Todd Kobayashi - Vice President, Investor Relations
Thank you, Operator, and good morning. Welcome to Great Plains Energy' s third quarter 2005 earnings conference call. Joining me on the call today are Mike Chesser, Chairman and CEO of Great Plains Energy, who will provide a strategic ov erview of the company; Bill Downey, President and COO of Great Plains Energy and President and COO of KCP&L, who will provide details on the performance of the utility; and Terry Bassham, Executive Vice President and CFO of Great Plains Energy will be pr oviding financial high lights and details on 20 05 earnings guidance. Shahid Malik, Strategic Energy CEO will also provide an update on our competitive supply business.
I wanted to take a moment to let investors know that we will be presenting at the Edison Electric Institute's 40th Annual Financial Conference on Nove mber 8th. We look forward to this upcoming opportunity to spend time directly with our investors.
Since some of our remarks will be forward- looking, I must remind you of the uncertainties inherent in such comments. The second slide included in this webcast as well as the disclosure in our SEC filings contains a list of some of the factors that coul d cause future results to di ffer materially from our expectations.
I would now like to introduce our Chairman and CEO, Mike Chesser.
Mike Chesser - Chairman and CEO
Thanks, Todd, and good morning, everyone. This truly has been an interesting time in the energy business -- record natural gas pr ices; unseasonably high wholesal e prices, in our markets, at least, are double those of last year; and high anxiety among energy customers. In fact, I'd venture to say that we are in a new age for the energy industry, and this new age is characterized by a number of trends.
First, volatility in natural gas and power prices that have become more the rule than th e exception; second, increased regulatory reactions are being seen in response to higher prices. These reactions affect both the regulated and the competitive states. On the regulated side examples range from exam ination of natural ga s purchasing strategies, closer examination of G&A in states like Michigan, a nd fuel clause recovery scrutiny such as what we've seen in Arkansas.
On the unregulated side, we are seeing many different proposals for the evolution of deregulation in Illinois and proposals for tem porary restraints to high prices in places like Texas. The third trend is that there is clearly an increased interest by customers in efficiency and demand response programs. And, finally, there is heightened interest in renewable energy strategies.
The good news in all this is that Great Plains Energy's strategic plan positions us to capitalize on this new environment. KCP&L's current supply portfolio is right for the times. KCP&L is a coal and nuclear-based utility . Over 95% of our megawatt hours in 2004 cam e from these low-cost fuels. Our fleet is extrem ely competitive. We start from a strong position that provides a hedge against th e difficult issues faced by utilities th at are heavily reliant on natural gas as a fuel source.
Our scenario planning has also helped. During last year's strategic planning effort, we identified multiple scenarios against which to stress-test our strategy. One of the scenarios which we call "natural gas chaos" provides a stress test similar to the current environment we find ourselves in.
Our comprehensive energy plan fits very well, because it emphasizes a balanced approach on a number of fronts. First, it balances the need for energy that is afford able and energy that is environmentally responsible. Coal, we all kn ow, is low-cost and in abundant supply. By increasing coal generation, we can deliver afford able, more predictably priced energy for years to come. At the same time, by investing in modern technology and environm ental upgrades in our plants, we can significantly improve air quality in the Kansas City region.
Second, the plan also balances th e need for renewable energy with the need to be practical. The addition of wind in our portfolio hedges us agai nst some environmental risk but not at the expense of reliability or cost.
Third, the plan balanc es actions we can take to reduce custom ers' costs with actions that customers themselves can take to reduce their own costs. This includ es valuable new customer programs for energy efficiency and demand response as well as affordability programs.
Implementing this plan in the near term, we are in the final stages of planning our investments in 100 megawatts of wind generation. The wind project is on schedul e to be completed during the third quarter of 2006, which will en able us to include the investment in KCP&L's rate case and begin earning a return on that investment in 2007.
Also, over the next two years, we will be rolling out a nu mber of demand-side management efficiency and affordability programs that we also will be able to earn a return on.
In competitive supply, current market conditions clearly are not optimal but, over time, as energy prices decline as it's being project for mid next year, and utility rates move up to reflect market prices for fuel, Strategic Energy is strongly positioned to capitalize on the growth opportunity in competitive electricity markets.
During this year we continue to increase sales of new flexible products that have been designed to help customers address the current high-price environment. These new products leverage our competitive advantage of being a valued cons ultant to cu stomers and further strengthen our brand. For instance, the new index-based products accounted for 57% of new sales year-to-date.
We are also aggressively managing our operating costs across Great Pl ains Energy. At KCP&L our internal production costs per megawatt hour are tier 1 today and, in fact, are am ong the lowest in the region. Initiatives underway in non-fuel O&M are anticipated that move us close to tier 1 next y ear as we ll. We also are targeting efficiencies in our delivery business that leads to tier 1 O&M costs in 2006.
At SEL, we have achieved reductions of G&A cost s in 2005, and as new state-of-the-art retail pricing and transaction management system s come onl ine in 2006, we expect further productivity gains.
Additionally, during 2005, we have completed a talent assessm ent proc ess with the goal of identifying top performers and matching individual skills w ith jobs wh ere they can be most productive. This will increase our effectiveness and improve our cost structure.
Overall, we continue to believe that Great Plai ns Energy is well positioned to benefit from the solid growth of our regulated ut ility, which we expect will expe rience nearly 60% growth in its rate base under the Comprehensive Energy Plan and produce 2% to 3% average annual earnings growth. The utility is complemented by our low-risk competitive supply busin ess, which can take advantage of customers' needs for advice and competitive products.
The 2% to 4% combined growth in these two businesses, along with our attractive dividend yield, which is currently north of 5%, provides a strong total return to our shareholders for years to come.
Looking at the third quarter for a second, KCP& L benefited from weather that was 15% warmer than normal, and wholesale power prices that were double the levels seen la st year. Strong retail sales and increased wholesale prices help to offset the failure of the main transformer at our 565- megawatt Hawthorne 5 coal unit. The 32-day outage drew higher fuel a nd purchase power costs during the quarter, which offset a number of positives including favorable weather, strong power prices, the benefits from regulatory treatment of pension expens es, and tax benefits recorded during the quarter.
