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Executives

Dennis Barber - IR

Mark M. Jacobs - President and CEO

Brian Landrum - EVP and COO

Rick Dobson - CFO

Analysts

Daniel Eggers - Credit Suisse

John Kiani - Deutsche Bank

Lasan Johong - RBC Capital Markets

Gregg Orrill - Lehman Brothers

Brian Chin - Citigroup

Elizabeth Parrella - Merrill Lynch

Michael J. Lapides - Goldman Sachs

Vikas Dwivedi - Morgan Stanley

Reliant Energy, Inc (RRI) Q1 FY08 Earnings Call May 1, 2008 9:00 AM ET

Operator

Good morning ladies and gentlemen. My name is Tina and I will be your conference operator today. At this time I would like to welcome everyone to the Reliant Energy First Quarter 2008 Earnings Conference Call. Thank you. At this time I would like to turn the call to Mr. Barber.

Dennis Barber - Investor Relations

Good morning and welcome to the Reliant Energy first quarter 2008 earnings conference call. Leading the call this morning are Mark Jacobs, our President and CEO; Brian Landrum, Chief Operating Officer and Rick Dobson our CFO. Following our prepared remarks, we'll have a question-and-answer session. Both our earnings release and the slide presentation we are using today are available on our website at www.reliant.com in the Investor section. A replay of this call will also be available on our website approximately 2 hours after the call.

I want to remind you that consistent with our past practice, we are using several non-GAAP measures which we believe provide additional insight into our operating results. Reconciliations of the non-GAAP measures to GAAP figures are available on our website. Let me point out two items that we adjusted for during the quarter. The first is unrealized gains and losses on energy derivatives which is an ongoing adjustment, and the second is a $34 million charge for some legacy natural gas related litigation. Additionally, as many of you know, we update our outlook each quarter using forward commodity prices. The current outlook uses forward commodity price as of March 21st, which was the last Friday of the quarter, for which there was a traded contract for April.

Given our recently announced sale of the Bighorn Plant, we have removed it from the outlook beginning in Q4 of this year. 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 filing.

I'll now turn it over to Mark.

Mark M. Jacobs - President and Chief Executive Officer

Thank you, Dennis, and welcome to this morning's call. Here are today's headlines; we have made good progress in our 2008 priorities. First quarter results are well ahead of last year for our key earnings in cash flow metrics, and we expect continued improvement in those metrics for the next several years.

On slide 3, we have outlined our 2008 priorities. You'll remember we established these at the beginning of the year and this is how we are executing our strategy. A strategy which we believe will deliver superior values to our shareholders over time. Brian will provide some of the specifics on the priorities and I'll hit a few with the high points.

In the wholesale business, we expect improved fundamentals to translate into substantially higher profit levels over the next several years, and our portfolio of generation asset is well positioned to benefit from improved market fundamentals. Our highest priorities are focused on capturing the full value of that cyclical upturn. Several years ago we were not satisfied with the performance levels of our generation asset. You may recall that we had a commercial capacity factor up 79% in 2004. We developed a plan to significantly improve performance and we've made great progress.

In 2008, we expect to achieve over an 8 percentage point improvement versus 2004 level. Now, let me put that into context. We expect those operating performance improvements to deliver approximately $130 million of margins for 2008 financial results. Another component of capturing the full value of this cyclical upturn is a well functioning market structure. As many of you know electricity issues were discussed this year in Maryland. The state conducted a spirited debate on alternative market structures. But when the session ended last month, the Maryland assembly maintained its competitive statues. I think it was a positive outcome.

I have discussed the success of the PJM capacity market on previous calls. The key take away is this; auctions delivered over 10,000 megawatts of additional capacity to PJM with much of it coming from non-traditional sources such as demand response. To-date each of the PJM auctions has been catch up in nature. Next week, PJM will conduct a capacity auctions for planning year 2011. This will be the first one which provides enough lead times for a new gas-fired generation.

Turning to the retail business, we see the retail business as relatively stable in the near terms with attractive long-term growth. One of our key retail initiatives is Smart Energy. As we've discussed Smart Energy plays a big role in enhancing the value of our core Texas residential franchise.

Here is how I see it. Today, we sell a commodity in our retail business, but Smart Energy is a gain changer. It will transform the retail business into one that provides a value added service that helps customers buy a commodities and that's a fundamentally different and more valuable business.

Bringing a new technology to market involves many logistical, technological and operational challenges. But I am encouraged by the progress our team has made. My expectation is that Smart Energy products will become a reality for a substantial number of Reliant Energy customers in 2008.

The other principle benefit Smart Energy is to provide concrete proof point to help open other markets to competition and that enhances the value of our longer term growth option.

On the last quarterly earnings call Rick Dobson provided the details around our balance sheet and reinvestment model strategy. We believe that our commitment to balance sheet strength and the flexibility afforded by our investment models are distinctive among our peers. And we believe those concepts will contribute to superior returns to our shareholders overtime. I am sure all you saw our announcement last week that we have agreed to sell our Bighorn generation station to Nevada Power, a subsidiary of Sierra Pacific Resources. As you know our strategic focus is on competitive market.

