Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Executives

Mark M. Jacobs - President and CEO

Brian Landrum - EVP and COO

Rick Dobson - EVP and CFO

Analysts

Lasan Johong - RBC Capital Markets

Michael J. Lapides - Goldman Sachs & Co.

Elizabeth Parrella - Merrill Lynch

Shalini Mahajan - UBS

John Kiani - Deutsche Bank

Brian Chin - Citigroup

Reliant Energy, Inc. (RRI) Q4 FY07 Earnings Call February 26, 2008 10:00 AM ET

Operator

Good morning and welcome to the Reliant Energy Fourth Quarter 2007 Earnings Conference Call. Leading the call this morning are Mark Jacobs, our President and CEO; Brian Landrum, Chief Operating Officer and Rick Dobson, our Chief Financial Officer. Following our prepared remarks, we'll have a question-and-answer session.

Both our earnings release and the slide presentation we're using today are available on our website at www.reliant.com, in the Investors section. A replay of this call will also be available on our website approximately two hours after the call.

I want to remind you that consistent with our past practice, we're using several non-GAAP measures which we believe provide additional insight into our operating results. Reconciliation to the non-GAAP measures to GAAP figures are available on our website. Additionally, as many of you know, we update our outlook each quarter using forward commodity prices.

The current outlook uses forward commodity prices as of December 21st, which was the last Friday of the quarter for which there was a traded contract for January. I would also like to remind you that any projections or forward-looking statements made on this call are subject to the cautionary statements on forward-looking information contained in our SEC filings.

I'll now turn it over to Mark.

Mark M. Jacobs - President and Chief Executive Officer

Thank you Dennis and thanks to all of you for joining us this morning. 2007 was a successful year for Reliant Energy. With our repositioning complete, we introduced a new strategy, made significant progress in our core markets and filled key roles on our leadership team. Earnings and cash flow were well ahead of last year and exceeded our expectations. And we have every reason to believe that 2008 will be even better, both operationally and financially.

This morning, I would like to first reflect on some of the highlights in 2007 and then offer a perspective on our direction in 2008. 2007 was a year of transition; a transition from a repositioning strategy to one that capitalizes on the strong foundation we filled. As most of you are aware, we introduced this strategy at the investor conference last March. This strategy is notable in several respects.

First it focuses on long-term value creation for our shareholders. Second it's distinctive. It's not a follow-the-herd strategy. What do we mean by that? The strategy addresses the challenge of how to create long-term value in an industry that will go through boom and bust cycles. And it uses a scenario-based approach to evaluate the many factors, such as commodity price volatility and environmental requirements that impact our industry. It also offers solutions to industry challenges of price, reliability and environmental impact through competitive markets.

In 2007, we filled the key leadership roles for our next chapter. Rick Dobson joined Reliant Energy as Chief Financial Officer and Rogers Herndon was promoted to Senior Vice President, Strategic Planning and Business Development.

Most recently in Public and Regulatory Affairs, we named a new leadership team of Albert Myres and Charles Griffey. Albert joined us from Shell, where he distinguished himself in public and external affairs. Charles Griffey has nearly 20 years of experience with Reliant and is one of the nation's leading experts on electricity market design. Albert and Charles will lead our efforts to develop competitive markets across the country. Today we have a senior leadership team that combines enthusiasm and diversity of thought with a strong set of shared values.

In 2007, we made significant progress in the development of competitive markets; and this was accomplished in a rising price environment which gave rise to political and regulatory pressure. It was the first year of a fully competitive retail market in Texas. During the Texas legislature's biannual session in 2007, Texas lawmakers affirmed their commitment to competitive electricity markets.

Over the last few years, Reliant Energy provided valuable insights to PJM stakeholders during the development of the reliability pricing model. From April 2007 through January 2008, PJM conducted its first four capacity auctions, covering planning years 2007 through 2010. The key takeaway from these auctions is that the competitive market is working.

Some have debated the merits of PJM's market design. But the results are very clear. Competitive markets have brought creativity and innovation, in addition to traditional approaches. Despite lead times too short for significant newbuilds, the first four PJM auctions brought over ten thousand megawatts of additional capacity. In response to market price signals, we elected to maintain the Brunot Island plant in service. And we brought back the wern [ph] in Werner stations for marked all status. The RPM capacity auctions also provide an important source of revenue for a PJM assets. I wanted to briefly touch on the financial highlights.

Open and adjusted EBITDA for 2007 were well ahead of last year and modestly exceed our expectations. Adjusted cash flow from operations of $515 million for 2007 was more than double 2006 levels reflecting improved profitability. And importantly, we concluded the repositioning phase of our strategy with a net debt-to-EBITDA ratio of 2.7 times for 2007. In only five years, we've gone from a company in financial distress to one with a strong financial profile and balance sheet. And we accomplished this without going through bankruptcy or at the expense of our shareholders.

Let me turn to the future on slide four. My expectation is that 2008 will be a breakout year for Reliant Energy. We have established priorities for 2008 that will create long-term value for shareholders. In the wholesale business, we expect improved fundamentals to translate into substantially higher profit levels over the next several years, even in the slowing economic environment. And our highest priorities are focused on capturing the full value of that cyclical upturn. As you know, we have made a significant investment to improve generation asset performance. 2008 is the year we expect to see the full benefits of our efforts and perform at top quartile levels.

In 2008, we will continue to provide thought leadership to both MISO and California, as those regions further their discussions on the development of their respective markets. As demonstrated by the success of PJM, a market structure that provides appropriate price signals is an essential designed element for a well-functioning market. We see the retail business as relatively stable in the near term with attractive long-term growth. Our priorities in the base retail business focus on improving the lifetime value of our customers.

So what does increasing lifetime value mean? It means we are building a long-term relationship with customers that's based on bringing innovative solutions to their energy needs. And Smart Energy plays a big role in that concept. Smart Energy does two things for us; first, it's part of the strategy to build high value long-term relationships with customers in our core Texas residential business. In addition, Smart Energy will provide concrete proof points to help open other markets to retail competition and that will build the value of our longer-term retail growth option.

