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Hawaiian Electric Industries Inc. (NYSE:HE)

Q4 2007 Earnings Call

February 22, 2008 1:00 pm ET

Executives

Suzy Hollinger - Manager of Treasury and IR

Connie Lau - President and CEO of HEI

Mike May - President and CEO of HECO

Tim Schools - President ASB

Curtis Harada - Acting Financial VP and CFO of HEI

Eric Yeaman - COO of Utilities

Tayne Sekimura - CFO

Alvin Sakamoto - CFO of Bank

Analysts

Paul Patterson - Glenrock Associates

Dave Parker - Robert W. Baird

Neil Stein - Levin Capital

James Bellessa - D. A. Davidson & Company

Operator

Good day ladies and gentlemen and welcome to the fourth quarter 2007 Hawaiian Electric Industries Incorporated Earnings Call. My name is Merlyn and I will be your coordinator for today. (Operator Instructions)

I would now like to turn the presentation over to your host for today's call, Ms. Suzy Hollinger, Manager of Treasury and Investor Relations for Hawaiian Electric Industries Incorporated.

Suzy Hollinger

Hello and good afternoon. Thank you for joining us for an update on HEI. Here with me from senior Management and speaking today are Connie Lau, HEI President and CEO, Mike May, HECO President and CEO, and Tim Schools, ASB's President. Also on the call today are Curtis Harada, HEI's Acting Financial Vice President of Treasurer and CFO, the Utilities COO, Eric Yeaman and CFO, Tayne Sekimura, and the Banks CFO Alvin Sakamoto.

Connie will start today's presentation with a few comments on 2007 earnings and the Hawaii economy. Mike will follow with an update on the utility, Tim will then discuss the Bank and Connie will make some closing remarks. At the end of the presentation we'll open it up for your questions.

Before I hand the call over to Connie, I would like to alert you that forward-looking statements will be made on today's call. Please reference page two of our annual report that was filed on 8-K this morning for additional information about forward-looking statements.

Now let me turn the call over to Connie to begin the formal comments.

Connie Lau

Thanks, Suzy. Aloha and good afternoon. One of the key issues for HEI has been to obtain recovery of costs incurred at our utilities, and earn a reasonable return on our investments and rate base.

Beginning in mid-2006, we filed three rate cases for each of our utilities and began receiving $108 million in additional annual revenues from interim decision in these three cases in 2007. [Audio Difficulty]

Because much of this rate relief was received late in the year, 2007 net income was $85 million, down 22% compared with 2006. Bank net income was down 5% year-over-year, but the decline in bank net income was almost entirely offset by 10% lower holding company losses.

The financial details of the quarter were included in last night's earning release and on 2007 annual report that was filed on 8-K this morning. I assume that most of you had a chance to read through the release, so I won't go through it, but would be happy to answer any questions you have at end of the formal presentation.

Let me now briefly update you on the Hawaii economy. This slide shows a snapshot of Hawaii's economy over the last five years, as you can see, Hawaii experienced robust growth over the 2004 to 2005 period with growth moderating to a more sustainable pace of around 3%.2006 to 2007 period. Growth in 2007 reflected continued job growth, low unemployment, strength in commercial and military construction and stable home prices.

The visitor industry saw modest decline in arrivals, but length of stays remained flat with 2006. Visitor expenditures were $12.2 billion, slightly higher than they were in 2006. Over the next three years date economist expect growth to slow to about 2.5%.

Centering Hawaii's growth rate projections are the effects of a weakening US economy and persistent high fuel prices and their possible effect on tourism and consumer spending. While sub-prime loans were originated in Hawaii over the course of the last several years, the impacts of the sub-prime mortgage crisis have not had a significant impact in Hawaii as on the mainland. The foreclosure rate in Hawaii remains one of the lowest amongst all states. Although transaction levels have fallen off, overall prices have remained relatively stable, especially on Oahu.

Several factors have contributed to the relatively strong performance of the housing markets, including the stable economy, strong job market and lack of excessive over buildings in prior year. In summary, Hawaii's economic growth rate is expected to moderate to about 2.5% in 2008 after several years of solid growth. Risk includes a national economic recession and the timing and severity of its impact on Hawaii economy and continued volatility in the national market and its effect on the interest rate.

Now, I would like to ask Mike, to update you on the utility.

Mike May

Thanks, Connie and good afternoon. As Connie mentioned, a key objective for the utilities in 2007 was to obtain recovery of costs and a return on investments we are making in the electrical system. Let me begin my discussions with that topic.

In 2007, as summarized on this slide, we received interim rate relief for all three of our utilities. Most recently, in December, we received an interim rate increase for our Maui County utility. I will discuss that decision in greater detail in a moment.

In total, we recorded $32 million of additional revenues, due to rate relief in 2007. Because the HECO and MECO decisions came later in the year, we expect to see incremental revenues of $76 million in 2008. These three rate cases will help our utilities to recover higher levels of O&M costs and a significant amount of capital projects completed in the last several years.

As I said earlier, in December we received a $13.2 million or 3.7% interim increase for our Maui County utility. We began recording the additional revenue in late December. The interim decision reflects the terms of a settlement we reached with the Hawaii Consumer Advocate. Like the HELCO and HECO rate case decisions, the MECO decision also included a tracking mechanism for pension and post retirement benefits. All three companies are also continuing to pursue a tiered rate structure to encourage residential conservation of energy.

The rate relief we received in 2007 was partially offset by two one-time charges. In April we recorded a write-off of $12 million or $6.9 million net of taxes where cost were related to the Keahole plant addition.

In the third quarter, we accrued reserves for a refund to Oahu ratepayers, due to the proposed final D&O for the HECO 2005 test year rate case. This totaled $16 million, including interest or $9 million net of taxes. Although this charges had a significant impact on our 2007 results, they also resulted in needed closure for these items.

Looking ahead, we expect sales to remain relatively flat. Our customers are conserving and are using energy more efficiently and we've been encouraging them to do so.