Last years we explored the sale of four of our plants in regions that are not as far along towards the competitive model, Bighorn was one of those facility. We did not receive an attractive offer for Bighorn and we concluded that process last summer. But earlier this year Sierra Pacific approached us about its interest in acquiring Bighorn. And its offer of $500 million exceeded the value proposition of our continued operation as a plant. The transaction is subject to approvals from the Nevada Public Utility Commission and the Federal Energy Regulatory Commission. We expect to this close in the second half of the year.

I'm sure the question in many of your minds is, what are you going to do with the proceeds? The answer to that question is the same as what we will do with the substantial free cash flow we expect to generate over the next several years. We will use our reinvestment model to make those decisions. I discussed our approach on our last call but it bears repeating. Here is the way we approach investment decision, first, we're looking for alternatives that create the most long-term value regardless of whether they are new investments or returning cash to shareholders. Second, we use return on investment capital as our measuring stick. Third, we will thoughtfully consider all of the alternatives, that means evaluating alternatives across a wide range of scenarios not just looking at the economic given opportunity at one point in time. And finally, we will maintain an appropriate level of flexibility. Don't look for us to spend every dollar of free cash flow each and every month.

We have seen significant turmoil in the financial and credit market and we believe that financial flexibilities in this type of environment is an extremely valuable asset.

Turning to slide 4, I will briefly cover the financial highlights and Rick will review the numbers in more detail. Results for Q1 2008 were well ahead of last year on our key earnings and cash flow metric. As is our practice, we have provided a three year outlook based on forward curves for commodity prices. There are two key points on this chart; first, you see significant improvement from 2007 actual for 2010. And second, despite increased profit levels, the outlook is far below new intern economics through 2010.

In fact, if market prices supported a 7.5% greater return on new bills, it would translate into a $550 million increase in 2010 figure. You'll also note that changes in forced commodities prices had a meaningful impact on the numbers this quarter. I recognized that it is easy to get caught up in a, what did natural gas prices do or what did coal prices do in each quarter and in the near term they will affect our earnings and cash flow. But here is the key point; the fundamental tightening of supply and demand will have a far greater and more sustained impact on earnings and cash flow and this is the case in each of the wide range of industry scenarios that we evaluate. That in my view is the real value driver.

To sum it up, we are executing against the plan that we believe will create significant value for our shareholders.

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

Brian Landrum - Executive Vice President and Chief Operating Officer

Thanks Mark. I'll provide an operational view of our results for the quarter and the updated outlook. Later in the call, Rick will give a more detailed year-over-year comparison for the quarter and the changes for the outlook.

Let me start with an update on wholesale operations on slide 6. Results for the quarter and the outlook for our wholesale business continued to be influenced by tightening supply and demand with significant commodity price volatility.

Capacity payments and heat rates and PJM are higher, reflecting shrinking reserve margin. Natural gas was also up materially, it was offset by a large increase in coal cost. As a result, open contribution margin for the quarter, before and after adjusting for hedges, is up significantly over last year.

The outlook shows a drop in open contribution margin across all three years from high coal cost and slightly slower forward heat rate. Recall that we have largely hedged our coal needs for this year which causes the 2008 forecast of contribution margins after adjusting for hedges to be close to $100 million positive.

Our commercial team continues to be very effective managing our gas transportation position, which have increased in value by more than $100 million over the outlook. Consistent with Mark's comments, we believe it is more relevant to consider the full impact of tightening supply and demand on power prices then to consider solely the impact of movement in any specific commodity. To demonstrate this point, had we used commodity prices from last Friday rather than the end of March to update the outlook, open contribution margins would have been substantially higher than the outlook we are showing today. And if you take into account hedges would have been higher than our prior outlook.

Commercial capacity factor which is a measure of plant availability was above first quarter 2007 but below expectations due to higher than forecast forced outages at several coal plants. Better availability of higher margin plants however mitigated the financial impact. We expect commercial capacity factor to be 87.4% for the year and continue to be confident that we will achieve to top quartile availability in 2008. The PJM auction for planning year 2011 is this month. FERC recently ruled that since butane has asserted it will not be part of PJM in that planning year. Our assets in that region will be considered external resource. However, my believe is that under the order we have access to firm transmission right, giving us the same option of participating in the PJM auction as we have had in the past. Finally on wholesale, we continue to be on schedule to bring Cheswick and Keystone scrubbers online in 2009 at this plant.

Turning to retail on slide 7, overall contribution margins for the quarter was inline with the same quarter last year, and within expectations. The commercial and industrial business continues to perform well. The outlook for this segment is unchanged. Contribution margins for the mass business was within expectations for the quarter, but higher unit margins offsetting lower volume. As we have seen for the past few quarters, competition is intensifying in the mass business, especially on the residential segment. We had a net reduction of over 32,000 customers during the quarter. While our outlook incorporated some decline in customer accounts, our rate of loss is higher than expected. We also updated residential usage per customer in the outlook to be more consistent with our recent experience. As a result, the outlook for mass in 2008 is down by $18 million. We find this an unacceptable outcome and are committed to turning around this result. We have recently introduced more competitive products for the summer and increased our media and channel spending.