And finally in the retail business, we will expand upon a very successful platform we've built. In 2008, we will enter the New York market for commercial and industrial customers and we expect to make a decision later this year with respect to a New York mass market entry. Rick will cover the balance sheet strategy in detail. But what you'll hear from him is consistent with what we've articulated for last five years. We believe a strong flexible balance sheet is an integral part of our strategy to create long-term value for shareholders. As most of you know, we expect to generate substantial free cash flow over the next several years.

At our investor conference last March, we introduced our reinvestment model. It's a flexible, highly disciplined approach to capital investment decisions. That means we will direct investment dollars to alternatives that create the most long-term value, be they new investments or returning cash to shareholders. Here is what you can expect from us; first, a disciplined focus on return on invested capital. We believe ROIC is our measuring stick for value creation.

Second, thoughtful consideration of the alternatives. That means looking not just at the economics of one opportunity at one point in time, but rather evaluating all of the alternatives across a wide range of scenarios. And finally and most importantly, to maintain appropriate level of flexibility. Don't look for us to spend every dollar of free cash flow each and every month. So why is this last point important?

Conditions in the financial market and credit markets have been in turmoil. And financial flexibility in this type of environment is an incredibly valuable asset. Our commitment is to be prepared for opportunities that create significant long-term value when they arise; even if conditions in external financing markets are difficult. As is our past practice, we provided a three-year outlook based on forward curves for commodity prices. The details of the outlook in the appendix, but I wanted to make few observations.

First, you see significant improvements from 2008 through 2010 and second, despite increased profit levels; we remain far below new entrant economics through 2010. In fact, if market prices supported a 7.5% rate of return on newbuilds, it would translate into a $500 million increase in 2010 figures. I mentioned earlier that we expect to generate substantial free cash flow and that's important, because it gives us a lot of firepower to create additional long-term value for shareholders. To sum it all up, 2007 was a good year for Reliant Energy and we expect 2008 to be even better.

I'll now turn the call over to Brian Landrum, our Chief Operating Officer.

Brian Landrum - Executive Vice President and Chief Operating Officer

Thanks Mark. I'll provide more insight into our operating performance and focus areas going forward. Let me start with wholesale on slide six. As Mark said, supply and demand continued to tighten during 2007, which caused capacity and energy values to increase across our portfolio. In PJM in particular, the impact can be seen in the upward trend in capacity prices over the full reliability pricing model auctions completed to-date.

In the most recent auction for planning year 2010, we cleared about 6400 megawatts at a price just under $175 a megawatt day. For $407 million in revenue for the planning year and $394 million for the calendar year. Our efforts to ensure working wholesale markets in MISO and California continue to produce results. In late December, MISO took an important step in standardizing capacity requirements by filing its long-term resource adequacy plan we the FERC. In California, the final commission decision on capacity market structure is scheduled for May, with a number of opportunities to come in along the way. Despite the improvement in markets and prices, our assets are in regions where current forward energy curves do not yet reflect newbuild economics. At this point in the cycle, we remain largely open on forward power sales.

Let me highlight the increase in market prices for coal compared to our last outlook. We are almost fully hedged on coal for 2008, consistent with our approach to ensure availability and delivery of specific coals best suited for our plant. Beyond 2008, we are largely open. The sensitivity to changes in coal costs, with other factors held constant is on slide 27 in the appendix. I would encourage you however to look at all market sensivities rather than focus on just one commodity. Rarely do we see one market factor move in isolation. In fact, since the end of the year the contribution margin outlook for our coal fleet for 2009 and 2010 has increased, with higher market heat rates, higher natural gas prices and lower SO2 cost more than offsetting the increased coal cost.

It is important to point out that although commodity price movements affect our near-term financial results, tightening supply and demand through time will provide higher returns across our portfolio. In operations, we achieved 82.2% commercial capacity factor or CCF for the year, roughly within expectations. We continue to see a meaningful reduction and loss value from unplanned outages. These improvements came mostly within our higher margin plant such as Seward, where we achieved CCF of 97.1% in the fourth quarter and almost 8% better performance year-over-year. Given this progress, we remain committed to achieving top-quartile commercial availability of 88% in 2008.

Now I would like to discuss the impact due to King's [ph] efforts to leave PJM to join MISO. Based on the FERC's latest ruling, we expect to receive full capacity payments from completed auctions that cover periods through the end of May 2011. Our current assessment is that the impact on returns from our assets in the region will be modest.

Relative to our last outlook, you will see an increase in capital spending of about $62 million for 2008 and 2009. $12 million of the increase is due to timing differences on the Cheswick and Keystone scrubber projects that shifted spending from 2007 to 2008 and 2009. The cost of materials at the Cheswick project has increased modestly. So we increased our estimate of total capital expenditures by about $21 million or 6%. The two scrubber projects are scheduled to come online in 2009 as planned. The balance of the increase and the capital spending forecast is from higher estimated cost to comply with the Pennsylvania mercury regulations that begin in 2010. As a result of recent technology feasibility test, we have modified the equipment we plan to install at certain stations.

We remain very bullish about the future of our wholesale business and our operating performance improvements. The bulk of increase in free cash flow in the three-year outlook comes from improved returns on commercial positions and generation assets. Now let me shift to our retail business.

We made meaningful progress on each of the strategic priorities on slide seven. 2007 results reflect strong performance and provide another example that retail is a relatively stable margin business. We finished the year with contribution margin of $504 million, which was a significant achievement in a challenging market environment. As the outlook shows, we believe the strength of our Commercial and Industrial segment and investments in segmentation, innovation and Smart Energy will help us to deliver consistent solid margins through times. In the residential markets we continue to see comparators increase their spending on marketing and advertising. Our initiatives continue to slow attrition in the Houston area, while acquisitions declined outside Houston and among movers. The result was a disappointing net loss in 2007 of about 71,000 residential customers.

Competition in the small and midsize commercial segment continued to intensify, especially among brokers. In fact, the reduction in mass market contribution margin for 2007 and in the 2008 outlook comes primarily from volume losses in lower margins among these customers. Of course, we are getting more competitive as well. We are encouraged by our early residential segmentation efforts, which have already resulted in increased retention of higher lifetime value customers, improved overall mix and higher contribution margins per customer of $0.27 a megawatt hour.