The new commercial construction is substantially more energy efficient and existing facilities are being made more efficient through retrofits. However despite relatively flat sales growth, overall demand for power remains high, near record levels set a few years ago.

The need to meet this high demand levels continues to put pressure on our aging generating units, especially on Oahu. As a result O&M expenses have increased and the rate relief received will help recover the majority of these costs. In 2008 we do expects some O&M increases due primarily to inflation and our continuing tight generation reserve margins.

We are making capital investments to address the need for additional generation and transmission capacity and to modernize our infrastructure. Over the next five years we are forecasting $1.3 billion in gross capital expenditures for these reliability investments. The majority of our capital expenditures are expected to be financed with internal sources of funds. However, borrowing levels are projected to increase moderately to finance a portion of these projects. We'll continue to focus on the recovery of these increased investments and earning a reasonable return to a rate case process.

And before I wrap up, just a word about another aspect of our overall energy strategy. A critical component focuses on increasing our portfolio of renewable resources. So, noteworthy examples of our efforts include our new combustion turbine, which will be fueled by renewable biofuel. This unit will be 110 mega watts of firm, renewable power on our Oahu system. Also on Oahu we've issued a request for proposals for up to a 100 megawatts of additional renewable energy.

And on Maui we recently signed a Memorandum of Understanding with Oceanlinx of Australia to add a 2.7 megawatt wave energy demonstration project. To sum up 2007 was a year in which we gained significant interim rate relief for all three utilities. This will help recover higher O&M cost and significant investments in our electrical infrastructure, completed in the last several years.

However, inflation and tight generation reserves will continue, putting some pressure on O&M expenses. We are addressing this through the addition of new renewable energy generation and other reliability investments. At the same time, we are encouraging energy efficiency and load management programs to reduce demand, especially during peak times. In the last quarter of 2007, we begin to see the impact of rate relief on our utilities earnings. And we look forward to 2008 in which all three utilities will benefit from a four years worth of rate relief.

Now I'd like to turn things over to Tim to discuss the Bank.

Tim Schools

Thanks Mike. 2007 brought additional challenges to the financial services industry on top of what had already been for many a very difficult preceding two years. Since early 2005 the industry has been fighting off a rising and flattening interest rate environment and the negative effects it has on those net interest margins. After for long period of historically low rates depositors reacted by rotating their money in about the middle of 2006 in to higher interest-bearing accounts such as CDs.

Further those with heavier reliance on interest rate risk for earnings, many of who levered off in excess securities, felt the pinch of a flattening yield curve. The more recent sub-prime mortgage issue has contributed to increasing delinquencies and foreclosures nationally. This created liquidity issues for many institutions throughout the fall and has caused the banking system to tighten its credit standards leading to increasing provision expense.

Unfortunately, several companies took significant charges on top of already compressing earnings, with others having to either terminate business or in a case of countrywide, seek a partner to provide needed stability. While ASB's 2007 earnings declined 5% from the prior year, by all accounts we faired very well on a relative basis. As you will see in the later slide, ASB has not experienced the level of net interest margin compression seen across much of the industry, and credit quality to this point has remained solid.

I would like to spend the next few minutes walking through our fourth quarter performance, highlighting each of our key ratios and then leave you with some of the key initiatives that we are working on.

Net income in the fourth quarter increased to $17.2 million from $11.7 million in the third quarter. The increase was primarily due to the $8.8 million gain on the previously disclosed changes to the bank's defined benefit plan.

Therefore, on an operating basis, our numbers and ratios would be more inline with the third quarter numbers presented in this slide. The numbers and ratios presented in the fourth quarter column, other than the net charge-off ratio are a good indication of what we would like to achieve on a continuous basis.

Two things worth noting for the quarter are the expansion of our net interest margin and asset quality trends. As we mentioned in the previous calls, we have been provisioning in prior periods for a single large commercial relationship. This quarter we actually charged that off, which resulted in a higher than normal net charge-off ratio, and works to lower our NPA ratio.

One of the primary key indicators in banking is the return on assets ratio. This slide shows that we have actually proven to be more consistent overtime, but our earning at lower levels than the average of both the bank and thrift industry. To me, this highlights the opportunity at ASB. If we achieved a 1% ROA, which is still below the historical average of the bank and thrift line shown here. We would earn about $70 million, an increase of $22 million in annualized net income or 45% annually from our current run rate. Alternatively, one might achieve a 1% ROA by shedding lower yielding assets that are not earning a cost-to-capital and returning the equity supporting those assets to investors, which in our case is our parent company, AGI.

We are evaluating plans at this time on how we can migrate ASB toward a 1% ROA. In all likelihood, our strategy would entail a combination of what I just described. The key to improving your ROA is knowing where the opportunity lies and where to spend your time, the forthcoming slides will help to point that out. As footnoted in this slide, 2004 includes a $20 million expense related to a tax settlement.

Net interest income in the fourth quarter increased to $49.1 million from $47.7 million in the third quarter. The increase was due to a 7 basis point increase in the net interest margin and higher levels of earning assets. The 7 basis point improvement in net interest margin was due to higher yields on earnings assets, while funding costs remained flat. We did see some relief from pressure on deposit rates in the fourth quarter, but our overall funding cost remained unchanged. We experienced a net outflow of deposits and made up for it with higher cost in wholesale borrowings.

As you can see from the slide, we have some opportunity to improve our margin toward that of commercial banks, but it is in line with the thrift industry and actually has proven to be more consistent, as I mentioned with our return on asset ratio.

The growth in assets in the fourth quarter was primarily driven by growth in residential loans of $71 million and commercial loans of $18 million, partially offset by lower commercial real estate balances and lower investment balances. One of our financial objectives is to reduce our interest rate risk by reducing our exposure to longer duration, fixed rate residential mortgages and continuing to increase the percentage of higher spread, shorter duration loans, such as business banking, consumer and certain types of commercial loans.

