Aquila, Inc. Q4 2007 Earnings Call Transcript

Aquila, Inc. (ILA)

Q4 2007 Earnings Call

February 3, 2008 9:30 am ET

Executives

Jason Ketchum - Manager IR

Richard C. Green - Chairman, President, CEO

Beth Armstrong - SVP, Chief Accounting Officer

Jon R. Empson - SVP Regulated Operations

Analysts

Brian Russo - Ladenburg Thalmann & Co.

Yiktat Fung - Zimmer Lucas Partners

[Scott Kim] - Hadrons Capital

[Brian Tedale] - Broadpoint Securities Group

[Brent Siatre] - Mallet Capital Management, LLC

Terran Miller - UBS

Presentation

Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Aquila fourth quarter earnings conference call. (Operator Instructions) This conference call is being recorded today, March 3, 2008.

I would now like to turn the conference over to Jason Ketchum, Aquila Investor Relations. Please go ahead.

Jason Ketchum - Manager IR

Thank you, operator. Good morning, everyone.

Before we get into the presentation, I would like to point your attention to Slide 2, the safe harbor statement. This presentation and comments we will make contain forward-looking information concerning earnings growth, capital expenditures, rate relief, litigation, tax losses and our pending transaction with Great Plains Energy Incorporated and Black Hills Corporation. Important factors that could cause actual results to differ materially from these forward-looking statements are located on Page 53 of our Form 10K and for the quarter ended December 31, 2007. Additional risk factors that should be considered are located on Pages 18 to 21 of our Form 10K for the year ended December 31, 2007.

I will now turn the call over to Aquila CEO, Rick Green.

Richard C. Green - Chairman, President, CEO

Thanks, Jason. Good morning and thank you for taking the time to listen to our year end financial results. I'm here this morning with Jon R. Empson, our Senior Vice President of Regulated Operations and Beth Armstrong, our Senior Vice President and Chief Accounting Officer.

Turning to Slide 3, when reviewing our 2007 results, we're pleased to report that our Utility progress continues. Performance in the fourth quarter of 2007 improved due to rate relief, increased customer demand, and the continued implementation of the Missouri fuel adjustment clause.

Our call today is to discuss our 2007 results, but I'm aware that the market is extremely interested in the next steps of our merger. To address that interest, I would like to provide you with a brief update and then we can get on to our financial results.

On Slide 4, as you'll remember, a little over a year ago we announced the Great Plains and Black Hills transaction with the expectation that we would close within 12 to 18 months. While staying focused on improving our Utility operations, we have made a tremendous amount of progress in gaining the necessary regulatory and shareholder approvals as well as working toward a smooth transition with both companies.

On October 9, Aquila shareholders approved the merger proposal by 88%. We have received regulatory approvals in Colorado, Iowa, Nebraska and the FERC, as well as reached settlement agreements in Kansas. Hearings for the Missouri merger application are scheduled for late April and early May. We expect the close of this transaction still to take place in the first half of 2008.

Moving to Slide 5, as I've mentioned in the past, when this merger closes we are committed to turning over a high-performing and efficiently run business. Last year we not only continued to grow stronger financially as indicated by our 40% Utility EBITDA increase, but also operationally.

Aquila was recently recognized as one of the three top three Midwest utilities by J. D. Power and Associates for the 2008 Electric Utility Business Customer Satisfaction Study, as well as for customer service excellence under the J.D. Power & Associates Certified Call Center Program.

You may also remember that last year our combined gas utilities were ranked by J.D. Power as Number 5 of 21 in the Midwest in residential overall customer satisfaction. The Colorado Gas and Iowa Gas utility properties both scored in the Top 10 of all 61 gas utilities nationally, with Colorado Gas in the No. 1 position.

Even though many Aquila employees are working toward a transition of our business, we have maintained our momentum on our Six Sigma projects during 2007 and exceeded our Six Sigma objectives.