In small commercial, we are accelerating the launch of a number of distinctive new products and services over the next few months. Until recently, we achieved net customer growth in the mass market by aggressively adding customers outside of Houston, in numbers that more than offset the net customer losses in the Houston area. As the size of our customer base outside Houston grew to about 600,000, we shifted our focus from simply growing customer account, to improving the mix and quality of our customer base, through segmentation and product service innovations.

For instance, in our outlook, our residential customer account is similar to 2007 results. The contribution margin is expected to be about a $1 per megawatt hour higher. This is a significant part of how we plan to continue to achieve relatively stable contribution margins through time. One way we are differentiating our offers to mass market customers is through Smart Energy. We are developing products and marketing plans to launch in the first half of this year that will reduce customer bills, improve market reliability and lower overall environmental emissions. These innovations will change the basis of retail competition in ERCOT by transforming the way customers use and value electricity. To the extent we invest more in Smart Energy, we'll update the outlook and we have better line of sight to the spending level. We are also entering new commercial and industrial retail markets. We had successful entries into Delaware and Illinois in 2007 and plan to enter New York this year.

Now let me turn it over to Rick Dobson, our CFO.

Rick Dobson - Executive Vice President and Chief Financial Officer

Thanks Brian. Before I get into the financial results, I expect most of you saw our press release Monday morning, announcing the sale of the Channelview plant for $468 million. The sales agreement is subject to various closing conditions, including bankruptcy court approval. So timing is a little hard to predict. We expect this transaction to resolve the bankruptcy proceeding and provide value to Reliant.

Now, let's start with our financial highlight on slide nine. 2007 was a solid year for our company. Our open EBITDA increased to $110 million, primarily driven by improved capacity and energy margins in our wholesale business. Our adjusted EBITDA also increased significantly, up $261 million from 2006. Most of this adjusted EBITDA improvement came from proactive gas transportation decisions and lower historical power hedges.

Now let's turn to the wholesale business on slide ten. Improving supply and demand fundamentals was the headline here, driving $143 million of contribution margin improvements. These improvements are in operating markets where the catalysts were free positive margin variances. Number one, an economic generation increase of $72 million. Number two, unit margin increases of $128 million and number three, a $31 million other margin increase driven by PJM auction result. The planned outages at a number of our coal plants partially offset our economic generation improvements by $47million. These planned outages and cost end up putting our operations in the top quartile, with the primary contributors to the$41 million O&M negative variants.

Now, let's review the retail business on slide 11. The $59 million negative mass volume variance was driven by weakness in our small commercial and residential markets. About three-quarters of this variance related to our small commercial markets with remainder residing in our residential markets. On the positive side, our commercial industrial team's strong performance drove C&I volume and margins expansion totaling $36 million, which partially offset the reduction in mass volumes. In the end, our focus on attracting more profitable customers through products and service innovations and segmentation, coupled with C&I expansion and our unwavering focus on operational excellence drove a very solid and consistent contribution margins of $504 million in 2007. Well, actually when I think about the segment our business, I see relatively stable earnings in the near term and a very portable platform for earnings growth in the long term.

Turning to slide 12. Let's take a look at the 2007 cash flows. Mark pointed out that we had solid 2007 operating cash flows. And the key driver discussion we just completed on the previous three slides tells the story behind this solid operating cash flow performance. As you continue down the slide, you can see that 2007 free cash flow was $70 million lower than 2006. This was driven by a number of factors.

Number one. We sold $205 million of emission allowances at some very good prices in 2006, versus only $7 million in the lower 2007 price environment. Number two, we purchased more SO2 emission allowance in 2007 versus 2006. And number three; we began spending 2007 construction dollars for scrubbers at our Keystone and Cheswick plant that drove the $92 million CapEx increase. Let's move on to slide 13.

Before I begin talking about how we think about our capital structure, I'll take a moment to explain some of the components on this slide. The bars in the chart represent debt-to-EBITDA. The left scale on the chart applies to these bars. The green line in the chart represents actual EBITDA; the right scale on the chart applies to the green line. I will talk little about the flexible representation on the right hand side of the slide a little later.

Now let's talk about capital structure flexibility. We have been very consistent in communicating our desire to maintain a strong balance sheet as we believe that provides us with the financial flexibility to drive shareholder value throughout the market cycles. We have talked about maintaining debt-to-EBITDA on the 2.5 to 4 range, as a way of thinking about the level of debt that delivers optimal financial flexibility. Although this range was a good indicator, especially in lower earnings period by 2004 to 2006, we created a model that incorporated a notional permanent level of debt for a company of our size.

We believe for a company of our size that's maintaining a permit debt level in the $2 billion to $2.5 billion range, with the ability to increase that level as flexible that is appropriate, allows us to pursue shareholder accretive initiatives while providing adequate liquidity for our ongoing business needs. This permanent debt level might track a few years is low. But let's not forget the $2.5 billion of debt in the 2004 to 2006 timeframe would have yielded debt-to-EBITDA in the 3 to 4 range and would be consistent with our view of maintaining financial flexibility in such a period. It also strikes us that significantly increasing our debt levels as we move up to commodity cycle, is the kind of activity that got many of us in trouble in the last swap period.

Let me review the factors that we considered in determining the level of permanent debt. Number one, maintaining flexibility for accreted investments, including growth capital expenditures, environmental upgrades, accretive acquisitions, dividends and share repurchases. Number two, long-term market scenario modeling and number three, commodity-based cyclicality. The flexible debt portion of our capital structure will be shorter term in nature and will vary over time, depending on the position in the commodity cycle, projected cash flows and available investment opportunities.

We view the concept of flexible debtors dynamic and dependent on the type of investment under consideration. For example, investments that bring immediate EBITDA can support higher levels of debt and those that are more developmental in nature. Growing our asset base will ultimately to higher levels of permanent debt, commensurate with our current capital structure philosophy.

