PNM Resources Q3 2007 Earnings Call Transcript

Nov. 2.07 | About: PNM Resources, (PNM)

PNM Resources Inc. (NYSE:PNM)

Q3 2007 Earnings Call

November 2, 2007 9:00 am ET

Executives

Gina Jacobi - Director of IR

Jeff Sterba - Chairman, President and CEO

Pat Vincent - President of Utilities

Chuck Eldred - CFO

Jim Ferland - SVP of Energy Resources

Tom Sategna - VP of Corporate Controller

Jeff Weiser - President of FCP

Analysts

Lasan Johong - RBC Capital Markets

Greg Gordon - Citi Investment Research

Dave Parker- Robert W. Baird

Paul Fremont - Jefferies & Co.

Darren Conti - Wachovia Securities

Paul Patterson - Glenrock Associates

Operator

Good morning, ladies and gentlemen. Welcome to the ThirdQuarter 2007 PNM Resources Earnings Call. I will be your coordinator for today.At this time, all participants are in a listen-only mode. We will befacilitating a question-and-answer session towards the end of today'sconference. (Operator Instructions)

I would now like to turn the presentation over to your hostfor today's conference, Ms. Gina Jacobi, Director of Investor Relations. Pleaseproceed, ma'am.

Gina Jacobi

Thank you everyone for joining us this morning for adiscussion of the company's third quarter 2007 earnings. Please note that thepresentation and accompanying materials for this conference call and supportingdocuments are available on the PNM Resources website at www.pnmresources.com.

Joining me today are PNM Resources Chairman, President andCEO, Jeff Sterba; Pat Vincent, President of our Utilities; Chuck Eldred, ourChief Financial Officer; as well as several members of our executive managementteam.

Before I turn the call over to Jeff, I do need to remind youthat some of the information provided this morning should be consideredforward-looking statements pursuant to the Private Securities Litigation ReformAct of 1995. We caution you that all of the forward-looking statements arebased upon current expectations and estimates and that PNM Resources assumes noobligation to update the information.

For a detailed discussion of factors affecting PNM Resourcesresults, please refer to our current and future annual reports on Form 10-K andthe quarterly reports on Form 10-Q as well as other current and future reportson Form 8-K filed with the SEC.

And with that, I will turn over the call to Jeff.

Jeff Sterba

Thanks, Gina, and thanks to you all for joining us. In oursecond quarter call, we indicated that 2007 will be what you can call anextremely challenging year, and there is really a couple of reasons and let metouch on them.

First, increased load growth in the Mexico which is usually a goodthing except with our current rates structure which was set a number of yearsago. We find ourselves in a situation where current rates frequently don'trecover the margin of cost of supply.

Second, we had plant performance issues in the first sixmonths of the year at the Four Corners plantwhich is operated by APS.

Third, our current lack of a fuel adjustment clause torecover the higher replacement costs that we've incurred when either plantswere down or when our loads have outstripped our generation resources to meetour regulated retail load.

And last, hedging losses in both our regulated andunregulated operations due to mild weather particularly in our Texas operations and lowgas prices that resulted because of mild weather throughout the country thispast summer. And these items did impact our third quarter performance.

Overall, ongoing earnings per share were $0.41 compared to$0.62 last year. And on a year-to-date basis, ongoing EPS is $0.96, down from a$1.27 last year.

These numbers exclude unrealized mark-to-market gains andlosses on economic hedges in our ongoing earnings. And Chuck will go into thedetails of that in just a little bit.

The GAAP earnings decline is due to a number of items whichare reconciled for you, but let me mention the largest two.

The first, as you recall, that we transferred withcommission approval Afton Generating Station from our unregulated operationsinto our regulated operations and expanded it into a one-on-one combined cycleconfiguration. We had an agreed upon cap in the stipulation that was added intoto allow the transfer of that into the regulated side.

We have incurred higher cost in its construction than thatcap and so consequently and we previously announced this write-off. The higherconstruction costs were caused by a couple of things. First, with somechallenges in bringing the unit into commercial operation which kept it delayedabout two months from beyond what we had originally hoped. And the increasedcosts associated with that mostly dealing with control systems.

We also experienced particularly in '07 higher labor coststhen we had anticipated because of the shortage of skilled craft workmen andvirtually all construction projects you're seeing cost estimates for virtuallyall construction going up and it affected this project. And we also in 2006 hadexperienced some weather-related delays which we felt we could make up, andthese were weather-related delays due to flooding on railroads. We thought wecould make it up, but at the end of the day the schedule was further delayed.

The second item, as you'll probably read by now, weannounced a business improvement plan to streamline the company which willinvolve reducing our workforce by 15% over the next 12 months. About 5% of theemployees will be impacted today, and we incurred severance-related cost againnon-recurring of about $0.10 per share.

With us on the call is Pat Vincent, who, as you know, joinedour company about six months ago as the President of the Regulated Operationsfor both the Mexico and Texas. And she willoutline the plans to reduce cost and improve our regulated utility deficienciesas part of the business improvement plan.

But before I do, let me expand a few minutes talking aboutFirst Choice Power and the EnergyCo JV. First relative to First Choice Power,moving to slide four, First Choice earnings came in $0.23 below the same periodlast year and recall that we have consistently said 2006 was a blow-out greatyear. Results in 2006 were enabled by near perfect conditions with respect toweather, our trading position and trading performance.

Four factors lowered results this year compared to 2006,less usage due to mild weather, slower growth in the first half of the year dueto market uncertainty and the conversion to our new customer care system nothaving occurred until the summer, lower per unit retail margins driven bysomewhat higher purchase power costs and trading margin variances.

