircumstances probably won't be there. But our dedication to the minimizingcosts will be and we continue to focus on that. But some of them are reallyone-time quirks that came out --

John Kiani - Deutsche Bank

That's helpful, Don. Just to be clear. When you say kind ofballpark 40%, do you mean 40% of the $0.18?

Don Brandt

Yes, correct.

John Kiani - Deutsche Bank

Not of the $0.35.

Don Brandt

Hey, 40% of the $0.18.

John Kiani - Deutsche Bank

Got it. Okay. That's helpful. And then just a quick questionon SunCor. If we were looking out kind of beyond '07, should we take what'skind of implied by the fourth quarter, which to me seems like about $4 millionor so, and extrapolate that and assume that that's sort of the new run rate? Orwill those parcel sales you mentioned that are going to get pushed off benefitabove and beyond what that math would show?

Don Brandt

Let me address those two different ones. No, you shouldn'ttake that $4 million run rate and --

John Kiani - Deutsche Bank

Okay.

Operator

Your next question comes from the line of Greg…

Rebecca Hickman

Wait, wait, wait. Andrea, we were still answering Mr.Kiani's question.

Operator

Mr. Kiani, please press star-one again.

Don Brandt

John, John, are you still on?

John Kiani - Deutsche Bank

I'm here. Okay. Thanks, Becky.

Don Brandt

Good save, Becky. The $4 million for fourth quarter, you'reabout right. That's the way the math works. I would not take that as a run rategoing forward.

John Kiani - Deutsche Bank

Okay.

Don Brandt

And I will answer your question the second part a littledifferently than the way you asked it. But the three deals that failed to closethat we thought would close, it doesn't reflect the change in value. It waspurely the entities ran into financing problems.

John Kiani - Deutsche Bank

Okay.

Don Brandt

And it was very unexpected I'm sure on their behalf. Anybodywho was in the financial markets in early-to-mid August, even our owncommercial paper program was a little disruptive for a few weeks. And they puttogether. Some of them are looking to restructure those deals, take another runat it. But the issue is, one of these commercial deals falls apart, it's notsomething you put back together in two weeks. It's two to four months’ process.The value is still there for future years.

John Kiani - Deutsche Bank

Got it. That's helpful, Don. Thank you.

Don Brandt

Okay.

Operator

Your next question comes from the line of Greg Gordon.

Greg Gordon - Citigroup

Follow up on John's question and then one other question.Are we -- should we be comfortable that the underlying economic value of thosetransactions isn't in fact diminished when you come back to re-value thosetransactions in '08? To put another way, I think we leaned away from valuing thereal estate business on earnings and look at more as -- as an asset value play.What do you guys seeing in terms of asset value, and what are your accountantssort of do on a regular basis in terms of trying to assess impairments on thereal estate value?

Don Brandt

No. Greg, one, no, we think the long-term value is stillthere. And relative to the impairment issue, we don't believe there is an issuethere. Actually on the parcels that didn't close, the basis is literally asmall fraction of the current market value. And even if you take plus or -- 20%plus or minus of those current market values, we are still substantially in themoney.

Greg Gordon - Citigroup

Okay. My second question goes to timing of regulatoryactivity. I know you guys are taking a hard look internally at both youroperating and capital costs. At what point will we see you approach thecommission again to get rate making treatment, either for the pass through ofthe transmission revenues that you require, or taking another look at theunderlying revenue requirement of the utility?

Bill Post

Greg, this is Bill. As far as dealing with the growthissues, we are going to be dealing with the commission on those growth issuesthrough the rest of this year and probably into next year. And then based uponall of the things I mentioned, we will be taking a look at some kind ofpotential filing. And it's hard to basically predict that at this point becauseit depends on several of the things between now and then next year.

Greg Gordon - Citigroup

Thanks.

Bill Post

Good.

Operator

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

Bill Post

Hello, Dan.

Dan Eggers - Credit Suisse

On your last comment to Greg, what would cause you not fileanother rate case, kind of given this 825 ROE type of level?

