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Executives

Jo Smith - Director of IR

Jim Pignatelli - Chairman, President and CEO

Analysts

Dan Eggers - Credit Suisse

Brian Russo - Ladenburg

Steve Fleishman - Catapult

Maurice May - Power Insights

UniSource Energy Corporation (UNS) Q4 2007 Earnings Call February 29, 2008 11:00 AM ET

Operator

Thank you and welcome to the UniSource Energy yearend 2007 conference call. Today's call will be hosted by James Pignatelli, UniSource Energy Chairman, President and Chief Executive Officer.

First, I would like to turn the call over to Ms. Jo Smith, Director of Investor Relations.

Jo Smith

Thank you and good morning, everyone. In a moment, Jim Pignatelli will brief you on UniSource Energy's 2007 financial and operating results and outlook for 2008.

However, I first need to inform you that forward-looking information contained in this call with respect to revenues, earnings, performance, plans, strategies, prospects and other aspects of the business of UniSource Energy may involve risks and uncertainties. Actual events and results may, for a variety of reasons, prove to be materially different from those indicated in the forward-looking statements, estimates and projections.

Factors that could influence actual future outcomes include but are not limited to the outcome of regulatory proceedings; the cost of fuel and purchased power; performance at TEP's generating plant; weather; resolution of pending litigation matters; the cost of debt to equity capital; changes in asset depreciable lives; changes in accounting standards; the pace and strength of the regional economy and other factors listed in UniSource Energy's Form 10-K and Q filings.

In addition, the forward-looking statements in this call may include assumptions, expectations, predictions, intentions or beliefs about future events. UniSource Energy cautions that actual future results may vary materially from those expected or implied in any forward-looking statements. More information about the risks and uncertainties related to these forward-looking statements are found in UniSource Energy's SEC filings, which are available on the SEC's website.

Now, I'll turn the call over to Jim Pignatelli.

Jim Pignatelli

Good morning. Thank you all for joining us today. Today, we are reporting our earnings for 2007 at $58 million or $1.57 per share. That is down from the $1.80 per diluted share which we earned in 2006. We are within the guidance we have previously provided which $1.50 to $1.75 for 2007.

However, I acknowledge we are at the low end of that. We're at the low end of that because of anticipated fourth quarter outages. We were pleased that our cash flow from operations once more exceeded $300 million during 2007 and that the Board saw fit to increase the dividend from $0.90 to $0.96, showing its confidence in our forward opportunities.

Looking at 2008, we are providing guidance of $1.70 to $2.20 per share. This guidance assumes that $65 million that we in revenue collected after the TRA is fully amortized and will be retained by the company, and I will talk more about that in a little bit. We are also projecting consolidated cash flow from operations to once more exceed $300 million and we are seeing an improvement in cash flow from operations from TEP.

Now looking specifically at 2007, as I indicated, the net income was down from $58 million at UniSource to $67 from $67 million previously. Majority of that decrease was at TEP, with TEP having net income of $54 million.

Primarily, we were down because of higher fuel cost and purchased power cost. We do not have a fuel clause. We have managed this business, all the time I've been here, 15 years, without a fuel clause. Our gas was up 24% in '07 over '06, our coal was up $12 million in '07 over '06, and our purchased power was up $40 million in '07 over '06.

We do need a fuel clause. We have filed for a fuel clause. We're confident we're going to get a fuel clause. Just in last eight year since we have had frozen rates, our fuel costs have gone up 55%. Those of you who follow natural gas know that it's gone up almost 200%. APS has a fuel clause, UniSource Electric has a fuel clause, UniSource Gas has a fuel clause, I'm confident we are going to get the fuel clause.

Our equivalent availability factor, even though we did have some surprises in the fourth quarter, we're still strong at 89.4%. That reflects excellent performance at our Springerville units with the equivalent availability factor in excess of 92% at Springerville. Offsetting the higher cost of fuel to some extent, we had an extremely hot summer. That sort of aggravated actually when we had to buy gas in the summer.

Our retail sales were up 5% or $37 million. Our cooling degree days were up 11% over 2006 and up 7% over the 10-year average. We're still seeing customer growth at around 2%. It is slowing slightly. We have been watching also our consumption per customer and over the last five or six years we have noticed that the usage per customer is going up about 1% per year. That's a reflection of different appliances which are being used by the customer of flat-screen TVs and, I think, the switching from swamp cooling to refrigeration.