When investments requires flexible debt, we will maintain a clear path to our way back to a permanent debt level consistent with our capital structure philosophy. To sum it up, going forward we intend to actively manage Reliant's capital structure in a way that balances our primary goal of delivering long-term shareholder value with the need to provide adequate liquidity to manage our business throughout the market cycles.

Let me now turn it back over to Mark for some concluding remarks.

Mark M. Jacobs - President and Chief Executive Officer

Thanks Rick. Let me wrap up on slide 14, with a summary of key points. In the wholesale business, market fundamentals are pointed towards substantially higher levels of profitability and cash flow over the next several years. But the most important point is that we are still well below new entrant economics in 2010.

In the retail business, we are the clear leader in Texas and we believe that success in Texas will lead to other mass market retail opportunities overtime, a valuable growth opportunity. We've regained our financial strength and finally we expect to generate substantial free cash flow in the next few years and our commitment is to deploy that capital in a manner that creates the highest long-term value for shareholders.

Operator, we are ready for questions.

Question And Answer

Operator

[Operator Instructions]. Your first question comes from Lasan Johong with RBC Capital Markets.

Lasan Johong - RBC Capital Markets

Good morning, nice year results. Congratulations. Thank you and I wanted to quickly go over couple of important questions. Now that you guys are developing a rich man's problem, lot of free cash flow, but somewhat still restricted from your covenants from doing what should be the right move for shareholders. Rick or Mark, or whoever can, can you kind of address what your plans are to remove covenants going forward?

Rick Dobson - Executive Vice President and Chief Financial Officer

Yes this is Rick, Lasan. You can see that one of the things I would touch on first is that we do have two pieces of debt that are pretty restrictive. And it used to aggregate about $1.25 billion. They don't aggregate that anymore because we did take out about $38 million by the end of the year. We've taken out about $83 million to begin addressing restrictive covenants as of today. We looked at it economically and we do want a flexible balance sheet as we move forward, as we said in the previous remarks and those giving away those colors would maximize our flexibility. But right now, at the current financial markets it's very expensive proposition; somewhere over $150 million to refinance those instruments and then trying to go back and put some refinance debt back into the marketplace at the current yields and its pretty tumultuous right now, would be even more expensive versus the current coupons of six and three quarters.

So at this point we are really looking at being patient with respect to those instruments, realizing that we have a call date for the $750 million piece of the debt which is not debt any more it's about 670. At the end of 09, 103.38. And also realizing that we will need some... realistically some more some stable markets moving forward and then lastly this thing I would add into that are restricted payment capacity is actually growing very nicely under those instruments. So we do have a call modern-to-modern flexibility and we feel that, that will grow over time when you kind of look at our outlook.

So that's how we are thinking about those restrictive payment capacities and the ability to have what I will called more flexibility than we currently have now.

Lasan Johong - RBC Capital Markets

Okay, last time we chatted Rick, you said, I think you mentioned the restricted cash as being roughly around $400 million. What is it now and how much more channel you'll add to that?

Rick Dobson - Executive Vice President and Chief Financial Officer

The restricted payment capacity right now as of the end of the year is about $400 million and then it as you know it kind of grows roughly at 50% net income over time. So it will exceed $1 billion within a reasonable period of time. It's a little early to call the ball in Channelview, but it could add a milestone amount. But I really look at the bigger just of just forecasting our net income using our outlook overtime and what that gives us in the basket. We have a modest amount of flexibility with the covenants in place. But I think down the road keeping our eye on doing with those covenants when the pricing is a little more reasonable and the capital markets are a little bit more stable.

Lasan Johong - RBC Capital Markets

Without giving anything away are you thinking about potentially doing something with that $400 million?

Rick Dobson - Executive Vice President and Chief Financial Officer

No I think that would... I will let Mark take that, because that really gets into a bigger philosophy question.

Mark M. Jacobs - President and Chief Executive Officer

Lasan the reinvestment model that we have described is one that's very flexible and highly disciplined. It were pre-disposed to any alternatives, but we will look to invest capital in alternatives that we think will create the highest long-term value for our shareholders. And as we mentioned in the prepared comments, there is a lot of turmoil out in the financial and credit markets today and uncertainty over the future direction. We are in incredibly good position and we believe that maintaining financial flexibility in this type of market is a very valuable asset and a prudent thing for us to do.

Lasan Johong - RBC Capital Markets

Okay and help me understand this permanent debt structure. I understand what your underlying philosophy is getting at but, the... it seems to me that there is a rational net debt to total cap ratio as opposed to fixed dollar amount for the permanent debt. So unless you are saying that the company is not going to grow too much to accommodate the debt level above $2 billion to $2.5 billion, something doesn't click in my head?

Rick Dobson - Executive Vice President and Chief Financial Officer

Well this is Rick. Yes, I intended to address that in my comments in the opening remarks, but let me say it little differently. As we grow the company and that could be capacity growth per megawatts and other basic growth with a retail footprint. As we grow the company that permanent debt level, it does move up.

Lasan Johong - RBC Capital Markets

Okay, okay.

Rick Dobson - Executive Vice President and Chief Financial Officer

It moves up commensurate with the growth of the company. That's... it's a dynamic type of thought process but for the... and I was, maybe said it too quickly. It's the permanent debt level for our current size of our company.

Lasan Johong - RBC Capital Markets

Okay. That makes sense, okay.

Mark M. Jacobs - President and Chief Executive Officer

But I think the other point Lasan that Rick made in the permanent debt, is that what we are not going to do is chase the commodity cycle and --

Lasan Johong - RBC Capital Markets

Absolutely.

Mark M. Jacobs - President and Chief Executive Officer

More debt to the company as supply-demand conditions tighten.

Lasan Johong - RBC Capital Markets

Absolutely, I agree with that 100%. Let me ask you a question about the 2010 wholesale margin. It seems like it's coming down and I am not sure why that is. Is there a particular reason that you are seeing commodity spreads coming down in 2010?

Brian Landrum - Executive Vice President and Chief Operating Officer

Lasan, this is Brian.

Lasan Johong - RBC Capital Markets

Hi Brian.

Brian Landrum - Executive Vice President and Chief Operating Officer

How are you?