When you study all of our key ratios, efficiency appears to be the primary cause behind our lower ROA. This is the measure of your non-interest expense to total revenues or said differently, how much it cost you to generate a dollar of revenue. If you were to adjust our fourth quarter items that appeared to be one time, our efficiency ratio would be in the 68%, 69% range. This is higher than many of our peers and we will be working to bring this ratio down. You can reduce the efficiency ratio by increasing revenues or reducing expenses.

The tick down in the chart for the current period is primarily the result of the pension plan benefit. The economic conditions make it very challenging in the short term to improve this ratio to increase revenue. Further as we saw our net interest margin is already in line with the thrift industry and Hawaii is not a high growth economy. Therefore, we will take a hard look at reducing our expenses. I will caution that the results from this type of effort take time, but I am optimistic that we can reduce expenses without hurting customer service levels or negatively impacting the safety and soundness.

Overall, credit quality remained good in 2007 as a result of our stable housing prices and our historical focus on prime lending, our residential loan and home equity portfolios experienced low levels of delinquencies. Fortunately, foreclosure levels in general, Hawaii foreclosure levels in general remain one of the lowest in the country. We’ve had no residential net charge-off's, since at least 2002.

In 2007, we had only one home equity net charge-off at about $80,000, prior to this last year we actually had a home equity net charge-off it was 2002. Most of our provisions for loan loses in 2007 were associated with the single commercial credit I mentioned earlier.

I will caution you that our and the industries credit cost have been at historically low levels for the past five to six years. So, we expect to see a normalization of credit cost for both ourselves and the industry, especially as the growth rate of the economy begins to slow.

We continue to feel good about our underwriting and the quality of our portfolio, however, we have begun to see some migration in our commercial watch and criticize categories. This is not unusual activity and is inline with industry trends. We are watching this closely and at this time do not expect any material loses, but it will require an increase in provisioning. Importantly, our NPA's remain at a very low absolute level and compared with the industry.

In closing it is interesting times that we have been able to operate fairly stable, we have a sizeable position in the Hawaii market and we are working on several exciting initiatives that we believe will improve our performance overtime.

First and foremost, we are going to embark on becoming a more efficient organization, with continued margin pressure and industry provision expense increasing it is critical that we make this a priority.

Second we have a number of exciting revenue projects targeted at our single product customers in order to deepen our share of wallet of existing customers.

Third we are focusing our retail and commercial teams on the acquisition of new customers checking for core operating accounts. This is the key to earning the relationship long term.

Now let me turn the presentation back to Connie for closing remarks.

Connie Lau

Thanks Tim. Well 2007 was a difficult year from an earnings perspective, progress was made on many fronts. Rate relief, much of which was received late in 2007, helped partially offset increased operations, maintenance and depreciation expenses and two charges related to the HECO 2005 and HELCO 2006 rate cases.

These interim rate increases helped put the utilities on a more solid financial footing for the future. Our utilities also made progress in getting commission approvals for the critical capital projects that are scheduled to come online in 2009 and 2010. Our bank earnings were down only 5% in 2007, despite a challenging environment for financial institutions. Margin compression continued, although as Tim mentioned some relief was seen in the fourth quarter.

Provisions for loan losses were higher, primarily due to loans to single borrower. And overall credit quality remained good. Non-interest expenses, excluding the pension change, were higher due to legal expenses and cost to strengthen compliance and risk management infrastructure. Non-interest income was higher and along with the gain on pension changes helped bank earnings.

At the holding and other companies gains on sales of non-strategic assets helped dilute earnings, and we know longer hold any significant non strategic investments. In 2007, the Board maintained the dividend and yesterday they declared a quarterly dividend of $0.31 per share, payable on March 11th, to share holders of record on March 3rd, at 5.5% our dividend yield remains attractive.

Overall we report to the better year of financially in 2008 and remain focused on key strategies in each of our core businesses to drive long-term earnings growth and increased shareholder value. While we expect to benefit from a full year of rate relief in 2008, expected increase in O&M and depreciation will offset some of that impact.

Our utilities focus in 2008 is to put additional generation and transmission capacity in place. To earn on this growing rate base, we will need to seek recovery of costs and returns on those investments. In addition we continue to pursue renewable energy and conservation initiatives.

At our bank, we expect that margin compression in loan loss provisions will continue. We will continue execution of the transformation strategy, paying particular attention to those areas with the best potential to drive future profitability and as Tim mentioned managed costs.

This concludes our formal comments and we’ll be happy to answer any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Paul Patterson with Glenrock Associates.

Paul Patterson - Glenrock Associates

Good morning, guys.

Connie Lau

Hi Paul.

Paul Patterson - Glenrock Associates

I wanted to touch base with you on a couple of things. First of all, on the utility, it sounded like you guys mentioned $76 million of additional revenue benefit in 2008, does that include the absence of the refund in Oahu or is that just from the annualization of the rate case?

Mike May

The rate case refund was reserved in 2007.

Paul Patterson - Glenrock Associates

Right, so in other words would that be an additional amount of money that we expect in -- would that be part of the $76 million increase that you are talking now?

Mike May

No. The amount just reflects what we got in our interim decisions, Paul.

Paul Patterson - Glenrock Associates

Okay. So the $60 million and the other guess $12 million would be in addition to that, year-over-year I would expect, right? Because those were one-timers.

Mike May

Yes. And the amounts you are talking about are revenue numbers.

Paul Patterson - Glenrock Associates

Right in pretax. Okay. And then, the other question I have is on the O&M. It sounds like there was a $6.8 million timing issue in the fourth quarter. For the year, is there any timing issue or anything else that we should expect a relatively O&M inflation everything else you mentioned, but is there anything else that we should think about in terms of impacting O&M any more color you can give on that?