From a regulatory standpoint, in 2007 we were able to utilize the fuel adjustment clause in Missouri, receive construction work in progress treatment for transmission in Colorado, and a gas system reliability surcharge in Kansas. More recently, the Missouri Public Service Commission voted out an environmental cost recovery mechanism. Once final, it will allow utilities in Missouri the opportunity to more rapidly recover environmental investments. We believe this reflects the Missouri Commission's continued support for the required utility investments and a willingness to provide a fair rate of return in the regulatory process to utilities making those investments.

I'll now turn the call over to Beth Armstrong for the financial review.

Beth Armstrong - Chief Accounting Officer

Thank you, Rick, and good morning. I'm going to begin with Slide No. 7.

The financial result for 2007 was a net loss of $5.4 million, which was $29.3 million unfavorable to the results for 2006 largely due to the gain on the sale of Michigan, Minnesota and Missouri gas properties included in discontinued operations in 2006 that did not recur in 2007.

The net loss from continuing operations was $18.1 million, which was favorable to 2006 by $263.9 million. The favorable result was largely due to the exit of the Elwood tolling contract in 2006 for $218 million, lower premiums on debt retirements in 2007 as compared to '06, and rate relief in Missouri, Nebraska and Kansas in 2007.

Earnings from discontinued operations of $12.7 million were $293.2 million unfavorable to the prior year due to the earnings from and the recognition of gains on the sale of Michigan, Minnesota and Missouri gas properties in 2006. Discontinued operations for 2006 also included a full year of earnings on Kansas Electric that was sold on April 1, 2007.

Income tax expense was $6 million for 2007 despite a pre-tax loss from continuing operations of $12.1 million. Because of our losses beginning in 2002 we have established a valuation allowance against our net deferred tax asset, bringing the net balance to zero on the balance sheet. If the company records pre-tax earnings in the future, income tax expense will be zero because we will also record an offsetting benefit to reduce the valuation allowance. The valuation allowance against our net deferred tax asset as of December 31, 2007 was $183.9 million.

The $6 million tax expense in 2007 results primarily from the release of a separate valuation allowance against capital loss carryforwards recorded due to an increase in the capital gains that were recognized on the 2006 income tax return that we filed in '07. The tax benefit from the release of this valuation allowance was reflected in discontinued operations and it resulted in an increase in our net deferred tax asset. An additional valuation allowance was then provided in continuing operations to bring the deferred tax asset balance back to zero on the balance sheet.

Interest expense for 2007 was $142.8 million, which represents a decrease of $16.4 million compared to 2006. The interest cost for 2007 reflects a full year impact of the liability management steps taken in 2006 and a partial year impact of the debt retirement in June 2007, offset by decreased interest expense allocations to discontinued operations. Interest expense for the fourth quarter was $31.2 million.

EBITDA for 2007 was $239 million, which was favorable to prior year by $325.2 million. I will speak to the EBITDA performance by segment on Slide No. 8. The $239 million of EBITDA in 2007 was comprised primarily of $260.5 million of Utility EBITDA. The $260.5 million of 2007 Utility EBITDA compares to $186.1 million in 2006, reflecting a $74.4 million improvement in Utility performance. The Utility EBITDA is offset by $5.6 million of EBITDA loss in Merchant and a $15.9 million EBITDA loss from Corporate and Other business segments. EBITDA from discontinued operations was $12.9 million, primarily due to earnings from the Kansas Electric utility during the fourth quarter of 2007. I will speak to the detail of these EBITDA variances by operating segment in the following slide, beginning with Slide 9.

Electric continuing operations EBITDA of $195.5 million was favorable by $53.6 million compared to 2006. The increase in EBITDA is primarily due to $36.1 million of base rate increase in Missouri Electric and $10.9 million of favourability due to the implementation of a 95% fuel adjustment clause effective June 1, 2007. Weather and other favorable usage contributed an additional $12.4 million.