Let me just give you a little more color on each one ofthem. Relative to the weather, in July, for example, we saw cooling degree daysin Dallas-Forth Worth area being 17% below normal. This led to average use percustomer being 14% below the same quarter in '06.

Relative to growth, we talked at the Q2 call that growthreally stalled in the first half of the year due to a number of reasons,particularly the public policy and market issues as the Texas Legislature triedto wrangle through what were they going to do with the marketplace.

Also, the timing of the in service of our customer caresystem put us in a position where we could not be as aggressive on some of ourmarketing efforts, as we would have liked to be. But, what we have seen in thethird quarter is that has begun to pick up significantly.

Enrollments in the third quarter of 2007 are about 60%greater than they were in the second quarter and comparable with what we haveexperienced in the third quarter of '06. I would remind you that in '06, ourfull year customer growth was about 17% and we now expect for 2007, that itwill be in the 5% to 6% range, because of the reductions that were occurred,that we've witnessed in the first six months.

Relative to lower retail margins, there is the couple pointslet me make. The first one is that FCP entered 2006 and 2007 with similarhedging strategies. Their goal was to conservatively position againsthistorically high summer power prices and result in load response, but as youknow mild weather and significantly lowering prices, in July combined a force aliquidation of the unanticipated long position at less than desired prices. Sothat affected the purchase power cost to serve those customers.

And second, the lower trading margins, again '06 we had --our trading is very tightly controlled and it is not a large volume of trading,but in '06 we did very well. In '07, because of the same things that happenedrelative to the pricing for our supply for retail load, with the mild weatherand the significant dropping gas prices, we ended up in a situation wherenumber of the positions they have been turned against us.

In terms of going forward relative to first choice, wecontinue to believe that it remains a growing company that’s increasing it'scapabilities to target and cost effectively serve customers in a maturingmarket. I think the turnaround that we have seen in customer acquisition in thethird quarter, where as you probably know when we sign up new customers wereally don’t see the revenue for a number of months, because there is a waitingperiod and we have incurred the cost of attracting them, but we haven't startedto generate the revenue from the contract. So, we'll see that starting to hitour books, really the first of next year, maybe a little bit in December.

So, we are seeing important returns of growth that we have experiencedin '06. I think there is a couple of things I want to note relative to that. Thefirst one is the key point has been the conversion to a new customer caresystem, which will enable us to provide stronger offerings, give us much moremarketing related information to help us target the customers that our FCPfolks want to go after, and we are already seeing the beginnings of the benefitof that, as I said referencing the increase in the attraction of new customers.

Also, as we look forward, remember that ERCOT will be movinginto a nodal market, probably not until the end of '08 or maybe more likelyearly '09, and that we are doing a lot of positioning relative to that. I thinkthat as the price to beat, this is the first year that we have had priced tobeat no longer in existence, which has also been a transition. Have yourecognized that -- I am pretty sure, but I am sure FCP is only formeraffiliated rep that has more new competitive customers than it has traditionallegacy customers within it system. So, I think we are showing the power to growthe business, we just have to and we recognize that you want to see thedemonstrated growth, particularly given what happened in the first six monthsof this year.

Relative to unit margins, we expect to see average unitmargins in the low 20s, it could hit mid 20s, that will be lower than 2006 inwhich it was in the high 20s, because of the changes in the marketplace and thevery unique position that existed in 06. But we expect to see them in the lowpossibly the mid-twenties.

We expect those margin differences will be amplified in thelonger term based on the wholesale opportunities, as the nodal market developsand matures and I believe that you will see, as we move in to the fourthquarter also hopefully continued strong growth in the numbers of customerswithin system.

Turning briefly to EnergyCo as you know EnergyCo at thisstage has two assets the mix of coal and natural gas, in terms of the Cogenfacility that totaled about a little over 900 megawatts and we have another 275megawatts under construction.

The units much like our San Juan units have there are operating wellin excess of top cortile performance of similarly situated units. Our tradingand marketing group is forming with in the EnergyCo joint venture so that itcan optimize the use of these plants in the market and prepare for the openingof the nodal market.

We delayed creating that marketing and trading organizationpartially, because the assets that we had were completely hedged, but we are --that group is now up and operational and will start – we are already startingto see them add some value.

At this point I would like to turn it over to Pat to talkabout our regulated operations, Pat?

Pat Vincent

Thank you, Jeff. Good morning everyone. I'll first start outabout talking about our ratings cases. As most of you know last week was thedeadline for intervener testimony in the PNM electric rate case. To summarizewe requested an $82.4 million increase to rate and the fuel clause.

This is the first rate increase that PNM Electric has askedfor in 20 years. We also asked for a changed rate design looking for higherrates in the summer to cover higher generation cost in the summer which Jeffmentioned was a factor in our earnings.

This slide outlines the major positions of the commissionstaff, the Attorney Generals Office which serves as the consumer advocate herein New Mexico.There are no surprises here. We have been in discussions with staff and the AGas well as the other interveners in our case, so we're very familiar with theirpositions.

I would like to point out on this slide that just becausethe staff or an AG rejected a particular item does not mean that they rejectedthe idea behind the item, they just may have rejected our requested methodologyin that particular item.

You turn to the next page; it outlines the schedule for ourrate cases. Suspension period for the current rates expires May 7th, so we donot expect to implement new rates prior to that date. We are continuing withour rebuttal preparation, and in it, we will counter the objections made by theinterveners. For example, we are going to point out that our application meetsall the requirement of the PRC's rule and fuel clauses which is known here asRule 550.