Mike May

Well, there is always unknown, Paul, like the 2006 earthquake it's hard for us to predict acts of God, we had a couple of storms last year that one in December, one earlier in the year, those things are always difficult to predict, but do have an impact on our O&M. So other than what we would characterize as inflation, we are seeing a run up in commodity cost. I think as you listen to other calls, you are probably hearing the same comments. But one of the things that we’re pleased to say is that, we believe that the interim decisions that we received is in large part recovering or covering a lot of our O&M expense.

Paul Patterson - Glenrock Associates

Excellent. Now, let me ask you about what we gained as a holding company. It wasn’t cleared to be exactly from reading the press release, how much in terms of -- there were some sales, I guess non core stuff and there was also some investment gains, how much would you say, there was at the holding company and how much should we expecting going forward. I mean how much of that would be usual, versus unusual?

Unidentified Company Representative

For the year, we had a $2.2 million gain from the sale of non-strategic assets versus last year. But last year we made some adjustment to either write down or write up assets, but essentially now all those assets have been sold or we really have no more material investments in any non strategic assets.

Paul Patterson - Glenrock Associates

Okay. So, there was a $2.2 million sale that probably wont be recurring and there were also some investment gains that were mentioned as well in 2008, is there any number associated with or…

Tim Schools

All are included in the $2.2 million.

Paul Patterson - Glenrock Associates

That’s all in the $2.2 million. Okay, great. And then with respect to the bank, just in terms of the loan loss provisions. You mentioned the single borrower, which seems a little unusual and then you also sort of mentioned that just in general, we should expect higher loan loss provisions. Can you give us any flavor as to what we should be thinking about going forward with respect to that line item?

Tim Schools

That’s a tough one to answer because we don’t offer guidance, But one way I would think about it is, if you just look at, and this is going back a while, but if you go, the chart I showed you, net charge-offs have been very low over the last five or six years. If you look prior to that period, I think ASB probably ran $2 million to $5 million a year in provision expense.

Paul Patterson - Glenrock Associates

And you now run $5 million, right?

Tim Schools

What's that?

Paul Patterson - Glenrock Associates

This 2007 was over $5 million, if I am correct. Correct, $5.7 million?

Tim Schools

That provisioning was largely related to that one commercial customer.

Paul Patterson - Glenrock Associates

Right. And now you have more loans than you had before that abnormally low level loan losses that you had for the last couple of years, right?

Tim Schools

I don’t know that more loans really. I don’t know again being sort of new going back 10 years, I'm not sure what the size of the bank was. But I don’t think the bank is substantially larger from a loan portfolio. What's interesting is, the mix of loans is different. So if you look today at the portfolio versus eight to 10 years ago, there is a much larger commercial portfolio. So even if you benchmark next year provision expense, to say, 2001 or 2000, it is a little bit different risk profile. Its not high risk but, if you did a probability of default on a commercial loan and a probability of default on a residential first mortgage, it would be higher, statistically. So, I know that’s not the exact answer you wanted but.

Paul Patterson - Glenrock Associates

Okay. We will take what we can get. Let me ask you this. With the non-interest expense and with this $1.1 million and $8.8 million of fine benefits, you are mentioning getting those costs down and it would seem to me that that might be a little bit challenging with what seems to be non recurring benefits to those to that line item? I guess just in the general thought here, Tim, on this getting to 1% ROA. What kind of timeframe were you thinking about that actually occurring? And if you could just give us a little more flavor in terms of what kind of cost reductions on this non-interest expense item which has been rising. I mean, I know it's not as legal and just what should we be thinking about that?

Tim Schools

Well, first of all let me just say to you and the folks on the phone it's in its infancy and it's something that we've been talking about for may be the last two to three months. And so, we don't have our action plans and timetables and milestones in place. So, anything, I mention to you it's very much in its infancy and I'll share my thoughts on the topic.

My thoughts are if you look at our efficiency ratio or another ratio that banks tend to look at that takes out the impact of revenue is non interest expense as a percent of assets. And if you look at either of those ratios, we're above the median in the industry. And so this should be an opportunity to reduce expenses.

Now you can either go and just cut everybody's budget 10% which really isn't a prudent way to manage the company or you can take the time to search for where are you inefficient and do some benchmarking that's going to make it take longer. So, I mean, my personnel ambition is if we cannot make material progress towards this goal over sort of a 24 month period, I personally I'm going to be disappointed.

As you saw in the slide, an average thrift probably runs over extended period, maybe 110 ROA and an average bank maybe 120 to 130 and we're trying to migrate some of thrift to a bank. So, certainly we should aspire to be at the average line. We should aspire to at least be at that 110.

Paul Patterson - Glenrock Associates

Okay, thank you.

Operator

And your next question comes from the line of Dave Parker with Robert W. Baird.

Dave Parker - Robert W. Baird

Hi, good morning. Maybe just two follow-on on your thought there Tim. My recollection was there was a fair amount of investment at ASB into systems and etcetera is that also an opportunity here as those costs sort of dial back here for you to be able to hit the numbers you're looking for in the next year or two.

Tim Schools

I think there is opportunity across the board. And again we're just starting our benchmarking. There is a company out of Arizona called Cornerstone and there is lots of benchmarking you can get, but they are one that sort of well known. They had a population of about 60 banks and they probably have 200 variables that they benchmark every two years.

Stuff like how many auditors do you have per FTE? How many auditors do you have per assets? I mean everything. I mean how many online banking customers do you have per checking account? And we need to participate in that type survey and then just go across our company and I think we're going to find opportunities on contract renegotiation.

I think we're going to find opportunities on data processing expense. I think we're going find some opportunities in FTE and it's just going to be across the Board. On that I don't think I answered the prior gentlemen's question on size. One way I think about it is if you sort of try and commonsize the non-interest expense to total assets or an efficiency ratio simply by looking at expenses about a $20 million reduction in pretax expenses would equate to about a 60% efficiency ratio roughly.