The difficulties experienced by railroad deliveries of coal for the Powder River Basin resulted in a decision that managed coal burn more closel y. With the outage at Hawthorne 5, however, our coal inventory levels have im proved, which will allow us to operate at highe r levels than originally anticipated for the remainder of 2005.
We are also encouraged by the third quarter trends at Strategic Energy. While we have seen a shift toward shorter-term products that has reduced future back log, quarterly de liveries, which we consider to be a critical m easure for this business, have remained relatively constant year- over-year and, importantly, strong customer loyalty continues to provide a foundation for future growth.
I would now like to introduce Terry Bassham, who will discuss our company's financial performance.
Terry Bassham Executive VP, Finance & Strategic Development and CFO
Thanks, Mike, and good morning, everyone. First, I would like to briefly discuss core earnings.
Beginning this quarter, we will disc uss core earnings to provide investors a useful indication of
Great Plains Energy's results that are comparable among periods. Core earnings is a non-GAAP financial measure that excludes the effects of discontinued operations, unusual or nonrecurring items, and mark-to-market gains and losses on energy contracts.
In past presentations, we discussed ongoing earn ings results, which included mark-to-market gains and losses on energy contracts. We have stated in the past that our ongoing earnings guidance did not include mark-to-market gains and losses on energy contracts. As a result, core earnings results will be consistent with our earnings guidance.
In the third quarter of 2005, Great Plains' revenues were $783 m illion, an increase of more than 9% compared to last year driven by warm weather and the KCP&L service territory and higher power prices at Strategic Energy. These power revenues were offset by higher fuel and purchased power costs due to th e Hawthorne 5 outage and slightly lower margins at Strategic Energy.
Earnings for the third quarter were just over $90 million compared to $75.5 million last year, and core earnings were $78 million, up from $65 million in the third quarter of 2004. Earnings in the third quarter benefited from the regulatory accounting treatment of pension expense that allowed Great Plains to establish a regulatory asset retroactive to January 1, 2005, for annual pension cost in excess of $22 million. Earnings also benefited during the quarter from income taxes that were $17.9 million lower than last y ear due prim arily to a lower com posite tax rate, which reduced KCP&L's deferred tax liabilities by $11.7 million and lower taxable income.
Earnings this quarter were significantly impacted by a $10.7 million after-tax net mark-to-market gain on energy contracts at Strategic Energ y. These mark-to-market gains are driven by increasing power prices and are ex pected to reverse, ov er tim e, as the energy is delivered to customers. These gains could also reverse if power prices drop prior to delivery.
The other category was breakeven during the quarter compared to a loss of $10.8 million in the third quarter last year. Results were impacted in this year's quarter by the release of tax reserves and, while not affecting Great Plains Energy' s consolidated earnings, the other category in 2004 was impacted by changes in parent company tax allocations.
Year-to-date revenues at Great Plains Energy were $2 billion, up about $90 million from last year. Earnings were just under $132 million and core earnin gs were $11 8 million, both down from the year-ago period. In add ition to th e items that af fected the th ird qua rter, year-to-date earnings were impacted by higher operating expenses at KCP&L and scheduled and forced plant outages that reduced megawatts available to sell in the wholesale market. These items more than offset the favorable weather and higher wholes ale prices ex perienced at KCP&L. Also, Great Plains Energy's year-to-date core earnings were negatively impacted by reduced core earnings at Strategic Energy compared to last year due primarily to nine months of Seams Elimination Cost Adjustment, or SECA charges, as well as lower retail gross margins excluding the impact of net mark-to-market gains on energy contracts.
At KCP&L third quarter revenue was $353 million compared to $323 million in the third quarter last year. Earnings were $69 m illion or 8% higher than third quarter 2004. Retail revenu es increased by nearly $3 2 m illion, or $310 m illion compared to th e same quarter last year, primarily due to weather that was significantly warmer than last year.
Higher retail usage, the 32-day Hawthorne 5 outage, and coal cons ervation measures led to third quarter wholesale volumes which were 37% lower than last year. However, wholesale revenues were roughly flat at $39 million, down just $1 million from last year as the decrease in wholesale volume was largely offset by wholesale prices that were almost double last year's level.
Fuel costs during the third quarter were $21.7 milli on higher than last year, prim arily due to an unfavorable fuel mix driven by the Hawthorne 5 outage, higher natural gas prices, and m odest increases in the cost of coal and coal transp ortation. Purchased power costs also increased $14.3 million during the quarter due primarily to higher prices and more megawatt hours purchased during the Hawthorne 5 outage.
As we alerted you last quarter, income taxes in the third quarter were $16.2 m illion lower than last year. This was due prim arily to a lower composite ta x ra te as a resu lt of su stained audit positions, in cluding the effect of th e lower co mposite tax rate of deferred tax ba lances that I discussed earlier, and lower taxable income.
Third quarter earnings also reflect lower pensio n expenses of $7.1 m illion primarily due to the establishment of a regulatory asset for a portion of the company' s pension costs, including $5.6 million relating to the first six months of 2005.
Year-to-date, KCP&L revenue was $858 m illion compared to $844.5 m illion last year, and earnings were $109 million compared to $118.4 million in the same period last year. During the first nine months, retail revenues increased $43 million yea r-over-year due prim arily to warm weather. Higher retail revenues were partially offset by a $28 million decrease in wholesale revenues due to scheduled and forced plant outages and coal conservation that reduced megawatt hours available for wholesale in the first nine months. The effect on earnings of the lower megawatt hours available for wholesale was partially offset by higher average wholesale prices.
The lower year-to-date earnings also reflect a $38 million increase in fuel and purchased power expenses due to higher natural ga s prices and scheduled and for ced outages, which resulted in unfavorable fuel mix.
KCP&L's other operating expenses year-to-date we re $15.3 million higher than last year due to several items, including a year-over-year outage -driven increase in plan t op erations an d maintenance costs, a $4 .9 m illion increas e in storm expenses, a $4.5 m illion in property and other general taxes, a $3.9 m illion increase in em ployee-related costs, $2.6 m illion in higher legal reserv es, and th e absence of last year's $1.5 m illion benefit from a reversal in environmental reserves.