Bill Post

Well, it obviously comes down to our success in dealing withseveral of the issues that we're dealing with today. One is the growth issueand how the growth issue is dealt with and certainly that could have asubstantive impact. I don't believe as I have mentioned we've been goingthrough our expense reviews and I know as you know, Dan, when you benchmark ourcompany on expenses, we perform very, very well.

So we are in a situation there where we are going to driveour costs down as I mentioned as low as we possibly can, but we aren't going togo below levels that have a negative effect on safety or customer service. Andcost savings alone will not offset the growth impacts that are placed upon usfrom new customer growth as we go forward. So savings alone will not offsetthat.

Our transmission, as Jack mentioned, we filed a transmissionrate case, and we expect that to go into effect early next year in the firstquarter of next year, and so all those variables kind of come together. Butfrom our standpoint, the big issue's growth and dealing with that on a goingforward basis.

Dan Eggers - Credit Suisse

As you have the conversations with staff, with parties, withcommissioners about addressing growth, is it a bit of a challenge to get toofar down the path of the conversation given the fact that three of thecommission's seats will be different by the time you could actually get aneffective rate case done?

Bill Post

Well, our commission as you know, it's an elected commissionand every two years we will have either two or three seats up for election.That's been the case in terms of election for some time. And the timing ofthese decisions in my memory has never been affected by that.

More specifically, as we have put forward rate cases thatwent as this one did over some months. It did not impact the new commissioner'sability to be able to engage on that and to deal with that issue. And I don'texpect it will going forward.

Dan Eggers - Credit Suisse

Don, do you happen to have right now where the equity ratiowas at APS at the end of third quarter?

Don Brandt

No, I don't.

Dan Eggers - Credit Suisse

And I guess lastly just kind of as we think about -- startthinking about '08, more actively the drivers, some help from loads, some helpfrom cost savings, some help from implementation of this year's rate caseresolution, those will all be positives. The negatives are going to be a morenormalization of tax rate and higher financing expense. Is that fair?

Don Brandt

Yes.

Dan Eggers - Credit Suisse

Is there anything else we should be thinking about rightnow?

Don Brandt

Well, let me start by a couple of things. Relative to '07,is jumping back there. I said in the last call that we'd expect an increase inO&M expense pre-tax $10 million to $15 million a quarter. And whereas thethird and fourth quarter and I was doing simple math dividing by two and forthe third quarter we were up about $5 million pre-tax.

So we still see that number on O&M coming to fruitionfor the year. In the fourth quarter we will see an increase pre-tax of -- inthe neighborhood of $25 million. In addition to that, something in the fourthquarter, and in future quarter’s kind of a run rate on capital-related expensesas I will categorize them, and there is depreciation property taxes andinterest expense is about a $0.10 per share quarterly impact going forward isthe cost of new plants going into service.

Dan Eggers - Credit Suisse

Okay. Thank you.

Operator

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

Bill Post

Hello, Paul. How are you doing today?

Paul Patterson - Glenrock Associates

All right. Just to clarify things here because I sort of --it was coming in, I don't know if it's on my phone, but I wasn't able to heareverything completely. It sounds to me like about 40% of the $0.18 is non-recurringin your estimation with respect to the guidance number that is sort ofmiscellaneous?

Don Brandt

No, I think it was the opposite. I'm not sure I'd categorize40% of it as recurring, but it was attributable to our cost management efforts.And those efforts will continue, whether the exact same type items arerepeatable or not, in their entirety I doubt it. But the other 60% is clearlyone-time oddities that just came to fruition.

Paul Patterson - Glenrock Associates

Okay. And then in terms of the real estate market there andwhat have you and what we are seeing just generally in the press, I think youindicated you saw no significant impairment at all in the business. And Iwanted to get a flavor for that. Is that because the market dynamics in --where you are operating, is that because of your low cost basis to begin with?

Could you give us more flavor as to sort of the outlookthere? What you are seeing and whether or not -- what you see the trend goingforward into 2008 in terms of different markets. I know that the commercialmarket might be offsetting to a certain degree. But just in general, what theflavor there is if you could elaborate on that a little bit more?