Look for changes consistent with the more competitive, differentiated strategy over the coming months. As Mark said, one of the ways we will differentiate the commodity element of our retail business, and shift the bases of competitions toward value added services in Smart Energy. You'll notice we included a separate line item for $11 million we have committed to spend in 2008 on Smart Energy. We continue to work with industry assistants and remain on track to be in market this summer with Smart Energy solutions. Customers will be able to lower cost and emission by shifting peak load to off-peak periods and by lowering usage overall. Last month, we entered the C&I segment in New York on time and within budget. This expansion grows the footprint of our successful C&I business and is our third new market entry in the last eight months. We believe New York also represents a possible mass market expansion opportunity which we continue to evaluate. As we have said previously, we view retail as a relatively stable margin business with a strong position in ERCOT, with growth potential via Smart Energy and new market.

Let me now turn the call over to Rick Dobson, our Chief Financial Officer.

Rick Dobson - Chief Financial Officer

Thanks, Brian. Let's start with our financial highlights on slide 9. We produced solid results in the first quarter of 2008. Our open EBITDA increased $58 million, primarily driven by our wholesale business result. Our adjusted EBITDA also increased significantly, up $137 million from 2007. The significant positive spread between open EBITDA and adjusted EBITDA was primarily driven by a lower historical power hedges and in the money, coal hedges which were procured before the first quarter coal price increase.

Let's turn to the wholesale business on slide 10. As I talk about the wholesale segment performance, I would like to remind everyone that we keep consolidated our Channelview project in the third quarter of 2007. This deconsolidation plays a role in many of the wholesale variances. It's a big piece of the $50 million negative economic generation variance and a portion of the positive O&M variance.

When it comes to the rest of the generation portfolio, improved plan availability, lower operating cost and tightening supply and demand fundamentals are the story, driving $57 million of open contribution margin improvements. These improvements were the catalyst for three positive margin variances. Numbers one, a $21 million commercial capacity factor improvement over 2007, primarily driven by fuel planned outages; number two, energy unit margin increases of $21 million; and number three, a $14 million improvement in other margins primarily driven by improved payment in PJM.

Lastly, lower O&M from fewer planned outages was a key driver of the $16 million positive first quarter variance.

Now let's review the retail business on slide 11. The $18 million negative mass volume variance was the result of a 0.6 terawatt hour decline in volume. The decline in volumes was primarily due to lower mass market customer accounts and milder weather. On the positive side, our commercial industrial volume results were stronger by over 1 terawatt hour. The C&I improved results couple with lower bad debt sort of offset our lower mass market performance.

First quarter overall retail margins were relatively consistent with the prior year. As we have said in the past, retail margin should be viewed more in a longer term basis because of seasonal and market supply shaping consideration. All in all, this segment continues to produce good free cash flow results in a very competitive environment.

Moving to slide 12, let's take a look at our first quarter 2008 cash flow. The main contributors to our $241 million of first quarter free cash flows are as follows; numbers one, tightening supply and demand in our four wholesale regions and improved availability of our plants drove $142 million of open wholesale contribution margin. Number two, coal procurement before the recent price increases, more historical power hedges and effective management of our gas transportation positions combined to add $45 million and number three, our retail segment contributed $66 million of contribution margin.

I am looking at the year-over-year variance, our improved earnings combined with lower interest payments are the primary drivers for the free cash flow increase. You will also recall that our 2007 refinancings accelerated interest payments from January to December.

Let's move to our 2008 through 2010 outlook on slide 13. The key take away here there is the significant free cash flow outlook which exceeds $2 billion over the three year period. Compared to our last outlook, retail contribution margins is marginally down, reflecting lower customers accounts and reduces usage by customers both in the mass market and some planned investments in Smart Energy.

The current outlook also excludes results from our big home facility beginning in the fourth quarter of 2008 and is based on commodity prices as of March 21st. In the appendix, we provide directional sensitivities related to the major commodity price drivers to help to provide free cash flow implications related to such price movements.

When you look at the outlook for ultimate full sale contribution margin, it's evident that increasing coal prices and more marketing implied heat rates exceeded increases in the TETCO M3 gas prices compared to our last outlook. Our 2008 coal procurements that occurred the coal prices began to significantly increase as the primary contributor to the increase in 2008 adjusted EBITDA versus our last outlook.

We have developed a flexible capital structure to account for all reasonable financial a commodity based market fluctuations as we moved up the tightening supply and demand curve. As we discussed last quarter, it makes sense for a company of our size current strategy and an uncertain market place to maintain permanent debt in the $2 billion to $2.5 billion range. This level of debt that allows for flexibility to create value in good environments as well as in more challenging time. Going forward, we intend to actively manage Reliant capital structure in a way that balances our primary goals of delivering long-term shareholder values with a need to provide adequate liquidity to manage our business thought the market cycle.

Now, let me turn it over to Mark for some concluding remarks.

Mark M. Jacobs - President and Chief Executive Officer

Thanks, Rick. Let me ramp up on slide 14 with a summary of key points. In the wholesale business market fundamentals are pointed towards substantially higher levels of profitability in cash flow over the next several years but the most important point is that the outlook for 2010 is still below new entry level.