Gas continuing operations EBITDA was $65 million, which was favorable to prior year by $20.8 million. This favorable variance was primarily due to rate relief in Nebraska and Kansas of $9 million, favorable weather and volume variances of $6.3 million, and lower operating and maintenance costs of $3.2 million primarily due to lower bad debt expense and office expense.

Slide 10, Merchant, Corporate and Other EBITDA loss of $21.5 million was favorable to the prior year by $250.8 million, primarily due to margin losses and the exit fee associated with the Elwood tolling agreement in 2006 of $235.6 million, lower litigation expense of $15.8 million, lower liability management costs in 2007 of $26.9 million, partially offset by lower interest income of $20.9 million. Transaction and retention costs increased $9.8 million in 2007, primarily due to the merger-related costs incurred in 2007 of $24.5 million. These costs were partially offset by costs associated with the asset sales in 2006. The total variance from continuing operations for the quarter compared to prior year was favorable $325.2 million.

Discontinued operations EBITDA was unfavorable $343.9 million to prior year, primarily due to the 2006 EBITDA generated from the assets sold, including $268.9 million of gains recognized on the sale of Michigan, Minnesota and Missouri gas properties and Everest in 2006.

Moving to Slide 11, we have improved the capitalization ratio from an equity ratio of only 33% in 2002 to 56.6% at the end of 2007 through the deployment of asset sale proceeds to reduce debt. As of December 31, 2007, our debt balance was just over $1 billion. We expect this debt balance to increase as we fund capital expenditures in 2008 using the Iatan II and the short-term financing facilities.

The reduction of debt has substantially reduced our interest costs over time, however the high coupon series that comprises approximately half of our debt structure continues to reduce our earnings compared to an investment grade equivalent.

Slide 12 - while we await final approvals related to the pending merger with Great Plains Energy, we continue to focus on delivering improved results from the Utility operations and the company as a whole. Since 2004, the EBITDA from continuing Utility operations has improved from $165.2 million to $260.5 million.

For 2008 we expect to see continued improvement in the utility EBITDA to $304 million, primarily resulting from a full year impact of rate cases resolved in 2007 in Missouri, Nebraska and Kansas, and the implementation of the fuel adjustment clause.

AFUDC is also projected to increase in 2008 during the peak construction cycle for environmental capital and Iatan II.

These improvements are offset by increased operating costs associated with filling positions that remain open while the transactions are pending. The Utility EBITDA is offset in part by projected losses in Merchant, Corporate and Other segments of $15 million. The net EBITDA outlook on a consolidated basis is $289 million.

These projections reflect the standalone earnings of the properties being sold to Black Hill as well as those being merged with Great Plains, excluding any 2008 merger-related expenses.

Slide 13 shows the capital expenditures by year for the next five years by type of investment. As you can see, the peak of the capital spending is in 2008, with $116 million of expenditures on Iatan II and $120 million of environmental upgrades at Iatan I, Sibley and Jeffrey Energy Center.

The capital expenditure projections for 2008 through 2010 also include $186 million of investment associated with the construction of a 300 megawatt peaking facility in Missouri. We are currently exploring transmission options to move the capacity in energy from our Crossroads plant in Mississippi to our Missouri operation. If this proves to be the best option for our customers, we will request to add Crossroads to our Missouri rate base and eliminate most if not all of this incremental capital investment.

These projections reflect standalone operations for the properties being sold to Black Hills as well as those being merged with Great Plains.

On Slide 14 we show how these capital expenditures translate into increases in net utility plant, which is the largest component of rate base. This graph distinguishes between construction work in progress and plant in service because generally CWIP is not included in rates. You will note significant increases in plant in service at the end of 2008 and 2009 for environmental upgrades and another significant increase in 2010 for Iatan II.