It also equates to sort of our 2006 run rate, which was just two years ago. So, that doesn't seem irrational. If we were their just two years ago we've not added a lot of brands. We've not added really any brands as what sort of net branch neutral if not a few closures, same sized company seems like we could get back to the run rate from two years ago.

Dave Parker - Robert W. Baird

Great and thanks. I appreciate your Southern Hawaii accent and how that brings good diversity of this call Tim.

Tim Schools

Well, I was telling them the other day like Ricky Bobby in Talladega nights, if you ain't in first you are last.

Dave Parker - Robert W. Baird

Exactly. One question we switch to the utility, there has been some approvals for some more infrastructure spend and what's just -- are the strategies to get recovery of those costs during the next couple of years?

Mike May

Well, the answer, I guess in a plain and simple Dave is that you first talk about our capital expenditure plan and one might reasonably assume that as you're spending at the levels that we anticipate $1.3 billion one might reasonably expect that we'd be filing rate cases to seek timely recovery of those investments.

Dave Parker - Robert W. Baird

Okay, I'd assume that there will be several more rate cases here in the next -- little short while I assume then?

Mike May

One might assume that.

Dave Parker - Robert W. Baird

Okay. One last question I think I saw a headline about a potential and this is probably for you Mike is that by a potential Hawaii biodiesel provider looked at if they backed off on their plans to build a facility on the islands. Any comment as far as source for biodiesel for the future or does that change your outlook and your plans?

Mike May

Just for all the callers the supplier in question is Imperium. Imperium has a 100 million gallon facility that they have in Washington. They have committed to us that if they lag on their facility development here that they will be supplying our biodiesel from their Washington facility. So, we did not see anything based on their commitment that would lead to inability to reach supply. The fuel contract is still under reviewed by the PUC as well.

Dave Parker - Robert W. Baird

Okay, great. Congratulations on a good quarter.

Suzy Hollinger

Thanks Dave.

Mike May

Thank you.

Operator

And your next question comes from the line of Neil Stein with Levin Capital.

Neil Stein - Levin Capital

Yeah, hi. I had a couple of questions if I could. First for '08, could you quantify or provide any guidance on what these O&M pressures might look like? And also what the depreciation kind of bump up in '08 might look like?

Tim Schools

We don't give guidance. As I said in my earlier comments, we'd expect that a fair amount of what we're spending on O&M we're getting some relief through our recent interim rate decisions through the PUC.

Aside from that, we're still expecting some normal inflation. We're seeing skyrocketing commodity prices and component prices on some of our systems. We'd expect that to creep into our O&M and we expect maintenance to continue. But again, we believe a lot of that has been taken into account in our recent interim rate decisions.

Dave Parker - Robert W. Baird

It looks like in the fourth quarter operations expense was up about $10 million year-over-year is that a good run rate?

Tim Schools

Well there were events that contributed to that. For example, things that don't hit the newspapers probably on a national basis and certainly give us havoc as we had a fluke storm in the early part of the quarter -- early part of December that reeked havoc on our system. We had hurricane gust winds that just appeared overnight and took out a fair number or fair parts of our distribution and sub transmission system. Those things you never can anticipate creeping into your costs. That was something that was just one example of the cost creep in our system.

Connie Lau

And to answer one more question related to depreciation expense. Based on the items that went into service, looking forward we can expect about $5 million to $6 million increase in depreciation expense.

Dave Parker - Robert W. Baird

Per year or for 2008?

Connie Lau

2008 and probably -- yeah for 2008.

Dave Parker - Robert W. Baird

Okay. And then regarding the maintenance expense that was $7 million lower year-over-year because of the timing. What was that by commenting that it was lower due to timing does that mean it's going to occur next quarter or was it delayed or something?

Tim Schools

Well, if you look at it quarter-to-quarter, year-over-year and keep in mind in '06, we had two back to back earthquakes in the fourth quarter of '06 that again goes to the storm and unusual events. Those factors figured into our fourth quarter of '06, which wasn't quite as dramatic as in our fourth quarter of '07.

Dave Parker - Robert W. Baird

That was more timing related to what happened last year as opposed to anything happening this year?

Tim Schools

Yes.

Dave Parker - Robert W. Baird

I suppose, okay. And then the $76 million of extra revenue, what's the tax rate we should be applying to that?

Connie Lau

When you take a look at the $76, that's incremental revenues that the rate cases deliver. It adds to the bottom mind of about $42 million.

Dave Parker - Robert W. Baird

42 million, okay.

Connie Lau

Yes. Net of tax.

Tim Schools

Before increases in O&M and depreciation.

Dave Parker - Robert W. Baird

Sure. We looked at your income statement for the utility; it looks like revenue net of fuel up was like $35 million year-over-year, which took me as kind of high relative to the rate increases you got. Is there anything else that goes into that gross margin?

Tim Schools

DSM

Connie Lau

DSM

Mike May

DSM is the Demand Side Management program is one factor.

Dave Parker - Robert W. Baird

But those incentives where $2 million?

Connie Lau

Yeah.

Mike May

That was net of taxes.

Dave Parker - Robert W. Baird

Net of tax, okay.

Mike May

Or gross.

Tim Schools

Neil the revenue piece for the interim decisions in '07 was about $32 million.

Dave Parker - Robert W. Baird

Okay.

Tim Schools

That's pretty close.

Mike May

And on top of that the DSM of 4 million.

Dave Parker - Robert W. Baird

Okay. With those DSM incentives, is that saying that you will get on a regular basis, should we see some of that show up every quarter Mike?

Mike May

No. No, the state passed a law that will be effective 1/1/09 changed the DSM program to a third-party administrator. We'll be able to participate in the DSM program. But we'll not have single point accountability for the DSM program.

Dave Parker - Robert W. Baird

And then, as I look -- going back to that $32 million that benefited you this quarter from rate increases? Because I guess there was a $17 million interim rate increase ordered October 22 and April there was one for $24 million and then you had the smaller one in December. It seems like that's a large chunk of those?