In the retail business, we have a solid core franchise and we believe that success in Texas will lead to other mass market retail opportunities overtime of 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're ready for questions.

Question And Answer

Operator

[Operator Instructions]. Our first question will come from the line of Dan Eggers with Credit Suisse.

Daniel Eggers - Credit Suisse

Hi. Brian, I was wondering if you could just give us a little more color or a little more precision around what the EBITDA or the opening EBITDA numbers will look like if you had to mark everything to today's market. I think you guys unfortunately could try one of the low points in the gas curve one you guys using March 21 days?

Mark M. Jacobs - President and Chief Executive Officer

Yes Dan, it's Mark. Let me make a couple of points here and then I'll have Brian fill in some of the details. As I think about the outlook, there is a couple of key points, the first is that the 2008 to 2010 big years are significant higher than where we've been and when you dissect those numbers what you see is the bulk of that increase is the affect of tightening supply and demand fundamentals and that shows up this capacity revenue largely from the PJM RPM capacity auctions. The second point that you hit on is that we do use the forward commodity prices at one point in time, is been our practice. We used the last Friday for which was the forth traded contract for the next month. And, so in this case it was March 21st. And as I commented in prepared remarks, commodity prices are going to move around. They are going to impact what that outlook looks like in the near term and that's what you see going on with this quarter. Ironically, and Brian is going to fill in some of the numbers for you here but ahead, we would have gotten a very different answer had we used a curve at the end of April rather than at the end of March which is a forward curve now that has come and gone.

I think the most important point though is that the commodity prices moves that we are seeing don't have anything to do with where we are in the cycle. And that's really the key factor when I think about what will drive our earnings and cash flow levels if this company over the next several years. We believe that we are coming out of the profit cycle and we've got several years in front of us with tightening supply demand fundamentals. And then you add into that the 2010 is still well below new entrant levels. Last point, I'd make here too is that when we look at some of the assumptions imply that came out of that March 21 forward curve, there are some things to us that didn't make a whole lot of sense or line-up with our fundamental view, namely that we've seen a decline in heat rates here than just as not consistent with what our fundamentals expect.

Brian Landrum - Executive Vice President and Chief Operating Officer

Dan, this is Brian. If you do take the Friday, April 25th curves and you essentially kind of take a look here, the open contribution margin for wholesale lands and then in between where the prior outlook was and where the current outlook is. So, kind of roughly it's put the difference between the two over the course of the full three years. But if take into account our fuel hedges and our gas transportations positions and you remarked April 25th; the current numbers would be substantially higher than the prior outlook and even more so than the current outlook in the hundreds of millions range. And just to add to that that April 25 curve doesn't address the issue that Mark raised on heat rates. That April 25th curve also has a backward rated heat rates that don't really make sense given the tightening supply and demand in the level of the commodity.

Daniel Eggers - Credit Suisse

On the coal cost side, with the numbers that you guys saw or you talked that you showed in the guidance, so this consistent what's you're seeing right now and how much of a difference you think you would get if you were as you contract a year in advance like you guys normally do relative to what's bond is?

Brian Landrum - Executive Vice President and Chief Operating Officer

You know this is Brian again. Our approach to coal cost our approach to acquiring coal, we run an open wholesale because it's our view that the foreign curves don't yet reflect new build economics. And, so our approach to buying coal has been to buy at as closest to when we're going to burn it is possible. We want to take into account availability and operational constraints, and so that approach has typically led us to buy about a year in advance. But if availability in operational constraints change, then we would consider buying for and could get longer or shorter, depending on what those constraints are. As you look at our data here, we constantly monitor the market and we reevaluate our coal procurement approach, our wholesale [ph] and tactics. And so as you can see in our outlook we are largely hedged for 2008 and we are partially hedge for 2009; and to your question on prices, those prices since the March 21st mark are up. Further you'd also note that gas is up substantially as well from March 21 to April 25th.

Daniel Eggers - Credit Suisse

Okay. And I guess this is one last question on the retail side of the business. Where do you guys seeing as far as the willingness that people assign term contracts, how is that makes looking between at a month-to-month product versus 12 and 24?

Well, the only step back and talk about retail a little bit more generally for a minute. But what we have seen lately in the market and we have recently introduced a much more competitively positioned two year product with a 10% summer savings associated with it, and we've seen strong response to that. So our view of what the mix between term and month-to-month is going to be that hasn't really changed overtime as far as we can tell. We still operate about half our business on term contracts, on the mass side.

Operator

Our next question will come from the line John Kiani with Deutsche Bank.

John Kiani - Deutsche Bank

I know you made some comments on retail Brain, I guess on the fourth quarter call, the company increased its retail in mass margin per megawatt hour assumptions, and now it looks like the retail volume and gross margin forecasts are down for 2008 through 2010. I am trying to understand what caused the change over the last 3 months? Is it increased competition from TXU and other retail electric providers?