Those three criteria are that the cost of fuel and purchasepower be a significant percentage of the total cost of service which they are,that the cost periodically fluctuate and cannot be precisely determined, andthat our practices are designed to assure that power is generated and purchaseat the lowest cost. So, we will make those arguments in our rebuttal.

We also have a national expert in to talk about fuel clausesand to show how PNM Electric will be an outlier if we do not have a fuelclause. We have also started dialogue with the interveners on the possibilityof the settlement. That said, we are fully prepared to litigate the case.

The Public Regulation Commission here has also opened up aNotice of Inquiry on fuel clauses here in New Mexico. We consider this as a positivestep. This purpose is to be look for a simplified and standardized clause thatcan be applied to all utilities in the state. We see this as a good sign fromthe Public Regulation Commission acknowledging that we are the only utilityhere without a fuel clause and that they want one that is standardized andsimplified, so that all utilities have the same treatment.

We also have an ongoing process of education and outreacharound our rate case and industry cost trends. Last week, we hadrepresentatives at the EEI and Wall Street to present to our legislativecommittees and other interested parties including staff from the PUC.

They discussed cost trends in the industry and how WallStreet views the regulatory environment here in New Mexico. We've had follow-up from some ofthe audience members requesting more information about Wall Street views of ourregulatory community.

Additionally, we are working here with the community to getsupport for our rate case. We have a very successful outreach program goinghere; the Albuquerque Chamber of Commerce, the Hispano Chamber of Commerce andthe Albuquerque Economic Development Community have voted formal resolutions insupport of our rate case. Matter of fact, the Albuquerque Chamber of Commercefiles theirs with the PRC, and while it's not part of the case because they arenot an intervener, their resolution was noted on the other parties.

Regarding the gas rate case, the issue is now in the handsof the New Mexico Supreme Court. There are two appeals, ours and the AGsregarding weather normalization. The court has consolidated appeals AND orderedsimultaneous brief. The slide here outlines that briefing schedule.

Turning to Power Plant's performance in the next slide; thehistoric in the upper left hand corner, we will start will San Juan. San Juan has an EAF of 85.8% as suppose to97.5% in '06.

We want to point out that this performance was below lastyear's. The plant ran much as expected and this level of performance had beenreflected in our revised guidance. The variance in the plant's performanceversus last year was driven primarily by a planned outage at Unit 4. Unit 4 wastaken off line on September 8th to start at scheduled environmental upgrade.

The environmental enhancements were completed on October 31,when the second day of a planned five-to-seven day start-up process and we havesteam and the boiler today. While the outage was there, we also upgraded ourcontrols from analog to digital. Without this planned outage, the third quarterEAF at San Juanwould have been approximately 91% or in the top quartile for those plants.

The plant also sustained a number of minor unplanned outagesduring the quarter, primarily associated with tube leaks and precipitatorissues. However, we expect improved performance moving forward for severalreasons. As we complete the environmental upgrade project on each unit, theprecipitators will be replaced by baghouses as a primary particulate removal system.

Baghouses are less prone to malfunctions that results forneed in outages on those respective units. And I will talk a minute about whatwe are doing on the tube leaks.

We turn to Four Corners, Four Cornershad good performance in this quarter and we continue to see improvement at thisplant. As you recall, there were some turbine issues earlier in the year, butwe have generally seen improved performance since then.

Terms of Palo Verde, Palo Verde ran in line with last year'sperformance in this quarter and our revised guidance expectation. As you know,the plant's unit 2 added extended three weeks in July, primarily due to startup issues. Unit 2 and 3 remained online through out the third quarter untilunit 3 shutdown for its scheduled refueling, steam generator replacement outageon September 29. The plant outage is scheduled through December 13.

Want to talk a little bit about what we are doing at theplant. You turn to the next slide. When the process of completing outage ateach of our San Juan unit for the purpose of environmental enhancement andduring those outages, we are also performing work that will continue to enhanceplant performance. For example, our analysis has shown that many of our forcedoutages were caused by boiler tube leaks. Therefore, we will review theseenvironmental outages we are also going to do replacement for significantrepair to those sections of each boiler that have the highest rate of tube leakfailures. This will help us avoid the forced outages we experienced earlierthis year.

Turning to Palo Verde. We believe that challenges the plantcapacity factors and O&M and capital will continue for the next 12 to 18months. In order to address these issues. We've planned direct and frequentinteraction with APS management to emphasize the importance of safety, plantperformance and cost containment. We are working with the other minority ownersto make sure that our messages are coordinated and heard by APS management. Weare working with APS senior management, APS finance management and APS plantmanagement on continuing plant improvements.

Turn to our next page, on the business improvement plansthat Jeff talked about. We have initiated this business improvement plandesigned to cut cost and strengthen our utility business, as well as the entirecorporation. We took a look across our entire corporation for areas we feltthat we could streamline processes and reduce cost. We found many opportunitiesto streamline our processes and to provide customers with more automated andself driven option.

These are win-wins, because they help reduce our cost, butalso help provide the folks we serve with better service. Providing more selfservice opportunity is just one of the ways we are going to rebuild andredefine our meter-to-cash process, resulting in more efficient operations andbetter customer service.

As Jeff mentioned, part of the business improvement plansincludes the need to reduce our workforce. We expect to reduce our employeecount by 15% over the next twelve months. One-third of those reductionsoccurred yesterday and today. This improvement plan is expected to save thecompany approximately $35 million on an annualized basis, not including ourcost to achieve. A portion of that savings will be realized in 2008.