Mike May

Actually, Neil, the number I gave you was an annual number. Not for the quarter.

Dave Parker - Robert W. Baird

Okay that's fine. Then, I'll move on to something else. Going back to your 1% ROA goal and you said -- you made the comment if over a 24 month period if that goes by and you haven't made a progress then you would be disappointed? Does that mean you hope to hit that 1% ROA in two years? Or you kind of hop to have a program to figure out how to do it in two years?

Tim Schools

Well, I think both. I mean we're not just going to try. So, we're going to -- that's my personal target and again like I said, it's in its infancy. So, we're going to gather a team and develop initiatives and it's not going to all be on the costs side. I don't what to mislead you. There are some great neat things we can do on the revenue side.

One of the interesting things in comparing Hawaii banks and I've studied Bank of Hawaii and I've studied First Hawaiian and CPB and us, very, very different model. Our biggest engine for a bank is the balance sheet, right? And so the two key numbers -- the biggest number is your net interest margin percentage and Bank of Hawaii and First Hawaiian have healthy margins. Their margins are about 4%, ours is 3%.

But when you look at how Hawaii banks get there versus mainland banks, our earning asset yield on the asset side is about size 50 okay that's very low compared to mainland institutions and it's about 70 basis points lower than Bank of Hawaii. So, we've an opportunity to get an improved asset mix, which would drive revenue.

Bank of Hawaii is about 620 earning asset yield last I saw and studied their number this quarter. Mainland banks probably their earning asset yield would be 750. However, when you look at the value of the deposits in Hawaii, I was really blown away when I came to Hawaii, whether you look at us Bank of Hawaii or First Hawaiian our cost of funding, we've a $7 billion bank and we're funding it at about 2.6%, that's pretty cheap.

If you look at mainland institutions or what I'm used to the cost of funds would be $4 to $450. So, we've a real funding advantage in Hawaii the challenge is how, can we look for that asset mix, which helps drive revenue. So, we're going to do some exciting things on their sides.

Dave Parker - Robert W. Baird

And in the absence of getting there you said, you implied you'd liquidate a portion of the business and bring it up to the parent?

Tim Schools

No. There is just two ways to improve -- in getting 1% ROA think about this. I mean, if you have I've seen this at a lot of banks. If you have some lower yielding assets that aren't really earning a cost of equity one thing I analyzed is what if we shrunk the assets. How much net income would you really give up and as a tradeoff how much equity could you free up and then I could dividend to the parent. And so you just have to play with the numbers, there's levers all around.

Connie Lau

Neal, I think one of the things that we have opportunities that we have on a consolidated basis is as Tim was describing on the bank side we have investment portfolio that's really funded by a lot of wholesale borrowing. So, there is an opportunity to perhaps reduce asset side and dividend that capital to the holding company at a time, when our utilities actually need the capital to invest in rate base. So, there is some need opportunity that world is exploring here.

Mike May

The last company I was had a similar situation in balance sheet and I've worked a lot with capital research, that bank equity analyst or investor there and it was big proponent of -- you shouldn't pay a price to book premium of PE premium or excess securities that are funded by wholesale. There is no real customer supporting those earnings. So, he was a very big proponent, he was one of our top ten shareholders was showing the institution I was that, you're not going to give up that much income and you are a going to be able to dividend, a lot of equity to the investor. At that time he would have been one of the investors or investor at HEI.

Dave Parker - Robert W. Baird

Okay. Thank you very much.

Mike May

Sure.

Operator

And your next question comes from the line of James Bellessa with D. A. Davidson & Company

James Bellessa - D. A. Davidson & Company

Good morning.

Mike May

Good morning, James.

Connie Lau

Good morning, James.

James Bellessa - D. A. Davidson & Company

First of all about the O&M expenses there were number of questions, but I am going to ask it from a different direction. The year ago maintenance expense was explained partially by the earthquakes, is that right?

Tim Schools

That is partial affect, that's correct.

James Bellessa - D. A. Davidson & Company

So let's just remove that, but for the first three quarters maintenance expense per quarter has been averaging $28.6 million and all the sudden, it drops to be low $20 million in the fourth quarter. So, I'm too trying to understand, is that new level that we can expect in the future or will it be going back to this $28 million level?

Mike May

No, I think Jim, one of the factors again that I have mentioned, it seems like, we seem to have been blessed with two really bizarre fourth quarter events. The earthquake last year, which led to a lot of an investigative work and reporting work, which showed up in O&M. When we had the fluke storms that occurred the early - the wind storms, the hurricane like storms have occurred of the 2nd and 3rd of December those diverted a lot of our assets from O&M to capital replacements to restore the system. So, I think you see some of our redeployment of assets, you've got the same amount of money being spent, but you're seeing part of that being diverted to capital.

James Bellessa - D. A. Davidson & Company

Here you just said the fluke storm occurred on December 2nd and 3rd and that's in 2007, right?

Mike May

That correct.

James Bellessa - D. A. Davidson & Company

That means that two thirds of the quarter were up and in fact you get breakout or take away Christmas vacation, you are well into 80% of the quarter have been completed, how can you switch gear so fast between O&M?

Mike May

Well, I think the message I would want to leave you with is that we are not expecting this to be new level, Jim. We expect a running rate one which I said earlier, we are excepting a lot of the costs we have been experienced in O&M to be compensated for in the interim rate release that we've had absent the inflation and the commodity prices that we have talked about.

It seems like Jim, post-Katrina and post-events that have occurred, not unlike the events that have happened here. We've seen a huge run up in commodity prices, everything from copper to transformers to conductors, to poles, all of our component prices have run up substantially.

The only thing we can explain is due to a number of catastrophic events that have been happening around the country.

Connie Lau

Yeah, let me add one more thing to Mike comments. We take a look at the fourth quarter of 2007 versus the fourth quarter 2006, we actually had more overhauls in 2006, and that is emerging due to timing, but if I'd just compare quarter-over-quarter, there were more overhauls in the last year 2006.