Don Brandt

Yes. First you mentioned the real estate market and I willaddress that two aspects. The commercial side and in commercial I'll throw inour potential parcel sales and then there is the residential home market andhome building market. And the commercial market we think is still very solid.And a combination of market dynamics here in the west valley of Phoenix, wherea good deal of our operations on the commercial side are centered.

And we have an extremely low basis in the land we own in thewest valley. Now on the home building front, that has slowed dramatically, andin a solid year we would have expected home sales in the 800 to 900 unit. Andwe will do a little better than 200 units this year with a good part of thatoccurred in the first six months and it's dropped off dramatically in the fourthquarter.

But with that said, we don't have much inventory in the waywe develop and do our home building with these planned unit developments. It'ssignificant, we just don't have a big inventory at risk.

Paul Patterson - Glenrock Associates

Do you see the market improving or declining or staying thesame kind of six months out, or what do you think about -- I mean I know it'spredicting and not easy to do, but --

Don Brandt

Well, based on the number of homes we expect to close in thenext quarter and it's hard for home building to go much lower. I don't thinkwe're going to see a significant turnaround until 2009 at the earliest.

Paul Patterson - Glenrock Associates

Okay. And then on the power plant performance, Palo Verdeand what have you. How much -- I guess in terms of turning it around andgetting it back to the top tier, what would the financial impact of that be?

I mean, obviously it's something you guys want to do and itobviously helps customers. But from a financial perspective, should we expect abenefit -- a financial benefit to come about as a result of that in anysignificant way?

Jack Davis

To address -- this is Jack, to address the turnaround at theplant, I think as I said last time I don't think we mentioned this time and wedidn't see a large impact on our costs to return Palo Verde to its former topposition, mainly because the -- all the capital, the major capital costs werepart of our plan in the first place.

And so we haven't identified large capital items especiallyupon completion of the steam generator replacements and low-pressure turbinesthat we're doing in unit three now, large capital items that would impact usnegatively in the future.

In fact, just the opposite the -- we see that once we getthese capital items passed us, we don't see larger ones coming into the future.The other side of that is, as we seen a steadying increase operatingperformance at the plant and I'm going to give you a fact I didn't give in myprepared remarks.

But for two months in the third quarter I had two plantsoperating at about 100% for that two-month period. So as we bring Palo Verdeback to its normal annual capacity factors of the 90% to 93% range that's boundto have a positive effect on our company.

Bill Post

Paul, if I could just add, this is Bill -- if I could addsomething to that. I think if you compare our capacity factors this year tolast year on average, I think we will be up in the range of about 10% to 15%improved performance.

And that includes the fact that we are replacing that steamgenerator and the outage that Jack mentioned. As we finished that effort, thatwill be the completion of the replacement of all of our steam generators atPalo Verde.

As we go forward we would expect to benefit from that as youcan see in the capacity factors.

Paul Patterson - Glenrock Associates

Right. But in terms of the O&M and what have you and thescrutiny and what have you -- that we've had, this year and some of that goingaway, is that have any substantial impact or is that capitalized, I mean andjust as there is any sort of lift up from that, sort of going back to thehigher capacity factor and maybe having a little of the NRC review kind of,activity or is that significant at all?

Don Brandt

Well, there are some significant dollars involved, Paul. Andlet me give you a little color on that. In the third quarter '07 compared tothird quarter '06, our share -- the APS share Palo Verde O&M is up $7.5million, and some of that is attributable improvement program that's going on.

We expect a like amount in the fourth quarter this year. Andthe impact in next year is largely dependent on how the finalization of the NRCinspection and what tasks lay ahead of us.

And we will likely see some costs next year. But the net-netbenefits of having Palo Verde up to its traditional industry-leadingperformance will be measurable for both shareholders and customers in thefuture.

Paul Patterson - Glenrock Associates

Great. Thanks a lot.