Brian Landrum - Executive Vice President and Chief Operating Officer

Yes. Let me comment this more broadly John for a minute and just talk about the outlook for retail income in full. The first thing I'd say is our commercial and industrial business continues to perform very well. The outlook for that is unchanged and so the bulk of the change you see in the outlook is on our mass market business. The primary changes in that outlook are usage for customers and through a lesser extent customer account. So the unit margins are not substantially different between this outlook and the prior outlook. One thing I'd say about the kind of point here is that we have taken a more conservative view of the pace at which our segmentation efforts will impact our mix of customers and thereby our usage for customer.

As we have said before, competitive intensity in mass business kind of adds and inflows through time and we've seen that through prior periods. For the last few quarters, competitive intensity in the residential segment is up, which has caused our customer counts to decline. I'd say that the level of competition now can change in different environments such as we saw in late 2005, when the first half of 2006 with much higher commodity cost. I would say retail is strategic to this. It's a the core business and as a platform for growth through Smart Energy and new markets. And as I said in my prepared remarks, we find our customer account outcome unacceptable and we are going to respond with a competitive value propositions. And in fact we are already in market with new products and increased spending in mass media and channels.

John Kiani - Deutsche Bank

Okay. That's thanks Brian, that's helpful. And then on the comment about the about your Ducane assets and having obviously the opportunity your option to bid those in to the PJM [auction using FTRs, how should we think about the cost associated with those FTRs as we are trying to model and get a handle on gross margin and EBITDA forecast?

Brian Landrum - Executive Vice President and Chief Operating Officer

What I'd say at this point John is that, we have decisions to make, still the FERC ruling is not final on this and our we were still on the process of working out those details like I can't give you any specifics at this time. We do believe that the bulk of our economics will be kept hold as a result of this Ducane relationship or Ducane filing with FERC.

John Kiani - Deutsche Bank

Okay. So, in other words if you bid the assets into PJM there is an incremental cost for FTRs but you think that you will recover that cost. Is that what you are saying?

Brian Landrum - Executive Vice President and Chief Operating Officer

John at this point I can't give detail. Don't how this is going to work exactly.

John Kiani - Deutsche Bank

Okay. Thank you

Operator

Our next question will come from the line of Lasan Johong with RBC Capital Markets.

Lasan Johong - RBC Capital Markets

Yes, good morning. Couple of questions, I am a little probably [ph] as to why your free cash flow in the second, third and fourth quarters amounted basically zero. It looks like the first quarter was $241 million and the same is before year end number results of 241 million?

Rick Dobson - Chief Financial Officer

Lasan, it's Rick Dobson. The full year number in the outlook is a little over $600 million. So, there is another 400 to go in the next three quarters.

Lasan Johong - RBC Capital Markets

Did I misread this chart?

Rick Dobson - Chief Financial Officer

I think so.

Lasan Johong - RBC Capital Markets

Must have misread something, my apologies. Second, on CenterPoint is looking out to do a smart metering program and that's going to probably start rolling out in '09 and my understanding is that the retail providers get to select which of their customers will get to smart meters? a) how are you going to decide who gets the meters is limited quantity and two, around those smart metering program it seems like there is a lot of opportunity, especially on the CNI side to deliver some enhanced products that could potentially be margin enhancing opportunity that a smaller representative could not provide. So, kind of what programs could you considerably introduced to take advantage of that?

Mark M. Jacobs - President and Chief Executive Officer

Lasan, it's Mark. Let me just give you kind of an umbrella view with the Smart Energy again. And then Brian can tell you around some of the details with CenterPoint. You here us on exactly the point how we thought about this, and I made this comment in the upfront comments. Today our retail business sells a commodity and the bases of competition is largely priced. There is some brand element to it. Customer service plays a role but it's largely a price competition type of business. What Smart Energy is that is an ability to transform that business into one where is it a value added service business that I think over time will have substantially increased kind of barriers for us if we are providing more value to consumers. And so it's something that we are incredibly focused as a company and something that we believe can be very transformational in terms of not only our business here but the industry.

Brian Landrum - Executive Vice President and Chief Operating Officer

Lasan as a brand, the $11 billion that I mentioned in the prepared remarks for 2008 is for a program to serve on the order of thousands of customers that is beyond the scope of a pilot. Any future investments we want to do around Smart Energy be based on our learning from this year and the potential to create value for customers going forward. And we are working closely with all the TDSPs and are cut all the wires companies and their cost around the meter rollout and expect that we'll get just some were allowed in 2008 to the customers on an on demand basis and then beyond that through 2009 we will be able to hopefully following behind their programs really lot more aggressively,

Lasan Johong - RBC Capital Markets

No, it's not reliant that's going to select it, the customers you are using will request it.

Unidentified Company Representative

The broad idea for 2008 is that we would market these services to customers, and customers will choose the services and then, the meter will go to customers on an on demand basis.

Lasan Johong - RBC Capital Markets

Can you give us an idea of what kind of services you intend to provide and how much you have a charge for it?

Unidentified Company Representative

Well, this is part of what we would like to do, that competitively differentiates this one and probably will let you know what that is once you role it out to customers.

Lasan Johong - RBC Capital Markets

I got you. I am little still confused about the forward forecast, because if you look at the February presentation, if I am not mistaken the gas prices that were there were still lower than what was shown in the 321 version but coal prices have gone up about 50%. So, from where I see the impact is not gas price but it's actually coal price. And it was not just gas price is coming down, it's coal prices going up that have made the big difference, that's the way we all look at it?