Higher operating expenses were partially offset by a $3.9 million reduction due to the application of the regulatory treatment of pension expense and a $4.6 m illion year-over-year reduction in transmission service cost.
Year-to-date, interest expense was $4 m illion lower than last year, and income tax expense was $32 million lower than last year due primarily to the previously mentioned tax benefit reported in the third quarter and lower taxable income.
Strategic Energy reported third quarter revenue of $430 million, up 10% from last year due to the higher pow er prices. While deliv ered retail megawatt h ours decreased by 5% to 5.4 m illion megawatt hours. Third quarter earn ings were $18.1 million compared to $13.4 m illion last year. Results for this qu arter were sign ificantly impacted by $10.7 million in af ter-tax net mark-to- market gains. Core earnings, which exclude mark-to-market gains were $7.4 million compared to $10.9 million in the same period last year.
Third quarter retail gross margin per megawatt hour was $7.85, which includes $3.36 per megawatt hour due to mark-to-market gain s. This compares to a reta il gross margin pe r megawatt hour of 5.50 last year, which included $0.77 due to the mark-to-market gains.
During the quarter retail gross margin also benefited from portfolio optimization strategies that are a normal part of actively managing our hedg e positions. The hurricane -induced volatility in the power markets provided optimization opportunities that were larger than normal.
During the first nine m onths of 2005, Strategic Energy's revenue increased 7.5% to $1.1 billion while earnings were $34 .6 million, up from $32 m illion last year. Year-to-date 2005 earnings were negatively im pacted to $4.7 m illion af ter-tax by SE CA and positiv ely im pacted $15.1 million after-tax for net mark-to-market gains on energy contracts. Co re earnings were $19.5 million year-to-date compared to $29.8 million last year.
Year-to-date megawatt hours delivered were flat compared to last year. Our retail gross margins per megawatt hour were $6.30, which included the $1.71 due to net mark-to-market gain on energy contracts, $0.08 due to a reversal of ta x reserve, and a reduction of $0.54 pe r megawatt hour due to SECA. This compares to $6.00 in 2004, which included $0.25 due to net mark-to- market gain on energy contracts.
During the third quarter, the tim ing of tax cr edits and a ccounting reductions of affordable housing investments resulted in earnings of $1.9 million from KLT investments. Year-to-date earnings from the KLT investments were $2.4 million. We continue to anticipate $0.07 per share for the full year.
The other category was breakeven during the quarter compared to loss of $10.8 m illion in the third quarter last year. Results were impacted in this year's quarter by the release of tax reserves, while the third quarter of 2004 included the loss due to changes in parent company tax allocations to subsidiaries. KLT Gas discontinued operations in the quarter reflect $1.8 million of earnings due to the partial reversal of a legal reserve established last quarter.
Based on Great Plains Energy's results year-to-date and the company's expectations for the fourth quarter, we are increasing 2005 co re earnings guidance to a range of $2.15 to $2.30 per share. The driver for this increase in core earnings gu idance is the anticipation that average gas prices should range from $12 to $13 per mcf during th e fourth quarter, which is expected to positiv ely impact KCP&L's fourth quarter wholesale revenues.
Strategic Energy's results have also improved in the quarter, a nd we have m oved their range up modestly.
Finally, we expect to provide 2006 core earnings guidance in mid-December as we complete our budgeting and planning processes.
Now I would like to introduce Bill Downey, who will discuss the operations at KCP&L.
Bill Downey - President and COO
Thank you, Terry. As you heard from Terry, KCP&L had a solid quarter, even though we were substantially impacted by the failure of a five-year-old main transformer at our 565-megawatt Hawthorne coal-fired station. The failure resu lted in a 32-day outage during the quarter. The backup transformer size limits the unit' s capability to 500 megawatts until a new transformer is installed. We anticipate the changeout to occu r in June 2006. As a result of the Hawthorne outage, much of our coal conservation originally planned for the fourth quarter was shifted into September. We anticipate to be able to r un Hawthorne at 500-megawatt capab ility until we install the new transformer.
Given the doubling of power prices compared to the same period last year, we project increased wholesale revenues in the fourth quarter should more than offset the 2005 financial impact of the outage.
The Hawthorne outage and m odest am ounts of coal conserva tion negatively impacted our baseload coal fleets equivalence availability, and capacity factors during the quarter. Availability and capacity were 82% and 76%, respectively, compared to 91% and 85% in the third quarter of 2004. Last year's third quarter, by the way, was a record for availability and nearly a record for capacity factor. The slig htly wider spread between availability and capacity in the third quarter of 2005 reflects our coal conservation efforts.
As a result of the higher retail usage due to wa rm weather, the Hawthorne 5 outage and coal conservation measures during the quarter, whol esale volum es declined to just over 900,000 megawatt hours in the third quarter. This represents a drop of 37% compared to the same period last year. The lower volumes were largely offset by wholesale prices that were almost double last year's level, nearly $51 per megawatt hour compared to roughly $25.50 last year. The net result of lower wholesale volum es and higher wholes ale prices produced wholesale revenues which were nearly flat compared to last year.
We were also gratified to have received a recent ruling from the FERC that KCP&L successfully rebutted a presumption of market power in our control area. KCP&L's successful rebuttal was based on a detailed economic analysis that took into account the obligatio n we have to serve our native load. This was th e first time FERC had accep ted a rebuttal of the pr esumption of market power under its revised market-based rate program. The FERC's action removes the potential of KCP&L being required to refund a portion of its market-based wholesale sales. In addition, the company can continue to make wholesale sales at market-based prices in the control area.
Favorable weather was also a sign ificant driver in the third quarter. Cooling degree days were 54% higher than the thir d quarter last year, and 15% higher than normal. This unusually warm weather was the primary driver behind the 11% increase in retail revenue experienced during the quarter. September, in fact, was the warmest on r ecord in Kansas City's history. Unfortunately, the Hawthorne outage did not allow us to take full advantage of the favorable weather.