As you all know, we are working through our excess coal, and our short-term wholesale revenues simply do not offset our increasing cost of gas and purchased power. Once again, I can't reiterate too strongly that the main impact which we are reflecting in our lower earnings comes from the cost of fuel in purchased power. And I am confident that beginning in 2009 we will have protection from the ever-increasing cost of fuel.

Looking at UNS Electric and Gas, their earnings were down slightly. Their customer growth is also slow to about 2%. It was running in the 4% range, if you recall 4% to 5%. We have seen a decrease in customer growth and we are reflecting that in adjustments to our capital expenditures at those entities.

UNS Gas received a rate increase effective December 1 of $5 million. We had anticipated that would come earlier also, but because of lag at the commission we did not implement those rates until December 1. We have filed another UNS Gas rate case already, and I'll talk about that in a minute.

Millennium currently has a cash balance of $31 million, and that's after we have dividended $15 million to UniSource.

Let's look at 2008 for a minute. I had hoped to be able to give you more information on 2009, but we'll have to wait that until after this evening. Our earnings outlook for 2008 is $1.70 to $2.20 per diluted share. As I said, this assumes a recognition of $65 million in the incremental revenue, which we will receive by maintaining our current rate level after the CTC drops off.

I feel that we have a legal right to those revenues. The last adjudicated rate case for TEP founded our rate levels were just and reasonable at rates that were actually 3% higher than our current rate of $8.04. There has been no determination that our rates were not just and reasonable at their current levels, and I think we have a strong argument that this potentially $65 million should be reflected in income this year.

Additionally, the termination of the CTC is only a function of the contract that we have with the commission, and it should all be bound up in that determination. I reiterate we did not raise our rates from what were established as just and reasonable when we started to collect the fixed CTC. We just increased our expenses, which were absorbed by you, the shareholder.

I believe that we will recognize this $65 million in the fourth quarter. Consequently, the second and third quarter earnings, which will be recorded, will be significantly below the 2007 levels. And we will not reflect the whole income until the final order is issued, which I would anticipate in December. The remaining CTC to be recovered is $24 million as compared to $78 million in 2007.

We continue to see customer growth at TEP at around the 2%, as I indicated. We are projecting another increase in our coal-related fuel expense of $18 million during 2008 over the 2007 cost. We have dropped our equivalent availability factor in our forecast to 87%. A lot of that reflects plant outages which we have.

We have a 3.5-month plant outage at Four Corners 5. We have a 1-month plant outage at Navajo 1. We have a 2-week outage at Springerville 3. We have a 2-month outage at San Juan 3 three. And then we have other miscellaneous outages. So you can see that the guidance of $1.70 to $2.20 anticipates the significant outages which are scheduled.

Just to give you a feeling, for every 1% equivalent availability factor is approximately $6 million pre-tax. So dropping from 89.5 equivalent availability factor which we recorded in 2007 to 87 is impacting us about $15 million pre-tax. All of this is included in the guidance which we are providing.

We have an issue at Springerville 1, which is causing a partial derating of about 10 to 15 megawatts right now. We have a four scrubber units at each unit. We have seen degradation in the inside of the scrubbers and we're in the process of repairing those. During repair, unless we can work while they are hot, that means gas is flowing through the inside of the scrubber, we have the derating units. So we are taking in a slight deration right now. Some of that which we anticipate in the first quarter is included in the guidance. It costs us about $18,000 a day when we have these derating.

Looking at our position on our forward sales, we have sold 287 gigawatt hours forward in 2008. We have remaining about 800 gigawatt hours for sale. We have hedged 33% of our gas at prices below what the current scripts are.

We continue our dispute with El Paso over our rights to transmission from Luna on September 6, 2007. An ALJ at FERC issued an initial decision, which fully supports our position. It's subject to confirmation by the FERC. If we're successful in adjudicating that or getting that decision during this year, we would have pending about $4 million to $5 million pickup in our forecast.

In the Millennium, we have included a gain in Millennium in 2008 in our forecast. We're continuing to harvest our investment and we expect to make a couple of sales at gain during 2008.

Looking at our regulatory update, UNS Electric, we're still waiting for an order from the ALJ on the UNS Electric case. We requested $8.5 million. Staff has recommended $4 million. The main difference between the $8.5 million and the $4 million is the inclusion of a new power plant in rate base.