Unidentified Company Representative

Yes, on the one hand, relative to the end of December, compared to the end of March forecast gas is up a little bit, it's up sum in '08 and it's up a little bit in 9 and 10.

Lasan Johong - RBC Capital Markets

Yes.

Unidentified Company Representative

And 10 is about. You are right coal costs are up in almost two marks, but also heat rate... market implied heat rates were down across two marks as well.

Lasan Johong - RBC Capital Markets

So the combination of heat rates and coal prices?

Unidentified Company Representative

Right.

Lasan Johong - RBC Capital Markets

I see. By the way, Rick of you look at page 4, or the outlook, it's page 4 of the presentation, there is $241 million free cash flow in '07, I am sorry '08, no, I am sorry, I did miss read this '08 never mind, I miss read it. The last question I have is on the expansion possibilities in New York for retail. Are you looking at it in terms of the entire New York, New Jersey, Connecticut metropolitan area or you just focus on New York and kind of what would incentivise you to step in and do a mass marketing business in this area?

Brian Landrum - Executive Vice President and Chief Operating Officer

Well, Lasan this is Brian again. We view the strength of our ERCOT mass business as a platform that will allow us to enter new mass markets. We have talked before about the capacity of our infrastructure to handle a substantially larger number of customers. What we look for and going into new mass markets, is we looked for workable market rules and distinct value proposition that we can bring into that market. And we can match those up then we will significantly consider entering a mass market as long as the economics makes sense.

Lasan Johong - RBC Capital Markets

But what would change between now and that decision point that would actually make you think that would be the case?

Brian Landrum - Executive Vice President and Chief Operating Officer

Well, there a number of variables that we look at through time, everything from the way the markets repriced, the default price to what smart energy opportunities might be available to us. So, we look across all the dimensions of different forms of rules and value proposition to see what we could come up with. One thing I say is New York is a big important for us and we are evaluating it carefully and to your question we are really talking about the New York ISO and then typically we start with certain utilities within the ISO's and then expand from there.

Lasan Johong - RBC Capital Markets

I see, does that mean that you might potentially look at buying generation in this area as well?

Brian Landrum - Executive Vice President and Chief Operating Officer

Well, Lasan we like the New York market, I could see it, but I really keep that conversations separate from the retail business, the way we think about those, those are separate parts of the value chain, we don't need to own generation assets to have a successful retail business, that being said, we have talked about over time we would like to add two more size of our generation fleet. But it has to come at a price where there is a long-term return on invested capital proposition for us.

Lasan Johong - RBC Capital Markets

I see, so the recent acquisition of TransCanada was kind of...would call out of the voice targets that you would kind of look at?

Brian Landrum - Executive Vice President and Chief Operating Officer

Well, I don't think it's appropriate for us to comment on specific transaction. Again I think as we have described the criteria of how we would evaluate acquisitions, we do believe there is a value proposition there, but again the key determiner, key factor is the what is the cost of bringing that asset into the portfolio and will that yield over its lifetime an attractive return on invested capital that exceeds our cost to capital.

Lasan Johong - RBC Capital Markets

Got it.Thank you very much.

Operator

Your next question will come from the line of Gregg Orrill with Lehman Brothers.

Gregg Orrill - Lehman Brothers

Mark what is your view, where we are in the cycle, about kind of the window for buying generation asset? And beyond that how do you think about evaluating the different assets sort of around the country what would be the screening criteria be?

Unidentified Company Representative

Sure, let me Greg take those, those are really two different questions. Let me first deal with the kind of where are we in the cycle. Our belief is that the power industry is the fairly long cycle business given the construction cycle we see and I don't whether that's 10 years or 12 years peek-to-peek or trop-to-trop but it's something in our view in that order of magnitude.

We believe that we... our coming out of the trough period here that we hit over the last couple of years, our expectation is for the next several years certainly through our outlook carried and beyond that we expect market fundamentals to continue to improve and that to translate it to higher level of profitability. And invariably at some point we do expect that we are going to overbuilt as in industry here and we will repeat the cycle. There is a lot of things that get into the second party of your question of asset values and certainly where we are in the cycle has a lot to do with that. We saw extremely depressed asset values going back over the last couple of years where you saw transactions at a very significant discount to replacement costs. We did see then a rapid acceleration in those values; largely driven I would add by private equity coming into the sector and fairly easy credit conditions.

Now those who have changed and so we really haven't seen very much M&A activity transpire since that credit double burst. So, I think it's a little bit early to tell. I said I think you got competing factors here. On the one hand you have the supply demand fundamentals that are improving, that should yield higher prices but on the other hand the financing market conditions are such that we may see a little bit downtick in that. here but again, that's something we are watching very carefully and again the approach that we've outlined is a very disciplined approach as we are looking for the opportunities where we think we can get an attractive, greater return over the life of the asset recognizing the cycle's cyclical nature here in the business. And we expect and plant to be opportunistic, when we see those here but we are also don't feel compelled to go out and acquire things just to acquire things.

Gregg Orrill - Lehman Brothers

Okay, thanks.