In order to make sure that we capture and retain the savingsin the plant, the Chief Administrative Officer and I are personally going to bemonitoring the tracking of these savings. We will have a detailed rigoroustracking plan, that will monitor our headcount and the other process designsaving and we will be looking at that on a monthly basis to ensure that we notonly get the saving, but we do retain those savings.

With that, I'd like to turn it over to Chuck, for details onthe third quarter, and the year-to-date earning results.

Chuck Eldred

Thank you, Pat and good morning everyone. Let me startbefore I get though the year-to-date walk across. I want to talk about thechange that we are making beginning this quarter to exclude from ongoing earnings,the net unrealized gains and losses from economic hedging activity. We haven'tdone this in the past, because those gains and losses have been relatively verysmall. For example, in 2006 there was a gain of $1 million. 2005 was a loss of$2.5 million and 2004 loss of $1.6.

We've given the change in our hedging strategy this year inthe mark-to-market activity has become more material energy as you can see fromthis particular chart we are providing you, that the good portion of this thingor longer term maturity that go out beyond 2013 that show mark-to-market lossbasically where about 60% of the losses group reflecting here.

In so for those two factors the materiality and the maturitydates, we thing it's important to reflect the -- excluding the unrealized gainand losses for ongoing operations going forward.

And again the reemphasize that when you get in to hedgingperiod of 2013 and beyond, these are really long-term hedge positions thatwe've taken with our merchant business, as we enter into long-term contract tolock in the margin our hedge generating assets.

So you can see in 2007 as example that particular positionis a fourth quarter loss that we expect to occur and again I want to retaliatethat particular loss is already baked in to the year end guidance that weprovided to you previously.

In addition to that the liquid period, which is really wherewe have market information from 2008 to 2012 see just slight loss relative togas and power prices and then beyond which is really reflect as illliquidperiod in 2013, which is the greater percentage of the losses I guess in the$0.06, which brings us back to the $0.11 that we have excluded from the ongoingearnings that we reported during this particular period.

Now I would like to go and talk about the significantdrivers for the business looking at year-to-date ongoing earnings from lastyear first nine month is a $1.27 that brings us down to $0.96 for the yearfirst nine months of this year.

The first part of it is a gain of $0.09 from EnergyCo andJeff talked about the plant performance in the current state of the EnergyCoand its acquisitions.

We've talked about guidance last month that we would expectthat year end to be around $0.07. We do have an outage in the fourth quarter ofTwin Oaks, but we expect our guidance at this point at year end to be at $0.08.

Given the current performance of the plants and we're onbudgets and on scheduled to meet that objective for year end. Jeff talked aboutplant performance and equivalent evaluated factors.

We see improved plant performance at Palo Verde hascertainly offset some of the impacts that we've seen from the plant performanceor base-load plants that's picked up $0.07. We also have $0.05 pickup from theTexas CTC charges which allows recovery of our standard assets in Texas from thederegulation and that's started in December 2006.

Also a $0.05 gain in PNM gas growth and weather, $0.04 ofthat is attributed to colder weather. Our heating degree days were up 16% andwe also see customer growth around 2 plus percent range.

As you know, we had a rate increase that goes in effect onJuly 1, and that's a normal impact and most of that would be seen in fourthquarter, assuming that we would have colder weather. In this week frankly, it'sbeen around 7 degrees, so we'll have the kind of weather we'd like to see forthat business.

On TNMP growth, that's a 2% low growth and an averagecustomer count increased about 1.4% over 2006. On other, that really is mostlythe financing costs, the higher short-term debt with capital expenditures andhigher interest rates that we've seen during the last quarter and year-to-date.

And the other next two items, the PNM Electric wholesalegrowth and weather and the cold costs are really goes back to some of Jeff commentsearlier, reflecting the business model that we're faced within the challengesthat we see going forward.

And if you think about the fact that low growth and warmerweather typically would results in a gain and the benefits to the utility, whenin essence it's actually working against us. And as Jeff pointed out, it worksagainst us because one the uncertain around the plant performance also resultin the fact that we have to use in some case our merchant fleet in other toprovide and serve our jurisdictional loan, and as also Jeff pointed out, theretail margins are really not covering with our electric rates, the cost ofthat energy. And addition to that as we lose some of that wholesale surplusenergy from our merchant fleet, we're not able to make money in the wholesalebusiness.

You tie that to the discussions we've had earlier this yearwhether coal cost increases due to the commodity prices as well as the cost ofmine and coals, those two factors clearly indicate the business model we'refaced with today and the reasons why we are having to pursue the rate increasesthat we are pursuing now that Pat referred to, and the fact that we don't havea fuel cost and ability to recover purchase power complicates our businessmodel and makes these challenges as you can see from this year's performancemore difficult for us to manage and deal with and we're looking forward to ourability to pursue this rate increase and justify our position.

In addition to that, we have $0.13 year-to-date for TwinOaks which is the contribution as you know of Twin Oaks EnergyCo [on 61],reduced earnings of $0.15. We picked up $0.02 from sub-property tax true-upthat occurred this year. The dilution, we talked about before is about a 9.6%increase on additional equity that we've issued in December last year. And thelast piece to this is that's First Choice Power. Jeff talked about the businessdrivers in that market and some of the challenges we've had this year. If youwould have break that down, you'd see $0.6 of that was from milder weather andreduced margins, and the other piece of that is the $0.12 which is the $7million trade gains that we had in '06 and the $7 million losses that we'veexperienced this year.