Operator

Your next question comes from the line of David Thickensfrom Deephaven Capital Management.

David Thickens - Deephaven CapitalManagement

Questions have been asked. Thank you.

Bill Post

Thank you. Do we have any other questions?

Operator

Your next question comes from the line of Andrew Levi fromBrencourt.

Andrew Levi - Brencourt Advisors

Hi, guys, how are you?

Bill Post

Good afternoon.

Andrew Levi - Brencourt Advisors

Just a question. Could you go over dividend policy for us,please?

Bill Post

I'm sorry I missed your question. Could you say that again?

Andrew Levi - Brencourt Advisors

Could you go over dividend policy for us, please?

Don Brandt

Sure. As I mentioned, we look at that every single year.It's a function of basically all the financial statistics that we have. As Imentioned to you, we have had a history there of significant increases everysingle year, basically a flat number of $0.10.

As we looked at the situation today, we concluded to holdour dividend at its current level.

Andrew Levi - Brencourt Advisors

I'm sorry I missed that. Thank you.

Operator

Your next question comes from the line of David Grumhausfrom Copia Capital.

Bill Post

Hi, David. How are you doing?

David Grumhaus - Copia Capital

Good. Just two questions for you. One, Don, you talked aboutthe tax rate, what's a good effective tax rate to use going forward?

Don Brandt

Incidentally, I happen to have something like to at myfingertips. Let see, somewhere around 32%, 33%.

David Grumhaus - Copia Capital

Okay. That's helpful. And then second question, Don, youtalked a little bit about the O&M and this $10 million to $15 millionpre-tax per quarter. And I know when you gave it you were really referring toQ3 and Q4.

Is that a decent number to be thinking about just given yourgrowth as we look to '08 and beyond? Or is that -- can that, will that numberchange significantly in your potentially change significantly?

Don Brandt

David, that number I mentioned, the $0.10 that was relatedto the capital-driven expenses, depreciation property taxes and interest.

David Grumhaus - Copia Capital

Okay.

Don Brandt

That's a reasonable number for the next 12 to 18 months perquarter.

David Grumhaus - Copia Capital

Okay. So when you say $0.10, is that $0.10 each quarter orthat's just a flat $0.10 we should put in and assume.

Don Brandt

$0.10 each quarter.

David Grumhaus - Copia Capital

Increase, just from adding the capital in front of yourgeneration and that type of thing. Okay, that's great. All right. Thanks forthe time.

Bill Post

Okay.

Operator

Your next question comes from the line of Shalini Mahajanfrom UBS.

Bill Post

Good afternoon.

Shalini Mahajan - UBS

Just had a few follow-up questions on what 2008 could looklike. If I just start with 2007, stripping out some of the one time items ofthat have -- that took revised that items of 200, I come to a recurring base ofbetween 260 to 265 for '07.

And then it seems that it's large head winds for theinterest you mentioned that's $0.10 a quarter, probably about a $0.25 hit fromO&M. Some other impact, too, because the weather was favorable this year.Are we looking at best flat earnings in '08, or possibly a declining trend?

Don Brandt

As I mentioned, we are going through several things rightnow as we deal with, for example, taking a look at our organization and ourexpenses. We would expect to provide guidance on '08 at the end of this year.

Shalini Mahajan - UBS

Okay. But did that need any color you could throw in. Andthe trend?

Don Brandt

And we will provide that guidance as we complete theseefforts and we expect that to be as I said toward the end of the year.

Shalini Mahajan - UBS

Okay. Thank you.

Operator

Your next question comes from the line of Chris Turo (ph)from Dahlman Rose.

Bill Post

Good afternoon.

Danielle Seitz - Dahlman Rose and Company

Hi. I think you just send me outside -- I just wanted to askyou in terms of the Palo Verde units, you are anticipating to be back to normalby the end of '08. Is that pretty much the NRC report sort of a final, final?Or do you just still not quite sure?

Bill Post

Danielle, as Jack mentioned to you we have a two fueloutages per year.

Danielle Seitz - Dahlman Rose and Company

Right.