Weather-adjusted retail megawatt hour sales growth was just unde r 2% on a year-t o-date basis.
Kansas City Power & Light's first generation proj ect in the Comprehensive Energy Plan is the addition of 100 megawatts of wind. In August RFPs were issued. We expect to complete our selection of proposed sites and developers during the current quarter. We remain on schedule for completion of the wind project in the third quarter of 2006. This will enable us to include the wind generation in our 2006 rate case and begin ear ning a return on this investment when new rates are effective in 2007. The RFP processes for environmental and coal projects currently are underway. We anticipate awarding contracts for the La Cygne 1 SCR project this quarter, and we should begin awarding contracts fo r Iatan 2 and the Iatan 1 envir onmental retrofits in the first half of next year. Permitting for Iatan 2 remains on track for completion by early 2006.
The process we implemented to gain approval of our comprehensive energy plan was highly collaborative and included workshops with cust omers and regulators. Since then a number of customer programs suggested during the works hops have been adopted. These program s would allow KCP&L to work with customers to reduce expensive peak demand and increase energy efficiency of their hom es and bus inesses. The programs, treated as regulatory assets, will allow customers to manage their energy costs proactively.
Within three years we expect to shif t approximately 100 megawatts of peak load to ours, where power is less expensive. We see almost 15% of our custom ers taking advantage of load management, as well as energy efficiency and a ffordability programs over the next three years.
Our strategy is to engage customers in an interactive relationship. This strategy has worked well in our Web-enabled self-service. Platts Research in this year's survey of utility websites rated the KCP&L site as the second-best in the nation overall for features and functionality. Our penetration rates for these services as well as paperless billing are two to three times the industry average. This customer acceptance allows us to hold down servicing costs. Mo re importantly, these capabilities allow us to transform our relationship with customers.
As Mike mentioned, with the recent natural gas price increases, customers have expressed an interest in accelerating the implementation of these programs. We are working with regulators to move these program s ahead quickly. Now I' d like to introdu ce Shahid Malik, who will discuss the operations of Strategic Energy.
Shahid Malik - Strategic Energy CEO
Thank you, Bill. Good morning, everyone. Let me start with a review of the competitive environment. We are finding that custom ers are no longer paralyzed by higher prices, but high natural gas and power pr ices do co ntinue to affect customers' purchasing decisions. We see a strong preference for shorter-dur ation products, including our inde x-based products that contain both fixed and floating com ponents and m onth-to-month renewals in which customers remain with Strategic but accept floating prices and thus assume commodity price risk, anticipating th at prices will fall.
This preference for shorter-term products has redu ced future year committed backlog relative to prior periods. However, as we will discuss in a moment, our quarterly deliveries have remained relatively constant. The custom ers on th ese s horter-term, m onth-to-month, and index-based products feel the financial sting of rising pri ces quickly, and we continue to believe that customers prefer price certainty. So while cust omers have gravitated to short-term product in response to high prices, we s ee considerable pent-up demand for long-term price certainty amongst our customers. We are quite confident that we will renew a signif icant number of these customers to longer-term contracts when the prices dip.
Indeed, the current forecast of na tural gas indicates that prices should decline after the winter period, and some customers may see such a price de cline as an opportunity to lock into longer- term contracts.
Customers today are looking for advice, education, and information, and we believe that this is an area where Strategic Energy' s em ployees have sign ificant va lue. Ou r whole approach to marketing to these customers is very much focused on a consultative sale, which is highly valued by our customers. In this environment, we are finding that sales are most robust in markets where pricing is dynamic, and where pow er prices can quickly adjust to changes in the market price, including Texas, New York, Pennsylvania, and Massachusetts.
Strategic Energy remains on track for 2005 deliveries of over 19 m illion megawatt hours with 4.1 million megawatt hours in back log for the fourth quarter. This is well within our previous guidance of 17.5 to 21 m illion megawatt hours. However, the im pact of our customers' current preference shorter-term contracts can be clearly seen in the size of our committed backlog for future years. As our product m ix has shifted toward shorter-term contracts, backlog is significantly diminished, and the backlog for futu re y ears tends to become a less meaningful measurement of our business volumes.
As such, if you exam ine the bar chart on the ri ght of Slide 25, you can see a period-to-period comparison of megawatt hours delivered. Since our run rate has remained comparable to last year when taking seasonality into consideration, customers are remaining with us, as you can see in our quarterly deliveries. They don' t show up in backlog due to the ve ry short-term contract that they currently prefer due to the current high energy prices.
Strategic Energy also continues to see strong customer loyalty, even as customers are moving to shorter-term, m onth-to-month renewals. Retent ion, excluding m onth-to-month custom ers, was 39% during the third quarter compared to 82% last year. However, when you include those month-to-month customers that are staying with us, Strategic En ergy retains approximately 80% of customer load year-to-date compared to 86% a year ago.
Excluding customers that have opted for m onth-to-month renewal, the cont ract duration of new business year-to-date has been 14 months, down just slightly from 15 m onths last year, and average retail gross margin per megawatt hour on new custom ers rose in the quarter to $3.53 compared to just under $3.00 last quarter. This was largely driven by a continued increase in smaller, higher-m argin custom ers. This segment represents ju st 4% of sales year-to-date bu t 12% of total sales in the third quarter.
We are continuing to execute several strategic operational steps to improve the business and adapt to the current market environment. I call them the four Ps -- positioning, procurem ent, product, and productivity.
The first is positioning -- we ar e focusing our resources on aligning the G&A stru cture of our business to the dynamic markets that have attr active headroom to sell. We are also finding customers increasingly valuing the consultative advice that's inherent in our sales and custom er service approach. In addition, we are sharpening our marketing and sales efforts with a particular emphasis on the sm all business cu stomer that has increased to 12% of sales in Q3 compared to less than 1% last year.