Lasan Johong - RBC Capital Markets

Very good.

Brian Landrum - Executive Vice President and Chief Operating Officer

We use forward curves at the end of December. We marked our three-year outlook at the beginning of year. So what you are seeing essentially is what the shape of the market forward curves are that reflect that 2010 number.

Lasan Johong - RBC Capital Markets

So, just to clarify it's obviously not your viewpoint that margins are coming down in 2010?

Brian Landrum - Executive Vice President and Chief Operating Officer

We don't typically put a fundamental view in these outlooks. We will frequently use a forward curve and so. We told you before, we don't believe that the forward curves yet reflect, for newbuild economics in all of the tightening supply and demand that we expect to see through time. And so, it wouldn't surprise me to find at the mark on time wouldn't be a consistent with newbuild economics yet.

Mark M. Jacobs - President and Chief Executive Officer

And just to be clear Lasan, the 2010 contribution outlook for wholesale is up from 2009 is not --

Lasan Johong - RBC Capital Markets

Right, right.

Mark M. Jacobs - President and Chief Executive Officer

As much as you might guess and maybe what you are getting to and again that's really Brian's point that we use an outlook here based on forward curves. You'll recall a year ago at our Investor conference when we provided a forward outlook. It really didn't have any capacity payments for PJM, because we hadn't, had that data yet. But one other things we saw as we went through time is the forward curves didn't catch up with that fundamental view. And I think that's a key point that when we look forward here, our expectation is that we will see markets continue to improve, as we get closer to newbuild levels.

Lasan Johong - RBC Capital Markets

Perfect. Thank you very much. I will get in queue again and pass the torch.

Operator

Your next question comes from Lesley Rich with Columbia Management [ph].

Unidentified Analyst

Good morning

Mark M. Jacobs - President and Chief Executive Officer

Good morning

Unidentified Analyst

Just sort of go back to the slides that Lasan was just talking about; on page 22, as you look at your 2010 capacity factors and economic generation, particularly for your commercial capacity factors. You show that your PJM coal plants basically will be running more, I guess rather to reflect that reserve margins are tightening. But you show that your MISO coal plants will be running less and I just wondered sort of what was driving that and then that feeds down into your generation volumes. You show a pretty big uptick 2008 to 2010 in terms of overall generation volumes. So I just wondered sort of what you're envisioning there?

Brian Landrum - Executive Vice President and Chief Operating Officer

Lesley, let me just take you to look at the... if you look at the total commercial capacity factor line; we are kind of steadily land between 87% and 88% through time. When you look at the individual components of the portfolio such as PJM coal and MISO coal, you are going to see variability year-over-year associated with planned outages. And almost all that variability comes from planned outages, but we plan to run the fleet at a top quartile level of commercial capacity factor of about 88% through time that we are going to adjust it for planned outages when that cycle hits.

Unidentified Analyst

Okay. So the over all generation volume uptick from 33.5 to 35, is that --?

Brian Landrum - Executive Vice President and Chief Operating Officer

That you can see that if you look up at the economic generation section on that same page, you could see the .... That its supply and demand tightens, there are more hours what are plan to put in the money. And therefore the number of hours, we expect those plans to run go up as well.

Unidentified Analyst

Okay. I just want make sure that that was the correct interpretation.

Brian Landrum - Executive Vice President and Chief Operating Officer

Right.

Unidentified Analyst

Thank you.

Operator

Your next question comes from Michael Lapides with Goldman Sachs.

Michael J. Lapides - Goldman Sachs & Co.

Hey guys congratulations on a good quarter and a good year. I have a couple of basic questions. One, when I look at your free cash flow forecast on page 19 and we typically think free cash flow is the most important metric. The cumulative amounts for 2008 to 2010 come pretty close to equaling the total amount of permanent debt that Rick discussed earlier. So this would imply a level of basically zero net debt by the end of 2010. A) Am I reading that correctly and B) can you comments a little bit on your capital spending forecast post 2009 where we see a pretty big drop-off and are you reevaluating options in terms of scrubber installations on some of your other coal plants?

Mark M. Jacobs - President and Chief Executive Officer

Yes Michael, its Mark and you right at the financial outlook, I made this comment on the prepared remark shows significant free cash flow generation over the next several years. You see as we talked about in the past, we do expect uncertainty in our business. We use a scenario-based approach to think about our business in lots of different outcomes. What we've modeled here is the in-flows based off of our forward curves obviously commodity prices are going to move around. It may add to or takeaway from some of that number. You know on the investment side, what we've included there is what I describe as our line of sight opportunities and I think those are going to change, may change over time.

And I think one area we've talked about is Smart Energy and that will be a good thing if we start putting more investment dollars into Smart Energy here and I think another one that you highlighted is the environmental CapEx. And our expectation is that we will see increasing rules and regulations around environmental CapEx over time and that going forward, we are going to make economic decisions about that. But what's backed in that forecast today, our line of sight observations. Taken all that into context, though, what you see though is still a picture that under any reasonable set of circumstances that we can come up with, we expect to have significant capital available to reinvest in the business or return to shareholders and the way we are thinking about that is to put that capital to work in a way that is going to create the most long-term value for shareholders.

Michael J. Lapides - Goldman Sachs & Co.

And, is the 7.5% IRR target, is that, when you think about what your target level for any use of capital, is that kind of the barrier?

Mark M. Jacobs - President and Chief Executive Officer

No, we think about our cost of capital, when you look at, we've not disclosed exactly what that number is but I'll say the way to think about that, I think when you look at, in general, cyclical capital intensive businesses, they have a cost of capital in the high-single digits. We would be looking for a premium over that, here in terms of the hurdle rate that would take something into the low double-digit type of number from a return hurdle standpoint.

Michael J. Lapides - Goldman Sachs & Co.

Okay.

Mark M. Jacobs - President and Chief Executive Officer

We've used that 7.5% just to be clear, that's a number that we've used to calculate what if we had pricing in each of the markets in which we operated we're new entrance could get 7.5% of rate of return what would that mean to us and then we provided a sensitivity around that. So if you wanted to use a different number, the math is it's about $115 million for each 1% change in newbuild economics that you'd look at.