Rate cases in Missouri will be prepared and filed so that the true up period for rate cases will be coordinated with the in-service timing of the plant investment. A Missouri rate case will be filed this summer to capture the environmental investment in rate [spend] in 2009. In 2009, another rate case will be required in Missouri to reflect the Iatan II investment in rates when it is placed in service.

Now we'll turn the call back to Rick.

Richard C. Green - Chairman, President, CEO

Turning to Slide 16 to wrap up, as we discussed in the call, our Utility operational and financial performance progress continues. We continue to improve the business as recognized by J.D. Power & Associates and are committed to turning over a high-performing operation once the transaction closes.

We are very proud of our employees, who continue to improve our operations and customer experience even while working toward a smooth transition during our pending merger, and I'd like to congratulate them on a great year.

Now I'd like to open up the call for any questions that people might have.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question comes from Brian Russo with Ladenburg. Please go ahead.

Brian Russo - Ladenburg Thalmann & Co.

Good morning.

Richard C. Green - Chairman, President, CEO

Good morning, Brian.

Brian Russo - Ladenburg Thalmann & Co.

You mentioned earlier that you expect the merger to close in first half '08 and I'm just wondering does the revised merger proposal that Great Plains filed, does that give you more confidence that the PUC will approve the merger?

Richard C. Green - Chairman, President, CEO

I think there's no question that Great Plains has done a good job in making tremendous movements in the regulatory plan, and I think that has to be looked upon favorably.

Brian Russo - Ladenburg Thalmann & Co.

All right. Thank you very much.

Operator

Thank you. Our next question comes from Yiktat Fung with Zimmer Lucas Partners. Please go ahead.

Yiktat Fung - Zimmer Lucas Partners

Good morning.

Richard C. Green - Chairman, President, CEO

Good morning.

Beth Armstrong - Chief Accounting Officer

Morning.

Yiktat Fung - Zimmer Lucas Partners

Just a question about the transmission opportunity to the Crossroads plant. How much - it says on the note on that slide with the Capex plan that $186 million of that Capex for the emission turbines would be eliminated if this transmission is built. How much incremental Capex would be needed to build this transmission line, and how much value can you get by rate basing the Crossroads plant?

Beth Armstrong - Chief Accounting Officer

Yiktat, this is Beth. The transmission is actually a transmission request to the RTOs, and what we are looking at doing is trying to lock up long-term ability to obtain transmission. So it's not the construction of a line but rather the rights to utilize transmission through the RTOs to bring that capacity to Missouri.

Yiktat Fung - Zimmer Lucas Partners

I see. And what's the potential rate base addition by adding the Crossroads plant?

Beth Armstrong - Chief Accounting Officer

The net book value of Crossroads is $112 million at the end of '07.

Yiktat Fung - Zimmer Lucas Partners

I see. And is there currently any earnings drag at the Crossroads plant?

Beth Armstrong - Chief Accounting Officer

Right now we do have a net earnings drag that would be projected in the Merchant segment because the margins don't fully cover the operating costs. So it's on the order of about $2.5 million.

Yiktat Fung - Zimmer Lucas Partners

I see. And that would be eliminated if the plant was rate based?

Beth Armstrong - Chief Accounting Officer

Yes.

Yiktat Fung - Zimmer Lucas Partners

Okay, I see. And one final question. Has the company filed the rate case in Iowa yet?

Richard C. Green - Chairman, President, CEO

No, we haven't.

Yiktat Fung - Zimmer Lucas Partners

Okay. And when is that contemplated?

Richard C. Green - Chairman, President, CEO

Right now we're waiting to see the progress made on the merger application, so we would say it'll be probably mid to late summer.

Yiktat Fung - Zimmer Lucas Partners

Mid to late summer. And right now the official, I guess, deadline for the merger is, I think, sometime in the beginning of May, but obviously the hearings are currently scheduled for after that. So should we just assume that it'll be extended, the merger's deadline will be extended sometime soon?