And again I want to point that all these aid in the tradingmargins certainly are well within our risk management tolerance, that approvedby the risk management committee and our Board, and certainly we typically lookto be about 10% to 15% of EBITDA in that particular business this year.

But, as Jeff pointed out to that going into the first partof the summer, we had positions and market condition softened with gas pricesbeing down and resulted in loss trading division.

I'd like to talk abut 2007 guidance and beyond. As wepointed out in the press release, we would affirm that EPS guidance will be atthe low end of a $1.30 to $1.40 range. But certainly, this has an impactrelative to plant performance as to whether or not we are able to make the$1.30 could have a risk of that being slightly under, given the plantperformance and we are providing some information of what EAFs would have to beto meet that guidance for Palo Verde and San Juan. And as Pat, mentioned theUnit 4 construction was completed on time, but the unit is currently in thestart-up node and certainly could have potential risks that could set us backin that regard and also on Palo Verde 3 with the steam generator replacement.We could have some risk relative to that start-up and being on schedule and theincreased NRC over side.

At this point, I want to talk about guidance for next yearthat we intend as we complete our 2008 planning process that as we finalizethat. We would love to get guidance in January timeframe of next year. But Iwant to point out some key considerations that you should take in mind as youlook forward to 2008.

First of all, don't forget about the $350 millionequity-linked securities that we will convert next year and that's driven, thatdilution will be experienced based on what our stock price is. Two-thirds of thatwill convert in May and rest we will convert in November. If you reference ourInvestor Relations website, you can get some details on the equity lineconversion and the price dilution information.

Secondly, I am going to talk about the impact to load growththat I just mentioned that continues to be a challenge as we see the electricdemand in New Mexico increases our excess capacity as limited and we continueto have higher cost and serving our jurisdiction load as we begin to have topurchase power to meet that load and we see our retail margin shrinkingrelative to our current recovery in our rates.

In addition to that, fuel cost increases continued to impactthe results of this year and as we go into next year without the fuel costrecovery and in fact that we don’t have a rate case settlement until May 7ththen we will have to continue to manage through these costs both on a coal andnuclear cost, fuel increases our of the first part of the year.

In addition, other issues that impacted our plant performancethat we talked about. We have increased the Palo Verde O&M cost associatedwith [ARC] oversight and we have a number of planned outages that San Juan in 2008, twomajor outages. One which we have a first quarter, about 50 days and the secondwhich is scheduled on fall which will last about 45 days. And also as point --as Pat talked about the [ABI] project, we have $35 million that is annualizedand a portion of that would be received next year and we are still working onthe timing of the savings as to when that will occur. We will talk more aboutthat during guidance. And lastly certainly the electric rate outcome.

So those are some of the considerations to think about asyou look into 2008 and we will work hard to get our planning information up-to-dateso we can give you some guidance in January 2008 to give a clearer picture ofwhat our outlook would be.

With that I would like to turn it back over to Jeff.

Jeff Sterba

Thanks Chuck. We will go to questions. But let me justmention that Chuck, Pat and Gina will be in Florida for EEI Finance committee,and I know that their schedules are fully booked to meet with many of you all.I've had anticipated and planned on coming out. I have decided that with thedown sizing and the impactions that we are doing today, I really need to behere not just at the end of this week, but also the first of the next week asthe folks are coming back in, and felt that, that was the better place for meto be as Chuck and Path and Gina can handle answer all your questions. I willbe missing you there, but we will see each other down the road.

So, operator let's go to questions.

Question-and-AnswerSession

Operator

(Operator Instructions). And our first question will comefrom Lasan Johong with RBC Capital Markets.

Lasan Johong - RBCCapital Markets

Good morning. Thank you. Couple of few quick questions. Isthe rate case filings have the 15% staff cut reduction in it?

Chuck Eldred

Okay. Go on your question, the two question -- Lasan, andthen we will answer both.

Lasan Johong - RBCCapital Markets

Okay, no problem. Basically with the Palo Verde when do youexpect Palo Verde to kind of regain it's past glory of being one of the topperformance in the nuclear industry?

Chuck Eldred

Okay. Relative to the first question, it is not in the ratecase because its out period. The rate case is the historic test year for theperiod that ended…

Lasan Johong - RBCCapital Markets

Oh I see.

Chuck Eldred

September 30, 2006. Now what this rate -- what the O&Mreductions are trying to do, is move our future O&M cost down closer to inline is move our future O&M cost down closer to inline to what is in therate case so it will move all the way down there at such that as we haveadditional rate cases those rate cases will largely be driven by the investmentpatterns. As you know we've got about $2 billion of capital to invest over thenext five years.

So it doesn't affect this rate case, because its way out ofperiod, but it's our efforts to try to help minimize disturbances once we havethe rate case to be able to operate under those rates for a period of time andto minimize future rate increases.

Relative to PV, regaining their glory Jim Ferland with uswho you may know he joined about six months ago from Westinghouse comes out ofthe nuclear industry. He was the CEO of LES and he is on point relative PaloVerde.

Jim Ferland

Thanks Jeff. We've spent some significant time with PaloVerde management as Pat indicated our operations level, finance level andsenior management and I think Pat also mentioned we have a kind of a 12, 18months window. We're looking at where we would probably not expect PV to regainits prior status. After that Palo Verde is a new unit and we would expect it tooperate in the top quartile or top [destile] in the country, but the 12 to 18months is a risky period for Palo Verde and we're going to keep our eyes onthem and work closely with their management.