Michael J. Lapides - Goldman Sachs & Co.

Got it. And then last item and then I'll wait away here. The $113 million of CapEx in 2010, is that primarily what you think as your normal run rate from maintenance CapEx on your existing facilities and it doesn't have any other kind of one-time items that would change or potentially go away in your future year?

Brian Landrum - Executive Vice President and Chief Operating Officer

Michael I'd say that the book of it's maintenance CapEx. There's some portion of it that is spending to comply with the Pennsylvania Mercury Regulations. But generally the bulk of what's in there is maintenance CapEx.

Michael J. Lapides - Goldman Sachs & Co.

Got it okay guys. Thank you. And once again congrats on a good year.

Brian Landrum - Executive Vice President and Chief Operating Officer

Thanks.

Mark M. Jacobs - President and Chief Executive Officer

Thank you.

Operator

Your next question comes from Elizabeth Parrella with Merrill Lynch.

Elizabeth Parrella - Merrill Lynch

Yes, thank you. Just turning to slide 21, your hedging slide. The hedging levels around coal are they also as of December 21st or are there more recent numbers?

Brian Landrum - Executive Vice President and Chief Operating Officer

Those are the numbers as of the end of the year.

Elizabeth Parrella - Merrill Lynch

As of the end of the year.

Brian Landrum - Executive Vice President and Chief Operating Officer

Right.

Elizabeth Parrella - Merrill Lynch

Have you put more coal hedges on for 08. You mentioned that you are pretty much fully hedged. I think that 227 translates to maybe about 80%?

Brian Landrum - Executive Vice President and Chief Operating Officer

Yes. The 2008 number, that's there. We are largely hedging 2008, recognizing that Conemaugh and Keystone have different peculiar mechanism because it's a partnership. But the, we are largely hedged in 2008. When we make decisions for 2009 and 2010, you'll see them in these outlooks. As we go forward, our strategy for 2009 and 2010 is some what it would have been previously which is we try to buy coal as close to when we are going to burn it is possible. But in the coal market there are specific coals that work better at specific plants for us and those areas we need to buy forward and typically it's at least a year forward to ensure that we have availability of supply to meet those specific plant needs. And so we will typically see as we'll have a year forward and then during the course of a year like 2008 will fill out of 2009 requirements.

Elizabeth Parrella - Merrill Lynch

Is the 2008 number currently here in mid-February higher than this 227?

Brian Landrum - Executive Vice President and Chief Operating Officer

The 2008 number, it will very easily go through time as we buy additional coals to meet the needs of the stations. So that's why it was at end of the December.

Elizabeth Parrella - Merrill Lynch

Okay and I am just wondering if you put more hedges on to get to the sort of fully hedged level if they are out for 2008, since the end of December?

Brian Landrum - Executive Vice President and Chief Operating Officer

The hedges that are... like I said Elizabeth, our strategy is to buy forward to the extent that we need it and then by a closer to it when we burn it for other purposes. And so that number will move as we go through time and as we burn coal it will change as well. So it's a little bit of a dynamic number. But we view 227 million Mbtus as largely hedged for the coal that this is representing here.

Elizabeth Parrella - Merrill Lynch

Okay. Brian you also mentioned that if we were to look at things on more of a current level of commodity price basis as well as adjusting forward changes in forward heat rates that have occurred, since December 21st the impact would be kind of neutral. I think that's what you were saying? Can you help us think about what those forward heat rates are today versus what sort of built into that guidance slide on page 20, as well as what coal prices you were using in that comment?

Brian Landrum - Executive Vice President and Chief Operating Officer

What we've done is, we looked at -- the biggest factor in this change Elizabeth is we agree that coal has gone up and depending on which coal you look at. We burn a mix of Pittsburgh Seam, caps, local map and waste coal and across that coal could be in $70 a ton and $90 a ton range today for that, for 2008. As you look out through time there will be 09 numbers were coming, have, are lower than that. And then the 10 numbers are lower than that. But that said, gas is up substantially, Petroleum (3) is up about $1.67 for 2008 and between $0.50 and $1 for 09 and 10. And so if you look at these numbers the SO2 is down close to $100 in 09 and 10. Heat rates are up in 2009 about three quarters of a point and MISO about half a point and PJM on peak heat rates. So you look at these variables and you add on together and actually 09 and 2010 are up from our market at the end of December.

Mark M. Jacobs - President and Chief Executive Officer

Yes, I think that's Elizabeth, you mentioned in your comments that if we were to remark the outlook with today's forward curves it would be significantly from what we showed at the end of December.

Elizabeth Parrella - Merrill Lynch

For 09 and 010.

Mark M. Jacobs - President and Chief Executive Officer

Yes right.

Brian Landrum - Executive Vice President and Chief Operating Officer

And 2008.

Elizabeth Parrella - Merrill Lynch

Reflecting, just wanted to be clear on this reflecting the higher coal price, higher gas price, lower emissions and higher market heat rates?

Brian Landrum - Executive Vice President and Chief Operating Officer

Yes.

Elizabeth Parrella - Merrill Lynch

Okay. All right. Just a question on a different area for you on the free cash flow forecast, could you tell us what's embedded in there in terms of cash tax payments in this three-year outlook and when you also expect to become a full cash tax payer?

Rick Dobson - Executive Vice President and Chief Financial Officer

It's Rick Dobson. We haven't embedded any cash taxes in there through 2010, but when you look at our NOLs and we have looked at them, 10 it's a difficult year to predict right now, but I would suspect that may be in 10 but realistically in 11 we'll be a cash tax payer. We're still analyzing that and there is lot of variables in that calculation, but no cash taxes in the outlook right now. Could be 10 but its too early to comment on that and definitely in 11 if this outlook comes true, we'll be a cash tax payer.

Elizabeth Parrella - Merrill Lynch

A full cash tax payer in '11 or partial?

Rick Dobson - Executive Vice President and Chief Financial Officer

Yes, probably... I guess that it's a little early to call that as we analyze it but, yes, probably.

Elizabeth Parrella - Merrill Lynch

Okay, thank you.