Eric Yeaman

Jim, I'd also add maybe from a run rate standpoint, it's probably better to look at it on an annual basis and taking into consideration the comments that Mike made about inflation and other things, because it can be lumpy quarter-to-quarter just depending up on what overhauls we have and the scope of the specific overhauls.

Mike May

Jim, one of the incidents occurs for example particularly here Oahu, we have a large concentration of purchase power. When our purchase power units decide to take overhauls, we delay our overhauls. And so what happens is, there is a -- when they declare that they are going to take -- and just take for example AES and Kalaeloa, they are each of 180 megawatt plants.

When they announce they are going to take an overhaul, we differ our overhaul and we will have to pick that up in another year. So, there is always this timing event that is not a normalized event, its usually triggered by some anomalies like that, that enters into our planning equation. So, that why I wouldn't want you get sort of caught up in a one quarters event and do a linear extrapolation.

James Bellessa - D. A. Davidson & Company

On the depreciation, we heard that perhaps the run rate will be increased by $5 million to $6 million and you reset that in the first quarter every year. Is that right?

Connie Lau

That's correct.

James Bellessa - D. A. Davidson & Company

And then you talk about some conservation by, some of your commercial customers and therefore your kilowatt hour sales are flat to down slightly?

Mike May

That is correct.

James Bellessa - D. A. Davidson & Company

Is there still continuing trend then in that, are you encouraging renewables like a solar power are going on Wal-Mart. And therefore generate down electricity and then they reduce the demand from your grid?

Mike May

Yes, we are seeing a host of things. The programs range from residential, commercial demand side management, Load Management programs. I will just give you one example, a couple of years ago the commission granted us the opportunity to do what we call the Energy Scout Program. Energy Scout is a wireless remote ability to cut off hot water heaters during a peak period of time. In other words, we can go into right now 30,000 homes and remotely cut off their hot water heater, which will create 17 megawatts of peak saving during the peak of period time.

We pay our customers $3 a month to have that ability and that is a hugely successful program. We have been promoting compact fluorescent lighting and offering rebates. We had in the third and fourth quarter last year over a million compact fluorescent bulbs that were sold to our customers to encourage reduction of lighting. We have the most successful solar water heating program in the nation.

We have one out of four of our customers that have solar water heating systems on their homes, which if you look at a typical residential bill, about a third of the residential bill is for solar water heating, for water heating. So, that program has been in effect since 1996 and we estimate that we have been able to take about 35 megawatts of load out of our system by installing these solar water heating programs. So, yes, we are very actively encouraging energy efficiency and conservation.

James Bellessa - D. A. Davidson & Company

Now, they give you an incentive to do that and therefore your margins aren't going to squeeze or should we build in some margin squeeze as?

Mike May

We are getting incentivize, as a matter of fact, as I mentioned earlier, we earned $4 million in incentives by hitting our DSM goals last year.

James Bellessa - D. A. Davidson & Company

And if you don't meet your goals, is there a penalty?

Mike May

No. We just don't get rewarded, at least under the current structure of the system.

James Bellessa - D. A. Davidson & Company

Over on to bank side, you had the of course your compensation employee benefit expense went down by $8.8 million I think due to the change in your I guess its your benefit plan, defined benefit plan, your discontinuance of that. So, if I back that back into the compensation employee benefit line and is that kind of the run-rate for that expense or is there, is it lumpy because of quarters, where you give I guess bonuses and so forth.

Tim Schools

No, because they would be accrued through the year, but there will be a small adjustment and I'll have Alvin speak up and correct me if I'm wrong, but if you 're looking like link quarter, the chart I had third quarter, fourth quarter or if its year-over-year, it depends on which time period you're looking at, because as we came to the year, you accrue for your bonuses and you accrue for long term incentive plan and at such point that you see that you are not on the trajectory to your hit your goals under GAAP accounting, you have to reverse those accruals that you may or lower than to a level to the target you think you are going to hit.

So, we had some accrual reversals in third quarter, which is where the largest adjustment was and then we had a minor, a less amount in fourth quarter point being when you start first quarter 2008, you're going to establish new accruals for bonuses and so forth this year. So, your run-rate if you adjusted for that pension plan back in the fourth quarter run-rate your first quarter could be modestly higher because you're going to start your bonus accruals again and that would not have been in the fourth quarter, but it should not be a substantial large number.

James Bellessa - D. A. Davidson & Company

Was that benefit or that gain 8.8 exactly or is there a figure different than 8.8, just rounded it.

Mike May

The gain is 8.8 million pre-tax.

James Bellessa - D. A. Davidson & Company

And then the tax benefits or the tax cost that was 3.5 million exactly?

Mike May

I believe so.

James Bellessa - D. A. Davidson & Company

Because when I do the arithmetic I'm getting the overall earnings going from $0.49 down to $0.42, yet when we do it on a standalone basis that using your number is like a $0.06 delta as a result of that gain. And I'd imagine going forward most analyst back that out because its non-recurring nature and so just wondering is it $0.06 a share or $0.07 a share.

Connie Lau

It $0.06 a share, James did you hear $0.06 a share.

James Bellessa - D. A. Davidson & Company

Okay. And I understand that, but when I put it into the model, the number comes down to $0.42 a share and that's why I'm asking about the exactness of those two numbers, 8.8 and 3.5 million in tax?

Connie Lau

Jim, I will follow-up with you later, but what the difference is that the shares outstanding in the quarter when we booked the adjustment versus what was outstanding for the year, so, it's a just kind of rounding difference. It's really $0.06.

James Bellessa - D. A. Davidson & Company

And now I'd like to ask about the charge-off, you have this one -- you've got the portfolio, doesn't look like there is a problem on overall, but there has been one customer. What did you learn from serving that one customer, you want to go into more of these kind of loans, but just customer cost you quite a bit, what have you learnt, what will you do differently?