Operator

Thank you I will take our next question from Paul Pattersonwith Glenrock Associates.

Paul Patterson -Glenrock Associates

Good morning guys.

Chuck Eldred

Good morning Paul.

Paul Patterson -Glenrock Associates

I just to want to follow up on Lasan's question and Isqueezed my agreements on the next two regulations but what has the historicaltest do they look at known measurable differences? And really if you justelaborate little bit more on how that would work with this announcement of costsavings?

And the second question I guess I have is what do think costto achieve would be and when do you think we'd actually see the savings?

Jeff Sterba

Okay. On the known and measurable under the rules of the Mexico,known and measurable can only go out of 150 days outside the test period. So weare barely into the first of '07 for the allowance of known and measurable andthese cost savings don't occur during accrue until some time in '08, even thefirst tranche that's occurring today.

On the cost to achieve, the first estimate of the cost toachieve is included in what we booked as a non-recurring item for this thirdquarter and I believe the numbers about $12.5 million pre-tax.

In terms of the savings and the timing of the savings, the$35 million is an annualized number, a portion of which will be accrued in 2008but not all of it. We don't yet have an estimate of how much in '08 we willinclude that in our guidance.

One other thing let mention Paul relative to both known andmeasurable and Lasan's question about is it in rates. The 15% is across theentire corporation, so it's not all electric or even for that matter, all inthe Mexico, as a piece ofthat is in the Texasarena in addition.

Operator

Thank you. We will move next to Greg Gordon with CitiInvestment Research.

Greg Gordon - CitiInvestment Research

Hi, Jeff, how are you?

Jeff Sterba

I am fine, Greg, how about you?

Greg Gordon - CitiInvestment Research

Good. So just to recap, maybe a summary of drivers for -- Iknow you haven't given '08 guidance, but just structural drivers for '08 versus'07. First, we had all these, what we hope to be non-operating related issuesthat depressed second quarter earnings that should reverse. We know coal costsare higher. We know you can get some benefit of the headcount reduction programnext year, how much of that is not in the third. You are also telling us wehope the Palo Verde influence, but there is no guarantees, but then at San Juan we are expectingactually a significantly higher number of outage days next year versus thisyear, and is that correct, and what other major structural issues should we becontemplate?

Jeff Sterba

Well on San Juan,it will be slightly higher, it's not significant. And just let me remind you San Juan has been in thetop, that's our performance for really last four years. We had a little troublewith some forced outages this year, greater than what we had typically incurredover the last five years. But with the outages, the planned outages next year,we will have slightly higher planned outages. I will tell you what we can, wewill provide you Greg is we can provide you the number of days of plannedoutage between '07 and ’08. I don't have that with me. I don't think any of ourfolks do today, but we can provide that to you. And then I'm sorry Greg, thefirst item you've mentioned?

Greg Gordon - CitiInvestment Research

I was just saying that first and foremost, we can hopefullynormalize second quarter.

Jeff Sterba

Right.

Greg Gordon - CitiInvestment Research

Second, we know that hopefully Palo Verde well improve. Thebig question is on regulation in the Mexico is still outstanding.

Jeff Sterba

Right.

Greg Gordon - CitiInvestment Research

What's your earn returns will be, you've got a cost cuttingprogram that will hopefully have some at least modest impact in '08.

Jeff Sterba

Yeah. The one that I was going to mention Greg was on PaloVerde. I think what we're saying is we don't expect to see significantimprovement in the operation of Palo Verde over the next 12 to 18 month. So youwill not see us banking on an improved capacity factor next year for PaloVerde.

We think it's going to take as Jim said 12 to 18 months forthem to work out of disposition. And it's largely caused by when somethinghappens, the NRC defense and what maybe forgiven in another plant and theplants allowed to start up or they take a written explanation as satisfactoryfor the clause, they end up with a much higher degree of scrutiny. So theoutage tends to last longer. That's why we just don't see next year's PaloVerde performance increasing.

Operator

Thank you. We will move next to Dave Parker with Robert W.Baird.

Dave Parker- RobertW. Baird

Hi good morning. Just may be a little bit of color on twothings. First of, with the commissions opening several workshop on fuel clauseshow will that sort of dovetail in with your rate case. And then secondly, youtalked about settlements talk so that may be being worked down, what youbelieve the probability is there and who the key players they or have been inthe past? That will be helpful.

Jeff Sterba

Relative to the fuel adjustment clause hearings, thisprocess is just getting started, so it's not clear what impact it would have.We believe that this is positive thing because instead of saying well may beshould eliminate fuel clauses, they are saying, well let's find a way to lookat standardizing fuel clauses.

So in terms of the rate case, obviously we will go forwardwith our arguments as to the installation of a fuel clause. If changes are madeto conform the different fuel clause mechanisms applied to the primarily threeutilities, investor-owned utilities that operate in the state, then that willbe fine. We will try to take some of our best thoughts. If we get into strongsettlement discussions, we may be able to help it establish that standard.

So that's the impact on the rule making process that theyare going to go through. Relative your second question, who wants to take that?Pat.

Pat Vincent

The major interveners in the case we have settlementdiscussions with the staff. The attorney general here who functions isbasically the consumer evicted. NIMAC, which are the industrial customers herein New Mexico.The city of Albuquerqueas there are largest city here and are very active. And then University of New Mexicois also a big player in this. We also have Western Resource abacus and some ofthe other environmental groups that have the forwarded some small issues, butthe major ones would be SAP AG and NIMAC sitting in the in the university.