Operator

Your next question comes from Shalini Mahajan with UBS.

Shalini Mahajan - UBS

Well, thank you. Good morning. Just kind of a quick question on call again. One if you could provide your take on the recent run up in coal prices, do you think its sustainable and second, if could remind us, what's the flexibility of burning PRB at your coal plans; I mean what's the mix that you can actually go up to?

Brian Landrum - Executive Vice President and Chief Operating Officer

This is Brian, the run up in coal prices; we've generally looked at that as... there hasn't been any surprises in demand. Most of what we have seen in demand was what everyone expected to happen. Demand is growing in developing parts of the world and the demand for coal in regions such as China, India and Europe as well, is really not that different than at least within a range of what the forecasts were. The change it seems to have been on the supply side and it seems like most of the changes are in infrastructure as it relates to ability to get coal either out of mines due to flooding or freezing or giving it to ports through either rail infrastructure or port infrastructure issues. And so most of what we look at is there is significant investments going in the fixing those infrastructure issues and if we look at our fundamentals, we think the backwardation in the coal prices is probably reasonable.

Now turning to the PRB let me come back our general point on coal though. Let me make sure I make that is that I wouldn't look at just the one variable for us. Coal can go lots of different directions from here. So given that there's uncertainty in that, a part of the strategy is to point out there is many variables that affect our coal spreads and that's the answer we gave Elizabeth a minute ago. On PRB on the flexibility related to PRB, we have gotten to where we can burn about 20% PRB at three different stations in our coal fleet and we are currently investigating expanding that flexibility or at least reinstating that flexibility now that spreads are a little higher.

Mark M. Jacobs - President and Chief Executive Officer

I might add on the coal price. And I appreciate that that's been a topical and timely issue for folks. It is awfully easy to get singularly focused on one commodity and if I reflect back over the last couple of years, there's a number of examples I think where we heard some of those things, I think the emission allowance price spikes that we saw in late '05 and early '06, the drop in the natural gas prices we saw in early 2006. In our perspective here is the commodity princesses are going up and down over time and I think the risk is that if you get singularly focus on a commodity you can miss the forest or the trees and in our view what's more important for us from a value standpoint is where we are in the fundamental supply-demand cycle in the wholesale business. When you look at the, we believe we're coming out of the trough. Here and we have several years in front of us with tightening supply demand fundamentals and when we do the math here on or we believe that we traded fairly significant discount to replacement cost. And I think that's really as we said in the big picture, a more important issue than kind of what commodity X doing right now.

Shalini Mahajan - UBS

Okay thanks that's helpful but just kind of a not to be wayward on the call, but just in terms of the inventory situations across the industry looks comfortable today. But given that a lot of coal companies are focusing on exports to capture the higher prices. Do you anticipate any problems for the industry if there is a hot summer?

Mark M. Jacobs - President and Chief Executive Officer

Yes seriously we think about speculating of what might happen down the road; historically we've not seen real issues here.

Shalini Mahajan - UBS

Okay. Okay great. And just to clarify these... the uplift of $500 million that you see, you know based on 7.5% of revenue growth, that's a down from $580 million, just making sure that just capturing the latest capacity auction and the bump-up in energy prices. Is that it?

Mark M. Jacobs - President and Chief Executive Officer

That's exactly what that is. That the 580 number was measured of '09. So now that we're in 2010 we have higher capacity prices that are embedded in that figure.

Shalini Mahajan - UBS

Okay, great thank you.

Operator

Your next question comes from the line of John Kiani with Deutche Bank.

John Kiani - Deutsche Bank

Good morning.

Mark M. Jacobs - President and Chief Executive Officer

Good morning.

John Kiani - Deutsche Bank

On slide 30, it looks like your retail mass margin per megawatt hour look increased from last time this was updated on the third quarter call. Can you provide some more detail on the drivers behind the mass margin per megawatt increases?

Brian Landrum - Executive Vice President and Chief Operating Officer

John this is Brian. As we had a very successful 2007 and you look at our unit margins in the mass business in 2007 and we demonstrated our ability to earn at these sorts of levels and so as we look at the out look, we look at 2008 for the residential business as an opportunity for us to improve our contribution margin in that segment with the implementation of segmentation and innovations solutions targeting higher lifetime values customers. We talked about that a little bit in my prepared remarks, but I want to highlight that as we shift our strategy from really aggressively acquiring customers outside of territory to replace... well more than replace, the losses of the customers in Houston area and we look at doing a much better job of lowering churn and improving attrition... retention of higher value customers and acquiring a higher value customers we expect to see improved margins in the residential segment in 2008.

In small business and mid C&I we actually did better during 2007 than we originally set out to on margin, but we saw a volume challenge especially from the brokers in that segment. So, as you looked out through 2008, 2009 and 2010, we are working on improving our margins there and improving our volumes and we have a number of efforts going in the market during 2008 to deliver that performance and you see that improvement out in 2010. And of course that our large C&I segment continues to improve performance trough time we got a very solid performance in 2007 out of that group and as you look at the growth in the large C&I segment a lot of that comes from the new markets we've entered and in PJM, C&I outside of ERCOT. And so we are generally feel pretty comfortable about the growth we are going to deliver in that C&I business out in the three-year timeframe.

John Kiani - Deutsche Bank

Okay so it sounds like you are working really hard and very focused on optimizing that business. I guess what I am a little confused on is can you maybe talk a little bit about those benefits exist and how they coincide with the increased competitive intensity from TXU. I mean what was the in territory discount that TXU passed last year, I thought there was something that was noticeable that we have been looking at in the press?

Brian Landrum - Executive Vice President and Chief Operating Officer

Yes, John, I think the... without getting into specifics of how we compete, and what we plan to rollout down the road, one of the things that we have been able to do is segment our customer base and determine what those customers care about and then figure out ways to deliver that better than anyone else can, so that price by itself is one variable, not the only variable that customers use to make decisions. TXU's price decline in 2007 was about getting to effect late in year and it was a net 15% discount to their former PTB customers.

John Kiani - Deutsche Bank

Right, Okay.