Operator

Your next question comes from the line of Brian Chin with Citigroup.

Brian Chin - Citigroup

Hi. Mark you opened up your comments with the statements of the capacity markets had added an incremental 10,000 megawatts of supply. And then you further on later said, that the supply and demand fundamental continued to retightening. How I square those comments? Is it basically what you are saying is that, you still see this fundamentals tightening but let's the time to recoveries get pushed out a little bit more or kind of... how I should square those comments?

Mark M. Jacobs - President and Chief Executive Officer

Brian,the other follow on comment I made is that when you look at the capacity additions for 10,000 megawatts, most of that has come from non-traditional sources. So, that would include demand response; that would not mothballing units and in fact there is a couple instances we were going to mothball our Brunot Island plant and elected not to when we saw the impact of those auctions. It would also include bringing back facilities from mothball status. So, we really haven't seen a lot of new generation that has been bid into the RPM market yet, and as we look at the economics as you know, the RPM is a zonal type of market. On the Eastern part of PJM we do see economics today that we think will generate some new build into current options. When you look out further West to Western part of PJM, RTO and the like, those figures are still well below new entrant economics. So, our expectation is you are not going to see a lot of new build that gets bid into the auction in those regions.

Brian Chin - Citigroup

So, I guess that the recent fallout in market heat rates, to be fair to say your view is that's more of a temporary dislocation between power prices and gas prices as opposed to a fundamental addition of capacities that people weren't expecting those going to be there say like 6 or 7 months ago?

Mark M. Jacobs - President and Chief Executive Officer

Yes and Brian we certainly don't see anything when we look at the fundamentals that would indicate that we are to see declining hear rates and to the contrarily we... the market clears in the dailies, we have not seen that either. So at the end of the day, there is this power market when you get into the daily market acts economically rational. Things clear, where they should.

Brian Chin - Citigroup

One last question on this?

Mark M. Jacobs - President and Chief Executive Officer

Yes.

Brian Chin - Citigroup

Aside from the demand response resources that you are saying coming online, who are the entities that are proposing those remaining megawatts, those 10,000 megawatts? Is that the integrated utilities, is it equity players? I mean there is sort of an undercurrent of thought out there that says that some of the integrated utilities might be proposing megawatts in order to maintain the capacity market structure and sendoff against vertical push back against them. What's your thought on that?

Mark M. Jacobs - President and Chief Executive Officer

Yes. That would really be more appropriate for those entities to comment on. Again I think we can certainly comment on what we have done and how we have approached it here but I don't think it would be appropriate for us to comment on how others are thinking about it.

Brian Chin - Citigroup

Could you at least comment on who is adding additional megawatts that you have seen outside of the standard response units?

Mark M. Jacobs - President and Chief Executive Officer

As I said there hasn't been a lot of new that has been did into the markets, but I don't have in front of me Brian that list. We can certainly follow-up with you on that.

Brian Chin - Citigroup

Okay. Great, thanks.

Operator

Your next question will come from the line of Elizabeth Parrella with Merrill Lynch.

Elizabeth Parrella - Merrill Lynch

Few questions. First on Bighorn, what was the impact on the outlook from removing Bighorn, from let's say on adjusted EBITDA standpoint?

Rick Dobson - Chief Financial Officer

Elizabeth its Rick, Taking Bighorn out, when you think about 9 and 10 would have been about 70... $65 million or 70 million EBITDA proposition. That would have been the reduction in the outlook due to just extracting the Bighorn 600 megawatt facility.

Elizabeth Parrella - Merrill Lynch

$65 million to $70 million a year on average for '09 and '10?

Rick Dobson - Chief Financial Officer

Total.

Elizabeth Parrella - Merrill Lynch

Total over the two and a one quarter years, is that right, I think you said you took it out for the fourth quarter of this year as well or?

Rick Dobson - Chief Financial Officer

That's right.

Elizabeth Parrella - Merrill Lynch

Okay, so for the cumulative impact two in a quarters year $65 million to $70 million.

Rick Dobson - Chief Financial Officer

Yes, that's correct

Elizabeth Parrella - Merrill Lynch

Okay, and then turning to slide 17 and this probably a question for Brian. It looks like you put on material amount of coal hedges for 2009, since the last call or really since late December I guess would be the way look at it. Looks like you are now about is it 45% to 50% half you can help us on that a little bit and also, since there isn't a lot of sort of visibility, in the coal market beyond say '09 could you tell us what coal prices would have been in the comment you made about the commodity curve as of the end of last week. What would the '09 and '10 market prices to stay in that scenario?

Brian Landrum - Executive Vice President and Chief Operating Officer

I can talk to the '09 position pretty quickly here Elizabeth. The thing I talked about when I talked about how we buy coal before, is that we look at trying to buy as close to when we burn, but we take into account an operational and any sort of availability constraint and as we look at 2009 and we got into the early part of the year. It was our assessment that it was good time to start giving some of those positions, especially the volumes lined up and then to get volumes lined up for some portion that we had to get the priced. So, what you are seeing here the 2009 outlook is that we did go ahead and acquire some '09... coal for '09 deliveries and that's above the volume that we acquired and so that's the volume that we have priced that we acquired. On the question around the mark for coal, we're going to have to get back down on that one I have to look at my sheets for that.