The second P is for procurement -- we are working on aggregation strategies to try and buy more effectively for our custom ers, especially in the renewal area with the opp ortunity to bundle load and to buy more effectively. We have added new talent to our team with a new vice president of supply that's helping us to im prove that portfolio optim ization strategy to more effectively manage our portfolio. We are al so implementing new system s, as Mike mentioned, to help us better measure and manage our risk. These pricing improvements have helped us to improve our competitive position this year, particularly in our key markets in Texas and New York.
The third step is new products -- as we have described, our new index-based products, our month-to-month renewals, and our new products marketed especially to the smaller customers are increas ing new sales and also driv ing slightly higher margins in the busin ess. These improvements are also producing results with 57% of new sales from our new index-based product and, as mentioned, a strong increase in that smaller customer segment.
And, finally, we're focused on our fourth P -- productivity. New systems that we're implementing are anticipated to im prove scalability. Focusing on attractive markets should allow us to rea lign G&A costs, and we also believe th at there is significant sales pr oductivity potential to be gained once prices declin e and customers b ecome motivated again to sign long er-term contracts. We would then have fewer customer touches and more opportunity to pursue new business.
Thank you for your attention, and that concludes our remarks. I'd now like to pass the baton back to Todd and open up the call for questions.
Good morning, everyone, this is Mike Chesser, and we'd be happy to take any questions.
Operator, do we have any questions?
Douglas Fischer - AG Edwards
Just a question -- you did mention that there was some portfolio optimization at Strategi c in the third quarter that was abnormally positive due to the volatility from the hurricane. Can you quantify or , in any sense, crudely, what -- how much of that was due to abnormally benefits and whether th at explains, essentially, all of the increase in guidance at Strategic for the year?
Good question. We started taki ng a much more active role managing our portfolio. As we buy the power, equally im portantly, once we've bought it, and it' s in our portfolio. But with respect to the activity that we took, it was relatively sm all. Specifically what it was, we have tr ied, in the past, no t to ac tively manage our purchased contracts, but with the recent volatility and with the increased attention of our supply team, we're paying close attention to low-risk opportunities to manage that optionality that's in our book.
For example, in this case we've made a sign ificant sale in Pennsylvania some time ago, and we've purchased power for delivery to a nearby liquid hub, and on closer exam ination of our book, we determined that we could actually swap out that transmission part, actually in PJM, of one for another one, which allowed us to take a dvantage of the fact th at we now had a more valuable opportunity. In this way, we reduced our risk and took over $2 million in pretax income earnings to the bottom line. So relatively small, I would say it' s about $0.01 to $0.015 net income.
But, Doug, not all of that was recognized in the quarter. We probably had less than $0.5 million that was recognized in the quarter.
So the rest of it would be recognized -- is part of that in mark-to-market is what you're saying?
Yes, part of it is mark-to-market and will get recognized in future periods.
So it's not really in the core earnings guidance?
Okay, thank you, and then ho w much was the SECA charge in the third quarter? I mean, I think you gave the nine months, but unless I missed it, I didn' t see the three- month SECA charge.
This is Terry -- the three-month charge was minimal for the quarter because there was an offset for some of our collection activities we started. So the actual SECA charge was the same as it had been on a quarterly basis, but we ac tually began the process of billing some customers as well, so net-net, given that offset, there wasn't a material impact.
Okay, so you're being able to pass that on or at least bill that?
We're beginning the process, that's correct. The charge itself was still there, but we also had a pickup from the initiation of that process with customers.
Kathleen Vuchetich - W.H. Reeve
I was wondering if you could tell me how the siting process is going at KCP&L. You guys were talking originally about getting siting sometime this fall, and I was wondering how that was moving along?
Sure, Bill will fill you in on that.
Kathleen, when you talk about siting, to which siting are you referring?
The coal facility.
Well, of course, I think we're m oving along very constructively. Everything seems to be on target. We have -- I think you're referring to the perm its, key perm its that are anticipated, and we still remain confident that, in the first quarter of next year, we will be able to obtain those key permits.
Okay, so it's Q1 of '06 that you're looking at?
Yes, that's correct.
Great. And I was wondering, at Strategic, two questions -- first of all, you mentioned that you' re looking at sm aller, highe r-margin customers. Could you talk a little bit about the dem ographics of what that group lo oks like? A nd, secondly, how big is the SECA charge on an annual basis, and how long is that incurred? I know it' s transition area, but I don't know how many years that cost will be passed onto you.
Let me address the SECA charge first, Kathleen. It was roughly about $1 million, $1.1 million, per month for 16 months, which works out to about $16 million in charge. As Terry mentioned, we are in the process of doing three things with the SECA charge. Firstly, we are filing regulatory appeals with various agencies, both FERC and various stat es. We believe that the charges are unjust and unr easonable and goes against the established doctrine of no retroactive ratemaking. So at FERC we're planning testimony. We've also started an intervention to pursue a shif t in th e cost of the shipper, and we've also filed a write of mandamus in federal court. So all those things are ongoing right now.
With respect to the charge, it was $16 m illion for the period from Ja nuary 1st of this year through March of 2006, so about $1 million a mont h. Our expectation is that we will recover some of that through charges to our customers and hopefully a good chunk of it as well back to the shippers who supplied us the power in the first place.
Does that answer your question on SECA?
Yes, it does, thank you very much.
You're welcome. With respect to the smaller customers, we've been quite active in trying to segm ent our business in a much more thoughtful way than we have in the past, and we've been very, very conscious of the customers that we haven't served in the past -- the larger customers and the sm aller customers. We believe that the sm aller customers represent a good opportunity for us. We've principally focused on them in our core states in Texas and New York, but we believe that we have a significant leve rage opportunity through our sales channel and, therefore, that's where most of our customers currently are. Total size -- those customers tend to be peak load of 150 kilowatts or less at any on e time. So a sm aller demographic than we've had in the past. But so far it's been quite a successful plan.
Paul Patterson – Glenrock Associates
I wanted to ask you just to clarify the pension and tax impact once again. The pension im pact for the quarter was how much? And how much of that is sustainable, I guess?