If the new power plant is not included in rate base, we have submitted or will be submitting this week a request to be able to sell the power from the owner, UniSource Energy Development, UED, to UNS Electric. So, the $4 million is a little misleading as compared to the $8.5 million. We expect an ALJ recommended order by the middle of this month, March, and a decision soon thereafter.

As I indicated, we have filed another UNS Gas rate case. We filed at February 26. We told the commission when they authorized the rate increase in November that it was insufficient and we would file again. We have filed again. We're requesting a $10 million increase. I do not expect an adjudication of this case during this year. However, we do have the $5 million increase from the prior case, which will have a full year this year.

Looking at the TEP, which I know is on the hearts and minds of all of you, I had hoped to be able to give you a forecast based off of staff recommendation. Unfortunately, the Staff Attorney had an attack of gallstones. We wish him well. We gave them leave to file a week late. We expect their filing today.

We have retained the schedule, which provides that hearings will be held commencing May the 12th. We will endeavor to get the full staff report and [RUPO] reports on our website over the weekend. I hope we're able to do it, so that you will have a place that you might be able to access. It's our intention to try and get an 8-K out to you in the middle of next week or no later than the end of next week.

We do need rate increases. I believe that the commissioners understand that. Our prices are 3% below what they were in 1994. Our residential rate is approximately 15% below APS. Our residential rate is approximately 5% below Salt River. We currently do not have a fuel cost. There is no reason to expect that we will not get a fuel clause. There is no reason to expect that we will not receive some consideration and an increase in our base rates.

I believe that our arguments are compelling. When I look at a comparison of 1999 through 2007, the prices which we pay are 1.7% lower now than they were in 1999. The CPI has gone up over 26% in that period. You all know what steel and copper have done which are essential to our business and you know where our fuel costs have gone. I am confident that the commission understands that, recognizes that and will properly adjudicate this issue.

I am open to any questions you might have.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Dan Eggers of Credit Suisse.

Dan Eggers - Credit Suisse

Good morning, guys.

Jim Pignatelli

Hi, Dan. How are you doing?

Dan Eggers - Credit Suisse

I'm okay. Thank you. First question for you just on the fuel side for '08, how much of that is locked out or how much exposure do we still have if you've only put down a third of your gas needs? Is there still some risk that that number could put more pressure on guidance than what you have in right now?

Jim Pignatelli

We have 33% of our gas hedged from April through October, which are our main usage. So we still have some risk in that regard. The gas that we have hedged is hedged at about $1 under current prices. So we do have that. And actually we still have the risk of operating risk. I said we're providing guidance at an 87% availability factor. I'm confident I can run my units better than that. I'll leave it to others to run their units.

Dan Eggers - Credit Suisse

Fair enough. The next question I guess is what are you guys doing in preparation for the intervenor testimony tonight? Are you looking at trying to start settlement conversations in the next couple of weeks, at least to hammer out some of the big issues?

Jim Pignatelli

Yes. I believe we will sit down. We have requested the staff that we sit down. We're also looking at, once again, writing a letter to the docket and to the other parties saying it's time to sit down and discuss any type of amendment to the contract that we have with the commission that might be appropriate. That is something that, you know, as I have maintained all along we have a contract, we have contractual rights, we're willing to sit down and amend that contract. And we actually have an obligation that we notify any party which we believe is taking a position inconsistent with the terms of the contract. And after we review the testimony, we will be prepared to take that action also.

But to thrust your question, yes, I'm prepared to meet at any time to try to stipulate these specific issues, big issues, so that we can get to the real meat of the argument. And right now I think that the staff almost has to sit down. They are being inundated with rate cases. The process is breaking down in Arizona. And I think it's in everybody's best interest to sit down and try to reach stipulations on as many issues as they can.

Dan Eggers - Credit Suisse

Jim, do you carry risk? I mean you have a rate case, presumably Pinnacle is going to file a rate case here pretty soon, actually a few rate cases going, that we see this get delayed beyond 2008, just because of the fact everybody else is too busy. And if that happens, what is the next phase for '09?

Jim Pignatelli

In my opinion, Dan, this case is the priority case at the commission. If APS was to file another case, it would have to be processed after this case. So I don't think it would interfere with this case. I think this case will be decided this year. If you really look at it, there are at least three and possibly four commissioners that would be new if this case is not decided this year. Three commissioners are termed out at the end of this year. Commissioner Mayes is considering whether she runs for Congress. If she does, then she would have to step-off the commission.