Jeff Sterba

And I think that we are not really out here with theinappropriate for you to walk away thinking we are in settlement discussions,we are not yet. We will be open to it. Our focus right now is on filing our rebuttalcase in a couple weeks. But if there is the opportunity for settlement we willalways remain open to settlement discussions.

Operator

Thank you. We will move next to Paul Fremont, Jefferies.

Paul Fremont - Jefferies& Co.

Thank you. Looking at 57, sort of two questions. One, itdoesn’t indicate the recommended equity ratio and the second would be that Icome up was about working a $15 million of cost to capital differences with therest, being expense items. Can you sort of review what the major disagreementis on the major expense item?

Chuck Eldred

Yes, the cap structure is a 50-50 cap structure in the ratecase. We will Tom Sategna who is our controller and responsible for the cost ofservice to explain the other item.

Tom Sategna

Paul, you are right. The cost of capital and differences arein the range of the $14 million. There are a number of issues across the boarddepending on the exact intervener all the way from disallowance of allconstruction work in progress, to adjustments, to some other capacity factorsthat we have proposed for Palo Verde San Juan. Also we have normalize someoutage numbers for maintenance cost going forward, and there is been exceptionthere. So, those are some of the major drivers, but the biggest single itemwould be the reduction in the equity rate from what we filed the 10 in threequarter down to 9.1 on the staff, and 9.57 for the AG.

Operator

Thank you. [Operator Instructions]. We will move next to DarrenConti with Wachovia Securities.

Darren Conti - Wachovia Securities

Good morning.

Chuck Eldred

Good morning.

Darren Conti - Wachovia Securities

Wanted to touch basically on the '08 guidance that youtalked about and some of the drivers, I noticed that you did mentionedEnergyCo, $0.09 year-to-date, I am just wondering do you expect that not to beincremental next year, could you just give us a little color around that?

Chuck Eldred

This wasn’t meant to give you guidance as much a there issome key considerations. Certainly we'll talk more about EnergyCo, we talkabout guidance in January, but I guess message this year is that we are righton track. We're meeting our expectations relative to year end performance, andwe have made some good success with the acquisitions that we have talked aboutwith the Altura Cogen and the movement of Twin Oaks over there and thecontinued construction Cedar Bayou which is on schedule to complete 2009. So,at this point we would give you more color around the expectations of EnergyCo,as we give guidance in 2008 and it's our objective to really give you as muchtransparency around the business you have a better outlook towards how we seethat contributing towards the performance of being in that resource.

Darren Conti - Wachovia Securities

Okay, just look for little more guidance January there?

Chuck Eldred

That’s correct.

Darren Conti - Wachovia Securities

Okay. Additional question, with the lack, I guess some ofthe challenges that Jeff talked about this year, actions clearly (inaudible),not recovering some costs of retail rates. How, -- what are you doing on theenergy efficiency in DSM front, to kind of may be mitigate some of that forthat cost exposure. (inaudible)?

Chuck Eldred

Absolutely very good question. I’m going to make a fewcomments I'll let Pat to fill in. We have now got eight programs that we havedeployed in the, just really in the last couple of months, before our retailelectric business and we have given an indication, a strong, very strongindication that we believe that there is substantively more that can be done, but we have to look at change in theregulatory framework to ensure that those things can effectively be done andprovide the incentive quite frankly for them to be done.

So we believe strongly that energy efficiency can have asignificant impact in not only in cutting the growth rate and particularlycutting it for more where we are incurring the higher costs. One of the thingsthat we are facing is that our load shed has shifted fairly significantly inthe last five years, which is the timeframe for the rate path that we have beenunder in the current settlement that we are operating under.

And we -- it’s get much more peaky, it's get driven by alarge amount of air conditioning load that’s been added to the system. I knowthose of you in the east don't understand this and you shouldn't, but weactually you do a lot of cooling out here through the years of evaporatedcooling. And so instead of having compressors running you have a fan runningacross border to cool the temperature 20 to 30 degrees. But we are not seeingthat being sold to new homes and we are seeing an enormous amount of conversionto air conditioning. So our load is becoming much more peaky and that's reallywhat’s driving our marginal cost of supply being higher than the averagerevenue that we get from those customers.

Pat Vincent

We have as Jeff mentioned an electric program and we alsohave a program on the gas side. For recovery, we have dollar-per-dollarrecovery on a rider now for those programs. We're working to do more. But thefirst thing we need to do is just that gets a regulatory theme right. Thegovernor of New Mexicothis year plans on introducing a major energy efficiency bill as part of the30-day session.

We are in discussion with his staff and some of theenvironmentalist in terms of what that would look like. Our major focus is thatit gives us the proper incentives to do more energy efficiency.

We're also working on some load control programs, which is abig focus for us. As Jeff mentioned, the penetration of refrigerated centralair conditioning, it's becoming quite large in our areas, so we're working onsome load control programs close to residential side and the commercial sidethat helps to level out that peak. But it is a major focus for us.

Jeff Sterba

One other thing let me mention. We already have on the booksfrom this last session. Legislation that says, that the commission is chargedwith removing disincentives and considering the application of incentives.

Obviously, we believe that not getting a return is adisincentive. But we agree to go forward, this is a voluntary filing in ourpart with those first set of programs to get them off the ground this year.

Operator

Thank you. We'll move to Lasan Johong with RBC CapitalMarkets.

Lasan Johong - RBCCapital Markets

Thank you. Couple of different questions, Chuck I thoughtyou've mentioned that – maybe I mistaken the mark-to-market loss of $0.04, thatis included in your guidance or $1.30 to $1.40, is that right?