This is Terry. Remember that the pension impact is related to th e regulatory agreement and basically what it amounted to wa s a reversal of the charge we had taken throughout the year that we couldn't really consid er until the regulatory orders were final. So what happened is when the final orders were a pproved in both states, we were ab le, th en, to reverse back the amounts over that $22 million cap that's in the agreements, and that's a one-time reversal of those first amounts. So it's certainly sustainable. It will be the am ount for the rest of the year.
Okay, how much is that?
It was about $4 million.
It's $4 million pretax?
Okay, and that is sustainable through the rest of the year, but going into 2006, does it still go on?
The cap remains for the next year as well, that's correct.
Okay, and then the tax impact -- I'm sorry, but I wasn't completely clear on what -- I mean -- there's a reversal there and what have you -- how normalized is that, I guess?
On a year-over-year basis, we did have a sim ilar size tax adjustment last year. So from that perspective, I would say it' s normalized year-over-year. We will continue to work, as we always do, on opportunities to reduce taxes. That single adjustment of $10 m illion-ish is certainly larger than we normally find on a regular basis, but we have been able to find that now in two different areas over the last two years, and we'll continue to look for opportunities.
Okay, so the $10 m illion is kind of an un usual item, but you guy s think you might be able to do that again, going forward, is that the idea? Or something in that neighborhood?
Well, I'm not sure I would say we could tell you today we'd do that at that level. We certainly would continue to look for opportunities, but to say today I wouldn't know we could do that level next year would probably be a little be yond what I would be comfortable with.
Okay, and then the invested tax credit of $0.07 that you plan on having in 2005, is that going to be continuing as well?
Yes. It reduces next year slightly, I think.
We're going to talk a little bit more about that when we give guidance in December, but we are going to have benefits th at con tinue for the next couple of years in invested tax credits.
Okay, and then, just briefly, on Strategic Energy, it sounds like the SECA charges are now able to pass that through to cu stomers to some degree. So I'm wondering if everything -- let' s say even if you're not successf ul with respect to th e SECA charge and your legal challenge, it soun ds like there was rea lly no impact associated with it financially and th at you were able to pass it through to custom ers. If we go into 2006, should we expect that $7.2 million -- or $4.7 million after-tax -- that you' ve incurred in the last nine months, to basically go away? Would that make sense?
Well, it would be great if that would happen. In reality, we are likely to only see a portion of that SECA charge come back to us . For competitive reasons, we clearly cannot talk on the full cost of that SECA charge to our cust omers, but we hope that with a combination of what we are passing onto our customers in these ar eas, as well as the potential sh ift back to th e shipper, that we can recover somewhere approaching a third to half of our charge. We' ll see. Our expectation is that for a good attempt of that.
Okay, and then, finally, with the new business margin that you guys were talking about, it obviously looks like it' s come up a bit, obviously, than the previous quarter, and that's because you're focusing on smaller customers, if I understood that correctly.
But you also -- I'm wondering if there are other char ges, or other costs that are associated with having sm aller customers -- administrative or what have you -- that might lower the actual earnings impact of getting those smaller customers, a, and then, b, you're looking at lowering G&A in 2006. I was wondering -- I saw that in the slide -- I was wondering if you could quantify that a little bit.
Yeah, a good question, Paul. Firstly, with respect to the cost of customers, we are seeing some incremental costs, which are relatively small because we're using existing channels and mostly existing channels of sale. W ith respect to the administrative load as a result of these higher sales, our scalability should increase once we implement these new systems. So long-term I'm not looking for a significant increase in cost s, and it's more than well covered by the incremental margin -- the net-net is a positive.
Okay, so the G&A -- net-net -- everything -- with the in itiatives that you' re taking place and this focus on smaller customers, should we expect that to go down in 2006?
With respect to G&A, you should see an increase in productivity. That will mean a combination of realigning our G&A, a combination of increasing our scalability and just being more effective in how we go to market.
Okay, so the to tal G&A number would -- producti vity-wise, it would im prove, but from a total number, would it probably go up?
My expectation is that it's likely to go down.
Erica Piserchia - Merrill Lynch
Just wondering if you could give us an update on when you'll file in Missouri in 2006. I think you had spoken to filing in early '06. Any way we could get any additional color on that?
This is Bill Downey, Erica. Our antic ipation is that we will f ile in February of 2006 and expect a decision for January of 2007. We would file not only in Missouri but also in Kansas at the same time.
Okay, and then second questi on, just kind of following up on what Paul was asking regarding the G&A im provements and some of the im provements in the cost structure that Mike spoke to in the beginning of the call. Is that expected -- the savings expected to drop to the bottom line next year? Is there any possibility that we would see some significant benefit to earnings next year from savings associated with some of those initiatives?
I think there are savings that will go to the bottom line. I'm not sure that I would call them largely significant, but I think it will help us in our goals next y ear. Next year, as you know, is going to be a challenging year for us, b ecause th e first half we' ll still see high gas prices, high wholesale prices, and next year will also be our final year before we get our rate increase in 2007 on the utility side. So it's very important that we do everything we can to realize these kinds of savings to keep the year being a solid year.
Eric Beaumont - Wachovia Capital
A quick question -- following up again on something Paul touched on. I understand taxes are -- even with that, your tax rate looks lower than it has been historically, and I'm just wondering if you can comment on what you expect for a tax rate, going forward, this year and next year?
This is Terry again. For next year, no reason to believe it shouldn' t be more normalized in the 38 to 39%. Anothe r couple of things th at affected it are not on ly the sing le adjustment we discussed, but we also had a release of a reserve related to some tax reserves that had a connection to or potential for capital treatment. Recall that we've been selling SO2 credits, which provided some capital gains, so we were comf ortable that if our treatment of a particular reserve was capital, it would be offs et, and so we released that as well. So there are a couple of things that affected it, but, going forward, again, we'll be looking for opportunities, but I couldn't give you any specifics right now fo r next year that would change a normalized tax rate for next year.
Okay, so even with that, you think there's enough opportunity? I guess I'm just trying to distinguish, as Paul was, the core earnings versus what you'd previous had is ongoing under GAAP earnings.