So that means if they laid it over, there would only be one existing commissioner, one or two currently existing commissioners, it would have to almost start de novo. And I just don't think they would do that. I also strongly believe that under the terms of the contract, as I've stated before, what we naturally do on January 1, we have zero negative CTC. We charge the market generation amount, which is a defined amount, the CTC. And the negative CTC are no longer there. So we're at market. If there is no action taken this year, that's the natural consequence of inaction.

Dan Eggers - Credit Suisse

Got it. Well, good luck in that. Thank you.

Jim Pignatelli

Okay. Thank you.

Operator

Your next question comes from the line of Brian Russo of Ladenburg.

Brian Russo - Ladenburg

Can you hear me?

Jim Pignatelli

Yeah, Brian, now I can.

Brian Russo - Ladenburg

When we look at 2008 earnings guidance you mentioned earlier $18 million increase coal cost, right, and $15 million impact on lower availability?

Jim Pignatelli

Yes.

Brian Russo - Ladenburg

Okay. And what about the incremental purchase power? Is that in the 15 million?

Jim Pignatelli

Yes.

Brian Russo - Ladenburg

Okay. And also, historically, as you mentioned earlier, short-term wholesale sales were able to offset the fuel under recovery in base rates, and I guess now its flip-flopping where a few under recovery exceeds the margin on short-term sales. Can you give us a sense of how much or quantify how much more under recovery is relative to the short-term wholesale sales?

Jim Pignatelli

I really can't Brian. I can't give you that right now. I'll see if we can get it together and Jo would have an approximation of it.

Brian Russo - Ladenburg

Okay. And what would you estimate the TEP's actual earned ROE in 2008 relative to your guidance?

Jim Pignatelli

I'm looking at some advisors here to tell me, see if they can give a number. What did you say, Kevin? You can speak to that. Why don't you ask the rest of your question while they are trying to give me a number?

Brian Russo - Ladenburg

All right. And my last question is, can you quantify 2008 long-term wholesale sales and maybe give us a sense of the pricing on what you've already hedged?

Jim Pignatelli

The sales we've to-date, we have, as I say, the long-term wholesale sales -- long-term or short-term? Are you talking about the excess power, the 800 megawatts we haven't sold?

Brian Russo - Ladenburg

Right.

Jim Pignatelli

The prices we're seeing right now are flat first quarter of '08, $63.50. On-peak, it's $69.50, and off-peak, it's $56. Second quarter is flat $64.25. Third quarter is $83.75 and fourth quarter is $70.25.

Brian Russo - Ladenburg

Okay. That's my last question. Maybe if you just want to follow-up later on, on the ROE, that's fine. Thank you.

Jim Pignatelli

Okay.

Operator

(Operator Instructions)

Your next question comes from the line of David Frank of Catapult.

Steve Fleishman - Catapult

Yeah, hi. It's actually Steve Fleishman. Can you hear me okay?

Jim Pignatelli

Yes, Steve.

Steve Fleishman - Catapult

Okay. Thank you. A couple of questions. First, in the '08 guidance, what pricing are you using for your open positions, for example, gas you haven't bought? Are you using just the latest forward curve for '08?

Jim Pignatelli

Yes, latest forward curve.

Steve Fleishman - Catapult

Okay. And was that updated just in the last few days or it go back to the beginning of the year?

Jim Pignatelli

It was updated two to three weeks ago.

Steve Fleishman - Catapult

Okay. Because I know gas has moved up a lot recently, would it be materially higher now or not really?

Jim Pignatelli

No. I don't believe it's materially higher than what we currently have in our forecast just like the open long where we are in power prices. They've moved up a little over what I just gave the last question, I just gave Brian. So there is some offset in that any movement right now.

Steve Fleishman - Catapult

Okay. Another question, I know APS has had an issue with regulatory lag even having a fuel clause, given the historic test years in the state. I know most of your pressure seems to be fuel, but are you also seeing capital and O&M cost go up? Even if you get an outcome, would you be able to earn a return?

Jim Pignatelli

I am confident we will. I was laughing. I am sort of looking at 11 year regulatory lag right now. We are seeing increases in our capital, but manageable in our side. We don't have the growth rates that APS has. And our capital seems to be a little bit more manageable than theirs.