Richard C. Green - Chairman, President, CEO

I think it will be extended as we move up to the more ending point of August 6. Anytime we move back the date, any one of the three parties can move that date, and that just simply hasn't been formally done, to move it from May 1.

Yiktat Fung - Zimmer Lucas Partners

Okay. Thank you very much.

Operator

Thank you. Our next question comes from [Scott Kim] with Hadrons Capital. Please go ahead.

Scott Kim - Hadrons Capital

Great. Thank you. Just wondering how you are going to fund kind of '08 and '09 Capex. Is that going to be all internally funded?

Richard C. Green - Chairman, President, CEO

Well, the biggest - the expenditures at Iatan II are funded through an investment-grade facility that we have in place of $300 million. To date, we've spent about $85 million on Iatan II, but we have yet to draw down on the Iatan II facility. We've done that out of cash flow and cash from assets we sold. So that whole amount still is for us to use on the Iatan II expenditures.

And then of course, as Beth said in her presentation, with our equity ratio up toward 57%, we've got room to go to the debt markets if we need to in the near term.

Scott Kim - Hadrons Capital

Okay. Thank you.

Operator

Thank you. Our next question comes from Brian Tedale with Broadpoint. Please go ahead.

Brian Tedale - Broadpoint Securities Group

Hey, good morning.

Richard C. Green - Chairman, President, CEO

Good morning.

Brian Tedale - Broadpoint Securities Group

Just a quick question. I wanted to get your take. If things don't go your way in Missouri and the transaction does not go through, I was just kind of curious, is your thought now that the Black Hills portion could still go through or it's an all or none? I just kind of wanted to get your take there. And if there's that 289 break you talk about for '08 in terms of EBITDA and if you're comfortable sharing, what - is there a percentage breakout which is actually tied to Missouri and the Black Hills piece? Do you break that out at all?

Richard C. Green - Chairman, President, CEO

The transaction that we have signed is everything or nothing, so we would not do the Black Hills - could not do the Black Hills portion.

In the past, as we've talked about, even outside of this transaction, considering selling the number of properties that are in the Black Hills transaction, that would be value degrading to us simply because of the cash flow and profit that we would sell off and really wouldn't have much use for those many proceeds and have a considerable amount of leftover expenditures that we couldn't get rid of. So that is a consideration that just - we can't move forward.

Brian Tedale - Broadpoint Securities Group

Okay. Thank you very much.

Operator

Thank you. Our next question comes from Brent Siatre with Mallet Capital Management, LLC. Please go ahead.

Brent Siatre - Mallet Capital Management, LLC

Hi. I just have a quick question about Missouri. Where does Lewis Mills' suit with recusing the members of the commission stand? Can that be brought back or is that largely settled? And if so, how much of a delay would it be if they had to nominate new commissioners?

And I guess the follow-on question would be: What sort of vote at the commissioner level is required? Is it unanimous? Because I think it's now two and two. Does a tie go to the company? Does a tie go to the commission? Can you just tell me a little bit about how that works?

Jon R. Empson - SVP Regulated Operations

Sir, this is Jon Empson. The motion that Lewis Mills filed was denied by the commission. On his motion for reconsideration, it was denied again, so right now the commission actions are completed. We haven't seen any other action that he has proposed to take on that issue of recusal.

The vote has to be a majority of the quorum, so the four commissioners, you would have to have a three-toone vote or a twotoone if someone else did not vote. But you need a majority of the remaining commissioners with one, since Chairman Davis has recused himself.

Brent Siatre - Mallet Capital Management, LLC

Okay. And does he have any possibility of appealing that, you know, if he decided to, or is the word of the commission on - I mean, is that motion final?

Jon R. Empson - SVP Regulated Operations

He could choose to try to take some court action if he desired. I think his time is almost expired for that. We haven't seen anything that he intends to.

Brent Siatre - Mallet Capital Management, LLC

Okay. And if for some reason this does come back, they would just have to nominate new commissioners, wouldn't they?