Chuck Eldred

That's right, Lasan. If you look at that chart that wereprovided in 2007, that's already baked into the guidance projection.

Lasan Johong - RBCCapital Markets

Okay. So excluding that it's $0.05 higher?

Chuck Eldred

Lasan, I think one of the thing we had, probably it'sunderstood but we want to clarify is that the only mark-to-market gains or lossesthat in the future will be included in earnings as those that are on thetrading book. So all of those that are economic hedges or related to ourbaseline operation, those mark-to-markets will not be included, but since thetrading one of the things that they do as part of their business is thetrading, the mark-to-market will be included in the income statement.

Jeff Sterba

So if you look at year-to-date anything we've done this yearhas been settled and then we expect at this point, the 2007 fourth quarterposition that we currently have would also be settled as a loss frankly andthat's included in our guidance.

Operator

Thank you. We'll move to Paul Patterson with GlenrockAssociates.

Paul Patterson -Glenrock Associates

Good morning guys.

Jeff Sterba

Good morning.

Paul Patterson -Glenrock Associates

I was just wondering if you could sort of based on themargin on the new customers versus the legacy customers in the First Choicebusiness. And just what you're seeing there in terms of just little more flavorfor the competitive market. What's actually happened with mass market and justin general what you're seeing in terms of how we should look at this in termsof cost to require the customers. Just give us a little bit more of a flavor sowe can be maybe a little bit more predictive of what would happen as whathappened in this quarter with a low volume one and versus a more normal volume(inaudible).

Jeff Sterba

Good question. And I am going to ask Jeff Weiser who is thePresident of the FCP and with us today to answer it. And let me put a caveatupfront Paul which is that obviously we're not the large player that at leasttwo other are, three others are. And so we are a little careful about ourcompetitive information, but Jeff I think can give a little better handle onhow we look at the different customer groups. Jeff?

Jeff Weiser

Thanks Jeff. First of all with respect to your question onmargin, we have recorded margins in the 20s as Jeff talked about. There is avariation above and below that depending upon the specific area. So you saidlegacy versus competitive, it's a little bit lower in the competitive, a littlebit higher in the legacy area.

And that's just the function as we go forward of volatilityin a competition. The competition remains strong in Texas. We did get some clarity with respectto a legislative picture earlier this year which obviously translated into thebeginning of the growth in terms of acquisition of customers as the year wenton.

With respect to your question on cost to acquire, we look atthis as if you look at any other capital budgeting opportunity and we want tosee significant returns, cash-on-cash higher or etcetera on our acquisitionprogram. So, we do those things completely consistent with capital budgetingcriteria, you would do for any other type of activity and we'd like to seeaccretion on customers within a year on those spends.

We won't talk specifically about what our cost to acquire,but I can assure you that those are the measures that we utilized to evaluatethe effectiveness of our marketing activities.

Jeff Sterba

There is one other item on there Jeff that you may want tomention which the positioning of our cost of servicing customers given [theusage].

Jeff Weiser

Well, yeah, thank you Jeff. Obviously as one of the smallerplayers, the fourth largest in this market, you have to have some competitiveleverage to apply and the customer service system that we deployed and therelated technology around that incense us significantly to acquire newcustomers, that is that their marginal cost to serve is significantly lowerthan on our existing base of customers that we had. So that's clearly a factoralong with bad debt in our acquisition model.

Paul Patterson -Glenrock Associates

And while we are not giving specific on numbers, the deltabetween competitive and other customers is on the high and so legacy customersin the high single-digit. Is that fair Jeff?

Jeff Sterba

In terms of dollars incremental whatever.

Paul Patterson - GlenrockAssociates

Yeah

Jeff Sterba

Probably so.

Paul Patterson -Glenrock Associates

And then relative to the cost of the service we arecertainly well below a dollar a customer at this stage.

Jeff Sterba

Our cost to serve is probably about at least around half asmuch for incremental customers it is to existing we had when we entered intothe market first.

Paul Patterson -Glenrock Associates

Okay. Hope that I gave you some more information Paul.

Operator

Thank you. Let's take our last question from Lasan Johongwith RBC Capital Markets.

Lasan Johong - RBCCapital Markets

Thank you. Jeff, you have mentioned that basically in Texas you guys arepreparing for the nodal market. What exactly goes into this preparation for thenodal market?

Chuck Eldred

Well, there is two things that go into that and I am goingto have Jeff address them but it relates both the systems and expertise of thepeople and the second one is obviously understanding where do you expect thereto be locational differences. Jeff?

Jeff Sterba

Exactly that system protocol testing that we have to do. Andwe think that it is a very good opportunity for us as wholesale lead retailer.We have those skills intrinsic inside the business and it makes a lot of senseas we go forward to understand how that market evolves and essentially toprotect our customers and take advantage of the opportunities that many of thesmall undercapitalized new entrants simply don’t have. They essentiallyoutsource those skill sets and that's a significant impact in this market goingforward and frankly we are prepared to address it.

Chuck Eldred

Okay.

Operator

And that will conclude our question and answer session. Iwould like to turn the conference back over for any additional or closingremarks.

Jeff Sterba

Well again, thanks for your time today, and I know you willsee Chuck, Pat, and Gina again in the Florida.Have a drink for me would you please, and enjoy yourselves. Take care. Bye,bye.

Operator

Thank you. And ladies and gentleman that will concludetoday's conference. We thank you for your participation, and you may disconnectat this time.

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