I had a lot of discussions about this specific issue with the commission, and I know that APS has had equivalent amount. I think you're going to see a movement in the next couple of years to a combination of some elements of the rates being set on a forward look. I think you're seeing that in APS's fuel clause now. I think you're going to see more and more of the expenses being looked on a forward, if possible, and I think you're going to see some movement towards some elements of construction work-in-progress in rate base.

I think the commissioners and the staff understands it. The current process is arguably not working for APS and I think you'll see some changes in that. If we get a properly constructed fuel clause and some rate relief, I believe that we'll be able to earn our authorized returns.

Steve Fleishman - Catapult

Okay. One last question. If you look at kind of a clean year '09 with rate release and assume you could keep rates essentially flat as you've talked about before, it seems like '08 is a bit of a bad year from operational standpoint, et cetera, but what would the earnings power be in '09 in that scenario?

Jim Pignatelli

I have my ideas right now, but actually I'm a little too far right now. We will wait till after we see what the staff is recommending, et cetera. There are too many moving parts right now.

Steve Fleishman - Catapult

Okay. Thank you.

Operator

Your next question comes from the line of Maurice May of Power Insights.

Maurice May - Power Insights

Yes. Good morning, folks.

Jim Pignatelli

Hi, Maury.

Maurice May - Power Insights

A couple of question on power plants, first of all, what do you call it, the Black Mountain CT that you want to try to get in the rate base at UNS Electric. Can you go through your efforts to get that in the rate base in the current proceeding?

Jim Pignatelli

Yes. We requested it to be put in the rate base. It's about $60 million investment for about 90 megawatts. We have to put it in rate base. It's owned by our development end, it's not owned by UNS Electric. We put it in the rate base, and staff has said it wasn't in rate base in the test year. Actually it's just coming in to operation here in April. So they said don't just get an accounting order that says you can defer these revenues. That doesn't give me any cash. That doesn't solve the issue.

We indicated in a strong fashion in our case that we wanted it in rate base as a post-test year adjustment. I don't know where the ALJ is going to come down on this. That's why we are filing a contract between the two companies. It's in the consumer's best interest to put it into rate base. It helps the company's capital structure at UNS Electric, and it's a cheaper way to go than to buy the power on as available basis. Once again, this company has a fuel clause, so whatever the cost of purchased power, it's going to flow through directly.

We believe our case is compelling. If they don't present a rate base, then we'll sell it under contract and we'd probably get a higher return on it. If they don't allow the contract, then we'll sell the power to Nevada Power or somebody else or I'll sell the plant. But we're not going to give free capacity out of this plant to the consumer until our next rate case. So that's where I am on it, Maury.

Maurice May - Power Insights

Okay. And my second question has to do with future capacity at Tucson Electric because your supply situation seems to be tightening up even with 89% or 90% availability. So what are your plans for our new peakers in the Tucson area?

Jim Pignatelli

We project the need for additional power plants, my recollection out in 2012 to 2014 timeframe. A lot of work we're doing now is there is still excess capacity in the region, and a lot of our CapEx now is more directed at transmission and import, and actually all the utilities that we're working with Salt River and APS to improve the transmission grid in Arizona.

Like I say, we start to see the need for more peaking out in the 2012 timeframe, and that's when we're sort of looking at those additions.

Maurice May - Power Insights

There is 2,200 megawatts at the Healer River plant. Do you have transmission now that can get that power into Tucson?

Jim Pignatelli

We can get some of it. That's one of the modifications in the transmission system that's been steadied. I think we can bring a couple of hundreds megawatts currently and we're trying to increase that.

Maurice May - Power Insights

Okay, all right. Thank you very much, folks.

Jim Pignatelli

Thank you, Maury.

Operator

There are no further questions at this time. Do you have any closing remarks?

Jim Pignatelli

Well, thank you very much all of you for bearing with us in this extended regulatory process. I cannot reiterate too strongly my opinion that we deserve a rate increase, that we will get a fuel clause, and we will stop this 10-year regulatory lag that we've have had.

Thank you so much. We'll get everything posted as fast as we can. And anybody that has any specific questions, please don't hesitate to call Jo. And I will see many of you in New York week after next. Anybody who wants to sit down one-on-one, please give Jo a call.

Thank you so much.

Operator

This concludes today's conference call. You may now disconnect.

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