Brian Landrum - Executive Vice President and Chief Operating Officer

And that carries to the end of 2008. And that did have an affect on head room in that market and did have an effect on the credit per customer acquisition costs and the rate of acquisition and so what we did is part of this segmentation work is high greater acquisitions to higher value customers, higher life time value customers.

John Kiani - Deutsche Bank

That's helpful Brian. So then the year 2009 and 2010 unit mass margin assumptions. Here, assume that TXUs discount is extent, the 15% that you mentioned has extended beyond the 2008... year-end 2008 expiration. Or that there... that discount is terminated and they raise their prices again?

Brian Landrum - Executive Vice President and Chief Operating Officer

We don't have a specific assumption like that in here. What we were saying is that our competitiveness is going to increase through time. Retail is a dynamic business, where basis of competition changes every few months, every year and so we are constantly reinventing the basis of competition and I'd expected by the time we get to 2009, that 15% discount won't be the basis of competition. We talked about investing in Smart Energy and as we get more and more customers on Smart Energy, we believe that's going to create switching costs, extend the lifetime that customers, customer lifetime with us and grow the customer lifetime value. So that by 2009 and 2010 we expect the basis of competition to be very different.

John Kiani - Deutsche Bank

Okay. I see that's, that's very helpful. Thanks Brian and then Rick just want to be clear on an earlier question. For 2010, does the $1.09 billion of free cash flow sounds like you said there are no taxes assumed but its possible that there could be some cash tax payment realize in 2010, just want to understand what the magnitude of that could be as you look out today?

Rick Dobson - Executive Vice President and Chief Financial Officer

You heard... you did hear me correctly. It's hard to speculate what that number could be and it wouldn't be very material relative to that number.

John Kiani - Deutsche Bank

Okay.

Rick Dobson - Executive Vice President and Chief Financial Officer

And that's the as far as I want to go with that until we get a real clear view on our tax that we are moving forward.

John Kiani - Deutsche Bank

Okay. So may be the cleanest way to look at it, is just assume no cash taxes in 2010 and then 2011 it's... you are closer to a full cash tax payer?

Rick Dobson - Executive Vice President and Chief Financial Officer

That will be a fair way to look at it.

John Kiani - Deutsche Bank

Okay. Great thanks a lot guys.

Mark M. Jacobs - President and Chief Executive Officer

Operator I think we have time for one more question.

Operator

Your next question comes from Brian Tudayo [ph] with the Bank of New York.

Unidentified Analyst

Asked and answered. Thanks.

Operator

That question has been answered.

Mark M. Jacobs - President and Chief Executive Officer

Okay. We'll take the next one.

Operator

Your next comes from Brian Chin with Citi.

Brian Chin - Citigroup

Just to clarify, when you are talking about the use of free cash flows going forward. You've made some fairly strong comments in the past. For example that, investing in new assets, doesn't make sense over the life of the cycle. That it's better to actually buy assets at the bottom of the cycle and I think you reiterated some of that commentary today. But then I look at your slide 31 you have an entire suite or menu of options for use of cash going forward and you also made comments about flexible debt for opportunities going forward. Just to be clear, are you shifting your tone a little bit towards being more flexible about how you might to pull that capital or are you still fairly strongly of the view that deploying capital into new Greenfield opportunities is generally not the right way to go here?

Rick Dobson - Executive Vice President and Chief Financial Officer

Look, Brian. Yes, just go back to, that chart represents it's not a, all inclusive but it represents the big buckets of opportunities that we have to reinvest capital. And one of the comments that we've made is we're going look at; we are not predisposed to anyone of those alternatives. We are going to look what will create the most shareholder value in terms of those different LIBORs. And that's going to change over time. All right and we can take a snap shot at one point in time. We have made the comment we continue to believe that in terms of Greenfield without a significant cost advantage on building, we struggled to see where that will be a real significant use of place what we would put a lot of capital. But in the other buckets, as I said, that's going to change over time in the circumstances and as we look at the world today relative to what the world looked like nine months ago when introduced this model we have a lot, we have a market today that has a lot more uncertainty and turmoil in it. And that very well could create some opportunities for us over the next three months, six months, next year that might not have been as obvious when we introduce this model nine months ago.

Brian Chin - Citigroup

Okay, I realized such things are volatile as we go forward and that those help clarify things. I mean if you can just to a snapshot and times as of right now even a preferred order of the way you might deploy that cash and I realized that this will change over the next few quarters. The snapshot now do you have a federal election towards occurred operations, in your retail markets, ground field, kind of give us a flavor of what's there as opposed to just saying, we are going to look all of these in terms of what maximizes ROIC.

Rick Dobson - Executive Vice President and Chief Financial Officer

Well again that represents just a snapshot in time and again our commitment again we... were not predisposed to any one of alternatives. I would tell you that on the Greenfield as I mentioned, our thoughts nearly haven't change that, that's not a bucket that we would expect to dedicate a significant amount of capital. Acquisitions, that's something that we've seen prices accelerate quite rapidly or had seen that. I think it's going to be very interesting to watch the market in terms of what happens. Do to these market conditions create a dislocation in the acquisition market that could represent an opportunity for us?

Our current operations are really spoke to that. Earlier that we baked in to the forecast these things that we have lined a side on but we are going to see facts and circumstances change around that. We've talked about new retail markets over time being something that our strategy here is to have success in Texas and then use that successful platform that we have developed to open up new markets over time. Share buybacks and dividends are certainly something that we've talked about in the past and I would say they are very much in the mix of things that we'll think about.

Brian Chin - Citigroup

Great, thank you very much.

Mark M. Jacobs - President and Chief Executive Officer

Sure I think on the debt pay down I think Rick gave you a little bit more clarity in terms of our, I think they are on the debt pay down front.

Brian Chin - Citigroup

Right. Great, thank you very much.

Mark M. Jacobs - President and Chief Executive Officer

Well thank you for your participation in our call. A replay of the webcast will be available in approximately two hours. Have a good day.

Operator

Thank you for participating in today's conference call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Reliant Energy, Inc. Q4 2007 Earnings Call Transcript
This Transcript
All Transcripts