Bill Post

And we would expect as we complete the steam generatorreplacement, our last generator replacement in our current outage, that wewould be on that kind of a cycle going forward without extended outages like wehave had over the last three or four years as a result of the steam generatorreplacement.

But from the standpoint of maintenance and plannedmaintenance, this outage would be very significant in terms of putting us onthat path of fuel outages that would deal for the most part with fuelreplacement. Obviously, you do a lot of other work while you are doing that.That would put us on a path that would be predicted going forward.

Danielle Seitz - Dahlman Rose and Company

Okay. And it's the NRC inspection is more of a final aftereverything has been done. Is that all you see it?

Bill Post

I'm not sure, I understand your question, but let me explainwhere we are with that. This year we were going through the 95003 inspections.That process has been underway for sometime.

And will be underway through the end of this year in termsof the inspection process and would continue through 2008. So we do expect tohave continued participation on the part of the NRC through the year 2008.

Danielle Seitz - Dahlman Rose and Company

Okay. Great. Thanks a lot.

Operator

Your next question comes from the line of Reza Hatefi.

Bill Post

Good afternoon.

Reza Hatefi - Polygon Investment Partners

Yes. Just a little bit confused. Can you hear me now by theway?

Don Brandt

Yes. That's fine.

Reza Hatefi - Polygon Investment Partners

I think, you mentioned that you are on pace to earn eight anquarter ROE at APS this year. Is that what the comment was?

Don Brandt

That's correct.

Reza Hatefi - Polygon Investment Partners

And does that eight an quarter include the benefits of thegood weather as well as the tax benefits?

Don Brandt

Yes. It does.

Reza Hatefi - Polygon Investment Partners

And so, I guess, if we were to sort of normalize that andstrip those one times out, certainly the ROE would be lower. So I don't knowwhat it would come out to calculation, but assuming it's 7% or something.

I'm a little bit -- I guess going into next year and facingfurther rate base growth as well as O&M pressures can you expand a littlebit on the reason of not filing a case?

And I guess -- because it looks like if you were to wait andfile one and let's just say mid 2008, it probably wouldn't be effective untilearly 2010. Just wanted to get a better feel for I guess what's going on.

Don Brandt

Well, as Bill mentioned, a couple of times on the call hereas we got -- it's not just about a traditional rate case. We've -- we'reexploring other alternatives relative to addressing growth and we have beenencouraged by the commission to do so.

They've expressed that in hearings in the past. And we aretaking their lead on this matter. And also relative to looking at the coststructure of the company we've just got a few other things that we have to bein place before we can address the timing and the extent of any rate caseneeds.

Reza Hatefi - Polygon Investment Partners

So, so to speak you are sort of have decided to sort of, Iguess for a lack of a better term take some pain in the early time frame to getinto positive benefits and a better relationship with the commission, once weget out a couple years from now.

Don Brandt

Well, I wouldn't call it take the pain. I think we weredoing what makes the best business sense.

Reza Hatefi - Polygon Investment Partners

Great. Thank you very much.

Operator

(Operator Instructions) You have a follow-up question fromthe line of John Kiani of Deutsche Bank.

John Kiani - Deutsche Bank

Hi, Don, just one more quick question. Thinking about therate base growth that Reza was just highlighting, and looking out into '08 andbeyond, and thinking about the sources of funding for that.

Can you talk a little bit about how you intend to financethe rate base growth, and whether equity would potentially be a part of that?

Don Brandt

Well, I can talk in terms of over longer period of time.We're going to have to rely on both the debt and equity capital markets.

John Kiani - Deutsche Bank

Got it. Okay. Thank you.

Don Brandt

Thank you.

Operator

At this time you have no further audio questions.

Bill Post

Well, I would say thank you for your time. We know it's verybusy, and we appreciate you giving us your time today. Thank you very much.

Rebecca Hickman

And if you have any questions following up, please call meor Lisa. Thank you very much.

Operator

This concludes today's conference call. You may nowdisconnect.

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