Eric, the only difference between the core earnings and the ongoing earnings is just the removal of mark-to-market. Otherwise, the two measures are the same.
Okay, so then it really -- even though something like a reversal could be thought of as one time, although you've done it for two years now where you could find reversal. You feel comfortable with that. It's kind of been a repetitive earnings load?
Yeah, obviously, what we're trying to do is provide a measure that's transparent and repeatable, and so we want to protect against considering t oo many things one-tim e. If it's truly one-time, we'd certainly do that. We want to explain the pieces of it as well. But, go ing forward, the purpose of our core earnings descrip tion is, we were giving guidance without mark- to-market but yet calling it ongoing, so it's effectively the same measure we've used, but we think a little more clear and consistent with our guidance, and then, again, there are moving pieces that will go up and down different periods, obviously, and within core earnings, what we've described is very accurate.
Okay, one last question -- could you just give us a little color on the index- based products such as the true floating product that market on a m onthly or daily basis -- how that pricing works?
The index-based products are tw o-fold. One is our m onth-to-month products, which has increased in size during the quarter as a result of custom ers really deferring decisions. We fully expect those to convert to longer-term, fixed-price sales. The ne west suite of products that we've introduced, which we call "por tfolio suite," which are different by customer class and by region that we operate in -- those are consultative sales, which are relatively low-risk for us in that the customer takes on most of the risk and that we help work with them so that we can lock in power at prices that m eet their budgets, and therefore, from a risk standpoint, and risk is transferred from us to the custom er, and they ar e able to buy according to when they feel most comfortable with the prices. We are, of course, holding their hand throughout this process. So that's what we m ean by index portfolio type product. They have the ability to either float or to partially float at any time they wish.
Greg Orrill - Lehman Brothers
Could you address the timing of coming equity issuance?
This is Terry. We don't have a set tim ing, obviously. We've talked about the possibility of an equity issuance next year. We continue to mon itor that and watch that from a timing and a size perspective. We'll be looking at the rate case process, and be giving you a little more specificity, if you will, as we head into next year. So that's kind of -- we still have the plan on the table. Not a lot has changed yet, but that's about as specific I could be today, I think.
Philson Yim - Morgan Stanley
I think you had previously talk ed about 15% volume growth at Strategic, kind of as a long-term target. Does that change at all given the new focus on the smaller customers?
Philson, that's a question that we are planning to address as we get to ou r planning process for the end of the year. What we are seeing, however, is year-over-year, we are seeing an increase in volum es, 2005 compared to 2004, and we do expect that trend to continue, moving into ' 06 and ' 07. Whether it's 15% or 20% or 10%, we can't get a good handle on that right now.
Amit Sanghrajka - Banc of America Securitie s
My question is -- your ability to partially to cover the SECA charge now, is that one of the factors of today's guidance at Strategic Energy?
I would say it' s one of the factors. Again, as Todd mentioned earlier, we're starting the process, and it' s not all impacting th e particular quarter or year, but it's one of the several factors that we're looking at as well as improved operations that we've talked about in Shahid's initial comments.
Let me just add to what Terry said -- yes, we are asking a little bit of recovery in the SECA charge. We're also seeing productivity gains as we manage our costs more effectively. We're being quite aggressive abou t those, and in addition to that , we ar e seeing some of these smaller high-margin customers fall into our four th quarter period. So the combination of those things is proving to be a better turn of events for us than we anticipated a quarter ago.
Okay, and Shahid, what percent of the charge do you expect to recover?
I just mentioned earlier on that we expect somewhere between a third to a half of the total charge for this period of time. Now, it may not come all in 2006. We'd love to see it as soon as possible, but we have a long process to get through to recover over that.
Ashar Kahn – SAC Capital
I was just trying -- can you tell us, as we try to forecast the business, what kind of ROE the regulated bus iness will end up based on the forecas ted ' 05 results? Or if you could give us th e rate base the other way -- what the rate base would be at the end of the year, whichever is -- I don't know if you have any of the data.
Mike Chesser We can get you the rate base information -- projected rate base. I'm not sure we have that right here, but the ROE is obviously going to be a product of the discussions in the case. We do feel like we have a strong case for a good ROE. As you know, interest rates are beginning to go up. Some commission rulings -- recent comm ission rulings , support a pretty favorable ROE, and we're going to be doing ev erything we can to put on the best possible argument. But I think it would be wrong at this point to forecast that.
This is Bill Downey. I would also suggest if you look back at the stip ulation and what we agreed to, this is a long-term agreement with a number of factors that will be brought to the attention, particularly around credit quality of th e company. So I think there is significant discussion that will be based on that and the fact that we have a major building program going on in the state that is unique.
As you know, in the stipulation we do have assurances that they' ll provide sufficient cash flow that we'll be able to maintain our credit quality, and I think that's also going to be an important element of the case.
Okay, but, Mike, what ROE are you currently earning, based on your guidance for the regulator for '05?
Well, technically, from an ROE perspective, of course, we don' t have a regulatorily approved ROE. We haven't been in a rate cas e for many, many years. I think the returns based on our guidance that we've given are going to be similar to returns last year. But in terms of an approved ROE from the regulator, we really don' t have one at this point -- the process that Bill and Mike were talking about starting to for next year.
Let me just indicate -- in that ROE, there are a num ber of one-time benefits, including the tax benefits we were talking about, so from a regulator's eyes, that ROE would be lower than the actual accounting ROE.
But Mike and Bill, Westar decision is expected in December. They ha ve the same wholesale. Can we use the Westar decision in December and, of course, yours is going to be a year later, so I understand the interest rates could be totally different at th at period of time, but can we use the Westar decision as a guide to you r decision in Kansas? Or are they going to look at you in a totally different light than, say, Westar?
I don't think you can use their decision as an indicator for ours. They don't have a stipulation, they don't have a building program like we have. There's more risk inherent, in some ways, in our building program. So I think we're in different places at this point in tim e, and I would suggest you use the past -- our past su ccess in dealing with the Kansas and Missouri commissions as an indication of the fact that we'll be treated fairly in the future.