Jon R. Empson - SVP Regulated Operations

Well, the commissioner - you really can't replace the commissioners. What you look at, and I think the importance of the filing that's been made, Mr. Mills' primary concern was that some of the specific issues that were being addressed with the commission were addressed in an ex parte manner.

Given the filing that's been made now on February 25 by GPE, virtually all of the issues have changed, so it's almost like an entire new case. So I believe his issues have really been addressed through the new filing. And you would have to have, I mean, that's the type of thing you would have had to have had in order to have this commission even consider it.

Brent Siatre - Mallet Capital Management, LLC

Okay, great. Thank you.

Operator

Thank you. Our next question comes from Terran Miller with UBS. Please go ahead.,

Terran Miller - UBS

Good morning, Rick.

Richard C. Green - Chairman, President, CEO

Good morning, Terran.

Terran Miller - UBS

How are you?

Richard C. Green - Chairman, President, CEO

I'm doing well. You?

Terran Miller - UBS

Just fine, thank you. Could you just give me a little bit more detail? You said you had $85 million in Iatan. You implied that you might draw down on the facility this year. I was wondering if you could tell us how much you anticipate being drawn at the end of the year? And I think you also mentioned that you're considering going to the bond market. How would that [verse] work, versus drawing down on the facility?

Richard C. Green - Chairman, President, CEO

Well, Beth will get to some of those other [nothers], Terran, but I think right now, with us closing the transaction in the first part of June, we wouldn't need to go to the bond market.

Terran Miller - UBS

Okay.

Beth Armstrong - Chief Accounting Officer

Yeah, the other thing to look at is that we have some significant short-term facility that we'll draw on during this peak construction period. We left a lot of facilities in place and in fact renewed that $50 million LC facility in December of 2007 so that we would have basically what's an overcapacity around our working capital requirement -

Terran Miller - UBS

Right.

Beth Armstrong - Chief Accounting Officer

So that we could provide some interim financing.

And then the environmental Capex is being placed in service in late '08 and '09, so, you know, if by any chance we would end up being in a situation to finance that, we'd probably look at something more permanent to put in place when those construction projects are complete on environmental.

Terran Miller - UBS

Okay. Thank you very much.

Operator

Thank you. (Operator Instructions) And our next question is a follow up from the line of Yiktat Fung with Zimmer Lucas Partners. Please go ahead.

Yiktat Fung - Zimmer Lucas Partners

Hi. I would just like to follow up on the Missouri regulatory schedule right now. Since Great Plains has filed their amended filing, I was wondering if - some parties have argued that since this whole new filing that you guys will have to just kind of start over and start the case again. What's your counterargument against that?

Jon R. Empson - SVP Regulated Operations

This is Jon Empson. Really, the argument isn't starting the case over again. We suspended the hearing on December 6. What we've done in this latest application is narrowed down the issues that were contained in the original application. So three new witnesses from Great Plains filed testimony, and the intent is to restart the hearing, basically, on April 21 and try to focus on the changes in the testimony that were made and just kind of pick up where we were before and then go on through with the synergy witnesses and other witnesses.

Yiktat Fung - Zimmer Lucas Partners

I see. So basically the argument is that there's no new issues being presented, it's just a narrowing down of issues?

Jon R. Empson - SVP Regulated Operations

Correct. It is just a subset of the original issues and just can move forward with the existing case.

Yiktat Fung - Zimmer Lucas Partners

Okay. Thank you.

Operator

Thank you. And management, I'm showing that there are no further questions. I'll turn it back to you for closing comments.

Jason Ketchum - Manager IR

We appreciate everybody's time this morning on the call, and, of course, other questions that occur to you, don't hesitate to give us a call so we can address those also. Thank you, everybody.

Operator

Thank you. Ladies and gentlemen, that will conclude today's teleconference. We would like to thank you again for your participation, and at this time you may disconnect.

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