Tim Schools

Yeah, you can lose money different ways, right. One is unfortunately there is a bad economy or the customer has issues. This was an interesting one, and it actually developed before I got here, I’m probably not the most appropriate person to comment what happened, maybe Connie could. But this was an interesting one and that it really was more operational. So there was some stuff on this one that we could learn that in the future, we could probably prevent this or limit this type of charge-off and ask I Connie, if she can describe it.

Connie Lau

Yes. Jim, this one did start before Tim arrived and it was a problem that was specific to that particular borrower having to do with contract that they had entered into. And so it really didn't have anything to do with general economic condition. And as Tim noted we have reviewed the underwriting of that credit several times to look at the profits for the underwriting and there are some changes that we have made although not large.

Tim Schools

Anyway, it is interestingly that the help of the borrower is good, it's really a weird situation where it's a contractor and it one project that he was working on and I don't want to say who its with but very large organization that it was for. And whether it was miscommunication or what but the project had some environmental issues and have been stalled. And then apparently the contractor got notification or felt the obligation with verbal notification that the contractor could continue with the project, so the contractor restarted and kept building and then the person that it was for, said wait a minute, we didn't tell you to go forward. So sort of he said she said, and now that person the project that was for doesn’t want to pay the contractor.

Now from our side as a lender, we should be monitoring and should have insured that a written, instead of verbal, but a written communication was signed and documented, before we released funds for future building.

So that's where operationally our procedures, we could probably learn and tighten that up and not that they were loose, accidents happen. But we did learn a lesson from that one.

James Bellessa - D. A. Davidson & Company

Now is it true then in the fourth quarter last year, and then for the last three quarters of this year, you've written off that full amount?

Unidentified Company Representative

Almost the full amount, we do have a small portion remaining, but that's more than adequately collateralized by property.

James Bellessa - D. A. Davidson & Company

And then I'm looking at the numbers in the net charge-off runs by quarter. The first quarter was $700,000 then $400,000 then $300,000 and then all of a sudden the net charge-off in the fourth quarter jumps to $5.3 million. Why weren't you charging this off as you went, or you just waited until you really knew it was completely bad or almost completely bad?

Eric Yeaman

We're not allowed to under GAAP accounting, and I'll let Alvin explain, but you have to wait until there is evidence of some state before you can actually charge it off. The way we sort of do it under GAAP accounting is still the provisioning. That's the way, in theory you're charging it off. But I'll let Alvin explain.

Alvin Sakamoto

Yes. As we had booked the provisioning on this one particular credit, we did do it and saved it as information became available, and we did noticed that it was deteriorating, we did book what we could under the GAAP accounting, and when it was determined that the collectibility of this particular loan was doubtful, and that's when we charge it off.

James Bellessa - D. A. Davidson & Company

Thank you very much.

Operator

And your next question is a follow-up from the line of Paul Patterson with Glenrock Associates.

Paul Patterson - Glenrock Associates

Hi guys, how are you? Can you hear me?

Unidentified Company Representative

Hi, Paul.

Paul Patterson - Glenrock Associates

Just I was wondering, Connie if you just like to comment a little bit about the dividend. It does look like you have a improved situation at the utility. Obviously, there is some potential issues with the bank and what have you. But just wondering if you can comment on the outlook for the dividend given what you guys are planning long-term for the bank and what you're seeing at the utility?

Connie Lau

Well, I think Paul you are right. We've always looked at weather, we have the fundamental earnings stream to support the dividend. And so, the earnings for the utility should improve although, as Mike indicated we still have continuing investments going in and there is still pressures on (inaudible) costs. We need to get new generation in before we can release some of those pressures. So, the dividend is an issue that we discussed continuously with the Board and every quarter make a recommendation to them. So, that is something that of course we just did and they reaffirmed the current policy and then we will continue to do that on a go forward basis.

Paul Patterson - Glenrock Associates

Okay. But do you see any thing that other than obviously your capital requirements and what you are looking, is this just pretty much a quarter-by-quarter sort of event here or anything longer-term that we should be thinking about?

Connie Lau

No, there are no changes at this time.

Paul Patterson - Glenrock Associates

Okay. Thanks a lot guys.

Operator

(Operator Instructions) And your next question [Edward Walbridge with RAA Corp].

Unidentified Analyst

People, you appear to be managing well in a difficult environment and I congratulate you on that. I have a question about the renewable energy program. You mentioned wave energy demonstration program and biofuel effort. But do you have any plans for a solar energy plant, either a photovoltaic or solar thermal that would be a major generating plant as opposed to solar at residences? Or wind energy or geothermal?

Mike May

Well to start backwards, we have a geothermal plant in the Big Islands, matter of fact, it's one of the largest resources that we have on the Big Island. That resource has been there since the early nineties. Photovoltaic, we recently announced adding a 12 acre PV park out in an area of our island called Kapolei. And there are couple of others on the drawing board. So, we are looking at a whole host of programs.

Interestingly enough as we are looking renewable energy, we are expanding that beyond the electric envelope and are looking to plug hybrid vehicles, as a way to take advantage of our off peak energy to, in other words, we could convert every automobile in Hawaii to a plug hybrid without adding one kilowatt of power, if we could find the right kind of inducements to get our community move that way. The reason has importance, two thirds of the oil consumed in our state is consumed for transportation, so if you convert our entire portfolio of electric sources into renewal sources you still have two-third dependent on oil because of transportation. So that is the next frontier that we're working on very aggressively.

Unidentified Analyst

Thank you.

Operator

And there are no further questions in the queue. I'll now turn the call back to Management for closing remarks.

Connie Lau

Thank you everyone for being on the call. If you have any additional question or anything you wanted to follow-up on, please call me, my number is 808-543-7385, again that's 808-543-7385. And thanks again for being on the call today.

Operator

And thank you for your participation in today's conference. This concludes the presentation. And you may now disconnect. Good day.

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Source: Hawaiian Electric Industries Q4 2007 Earnings Call Transcript
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