Okay, and then if I could end up with -- Shahid, could you break -- is there a breakdown in the quarter versus how much of the volum e that you did in the quarter was based on the old contracts, you know, a y ear or two years old versus new contracts? Is there a breakup between old contracts and new contracts in megawatt hours in the third quarter?
When you say old contracts, what do you mean "old?"
I mean the California, the higher-pr iced contracts that roll off -- I guess they roll off by next year, am I correct?
That's correct. You know, I don't have -- we can probably get you that information, but I don't have that to hand. What I can tell you, though, is that with respect to the segments that we're serving, and margins vary by those different segments, we are seeing 30% of our business right now that we are contracting fo r for the future is new business, and about 70% is current customers. So our new custom ers that we're bringing on board will have an im pact in the future.
John Hanson - Imperium
I'm still just a bit confused on a tax item here. I've heard a couple of different numbers. I just want to make sure I'm straight. The tax adjustment, I heard a $17.9 million number up front in your monologue?
And what does that represent?
That's lower than last year. It's a comparison of year-over-year numbers.
kay, but the adjustment --
I'm sorry, we ha d an adjustment last year go the other way as well of about -- I think it was about $4 m illion. I can get th at number, that final number for you, but -- so we had the adjustments I talked about for this year, and last year was s lightly less. Over all, year-over- year, the difference was $17.9.
Okay, so the actual adjustment that you made in quarter 3, though, was how much?
$11.7 was the one related to the adjustment to deferred taxes because of the composite tax rate, and then we also had lower taxable income.
Could you talk a little bit about what that adjustment for the deferred tax rate is? How does that come about?
Sure. If you recall, we had a similar sized adjustment last year, an d what ha d happened is we had an allocation methodology that Missouri state law provided for, and there were various ways of choosing your allo cation methodology. The S upreme Court ruled, I believe, it was last year, maybe late the year before, that allocation methodology could be changed, and you were allowed to alter your choice. In other words, by prior rule, if you made an allocation choice, you had to stick with it. Th e Suprem e Court allowed companies to make changes to that allocation methodology.
We did that last year an d received a benefit as a result. We also had several things happen this year that affected that same type allocation. Ou r receivables program that we put in place, and the receivables factoring reduced the revenue or numbers for the ut ility, and so we were able to again allocate under a more favorable factor. We had made those adjustments in our filings and our tax filings, but we had not been through the audit process yet, and what happened in the third quarter as we finalized our audit work with the state taxing authority, and we're comfortable now that those adjustments are appropriate.
Do those adjustments apply to prior tax years then?
The one last year did. The one for this quarter is more cu rrent. The effect, though, was to change deferred taxes, which is obviously a cumulative effect over a period.
Okay, so there is a catch-up am ount as part of this, and that's mostly $11.7 is in this quarter?
Correct, as it affected the deferred taxes, that's right.
Okay, and just to clarify, I think I got this right, but that is not adjusted out for your core earnings, and so that is included in core earnings for the quarter and for your guidance?
That number, and you've made statements about the sustainability of that, again, longer-term is what -- now in terms of repeatability or not?
Well, again, recall that we had the same type of adjustment about the same size last year, so we did have it last year, do have it this year. Certainly, going forward, I can't tell you that we will have a sim ilar adjustment again that would have that im pact related to these particular taxes. We do have othe r tax work and other work we do that we believe we'll be able to accomplish some of this. But to tell you that we have this kind of adjustment of this magnitude happening again next year, no, I couldn't tell you that. Again, fr om a core earnings perspective, we want to be consistent and transparent abou t what's included and not, but we don' t want to exclude things that aren't clearly one-time. Does that make sense?
I think I'm straight now, thanks.
Jeff Coviello - Dusquesne
I just had a quick question -- one of the things you mentioned on the call was that there was potentially pent-up demand for fixed price contracts and --
Jeff, I'm having a hard time hearing you. Could you speak up a little bit?
Yeah, I had you guys on a headse t. I guess one of the things you mentioned earlier on the call was the potential for some pent-up demand on the strategic side for fixed price contracts, given how high gas prices have been and the fact that people haven' t been buying them. I was wondering, given your di scussions with customers and your own view, if there is a way to think about what sort of dip might make people comfortable w ith signing fixed price contracts, whether that -- if you could give an ab solute number, I'd be very interested, but if you can't, if there's a way to think about it, if you c ould maybe give us some insight into where you think your customers might start to uptick their fixed-price contract signing.
Well, I think we had a very good indication in th e May-June tim eframe of this year. I think prices came down by a couple of bucks , our gas prices, and we had a pretty healthy signing rate during those two m onths, and, of course, they went back up to the teens again. So if the share fo recasts and other forecasts are right, that we're looking at $6 to $8 gas towards the middle of next year, we think it' s reasonable to expect that we could have a similar kind of signing success. Shahid, do you have anything to add to that.
You know, it' s a very hard question to answer, and I wish I had that answer. It would help me in my planning pro cess. But we clearly be lieve th at th e market will fall. We believe that customers will sign up. We've looked at three scenarios of low price, gas and power environment, and mid-price and a high price. We are planning for every single contingency, just so you know. We're developing products, and we're developing segments so that we can attack each of those three, regardless of the price.
My expectation, though, is that you would see, if prices get to the mid case or base case, you'd expect to see a pretty he althy surge in sales for not just for Strategic but also for the industry. In addition to that, you'd also see contract terms becoming longer as well. The combination of those two hold out great optimism for us.
It sounds like you thi nk if there's a -- roughly speaking -- if it's a fall below the double-digit numbers, then customers might get more comfortable with signing longer-term contracts.
We think they would, and the other point that I hope you heard in Shahid's comments is that he and his management team ha ve prepared for that. They have the market segmentation, the supply management, the processi ng systems in place, so I think they're well prepared to capitalize on it.
Okay, well thank you all very much. Just to reiterate, we believe that, with the regulatory plan that is moving ahead on schedule, and with the Strategic Energy business strategy in place, we think we are well positioned to create long-term shareholder value. We very much look forward to talking more in detail w ith you at the upcoming conference in Florida and have a great day.