Elizabeth Parrella - Merrill Lynch

Okay, and then a question for your retail as well. Trying to find which slide number this was on, slide 28. In the past you've broken out your gross margin per megawatt hour assumptions between the C&I and mass market business and I realize you indicate that you didn't really think much of the change was due to a decline in the unit margin than it was mostly volume. So, just wondering why didn't kind of continue to break it out that way?

Unidentified Company Representative

Well, Elizabeth as I said, we are in period of increasing competitive intensity around our mass business and its our judgment that, that degree of information around our margin structure, our margin model on the mass businesses is competitive information and we were from my perspective a little bit unique in that, we were providing that information to the competition and our judgment is that we are better off with the blended view

Elizabeth Parrella - Merrill Lynch

That's really versus --

Unidentified Company Representative

Yes, we were... are still reporting on an actual basis.

Elizabeth Parrella - Merrill Lynch

Yes.

Unidentified Company Representative

The break out of the margin but I think Brian has said here as we look about kind of our perspective, how much of margins we expect are in by classic competitor edges, really competitive recent information.

Elizabeth Parrella - Merrill Lynch

Okay. And just in terms of this would go to more the contribution margin piece of retail, but have your assumptions in terms of advertising spending, etcetera, have they been increased since the last commentary?

Unidentified Company Representative

If you look at the outlook, the detailed outlook page, you will see...levels of spending are roughly constant with what we had before. So the spending we have got is reflective of what we think of full year spending will be. But we... our spending for the summers.

Elizabeth Parrella - Merrill Lynch

Okay. I am just wondering why it hasn't really gone up much, because it sounded they are going to be, kind of increasing your...increasing advertising or different... looking at different channel to communicate your efforts or marketing efforts?

Unidentified Company Representative

I would just that what we are doing now, its higher than it was in the early part of first quarter. But it's still consistent with the outlook.

Elizabeth Parrella - Merrill Lynch

Okay. Thank you.

Unidentified Company Representative

Elizabeth it's Rick, I had a little bit of brain cramp there. That 60-70 million is a more of a contribution number, think about EBITDA on the 30-40 million range that would been extracted. So I want to kind of clarify that.

Elizabeth Parrella - Merrill Lynch

Okay, I am sorry. So, that was the contribute number and the EBITDA number would have been in the?

Unidentified Company Representative

30 to 40 range, yes.

Elizabeth Parrella - Merrill Lynch

Again on...

Unidentified Company Representative

For all 3 years.

Unidentified Company Representative

That would be for all 3 years, yes.

Elizabeth Parrella - Merrill Lynch

Cumulative impact?

Unidentified Company Representative

Yes cumulative impact.

Elizabeth Parrella - Merrill Lynch

Thank you.

Operator

Your next question will come from the line of Michael Lapides with Goldman Sachs.

Michael J. Lapides - Goldman Sachs

But actually I have four separate questions, I will try and be really quick. First question, would love your view on additional potential non-core assets sales, meaning, I don't know plains like [indiscernible]. Second, do you have a fundamental view on Appalachian coal prices; they are up at about $95 a ton right now. Just curious if you have a view on kind of where long-term or likely settle. Third would love your thoughts on what the Senate Bill 221 in Ohio really means for wholesale market in the MISO and four quick question your city gone a billion dollars of cash, and you can accumulate some more cash just wanted your thought on timing for when you are likely to make a decision about what to do with the cash. Thanks guys?

Mark M. Jacobs - President and Chief Executive Officer

Okay, Michael its Mark. Let me tackle a couple of those questions here. I think number one on asset sales, we discussed in the past and our focuses on competitive regions, and we previously conducted sale process to try to monetize, assets were not in competitive markets, but we are only going to do that, the way feel was value creating here for shareholders, we run the process last year, we did not, but we had opportunities to enter transaction they wanted values they made sense for us. I would characterize all of these facilities as very good assets in markets that we expect tighten over time, let me said Bighorn I think was somewhat unique set of circumstances, given the market affair and given Nevada powers overall and kind of their interest in what they were trying to do. So I wouldn't necessarily draw any conclusions from the Bighorn transaction that your gone see more these, but again we have expressed kind of right value accretive level. There we would be interested in again shocking our focus on the competitive markets, let me also take the question on what will we what to do with the cash and again I think a key point here in as you mention we are in a very good position here with the billion dollars of cash here and expectations, with the Bighorn sales proceeds and with additional free cash flow that we expect to generate, that we are gone to be very, very strong financial position.

We don't have specific time table for when we will make decisions here about that but I'd emphasize a couple key points. One is that what we have described here is a very flexible disciplined reinvestment model were not pre disposed any one alternative but really looking for the one that creates the most value for our shareholders. The second point I would make is that we think that it is in this type of market environment it is very prudent to maintain some additional flexibility. We think we are in a good position now, and financial flexibility is a valuable asset and pre maturely committing to what we are going to do with the cash in our view isn't consistence with either those two points and one of the ways I think about this, I think about Reliant Emery as a value based investor and let me use an analogy for you here. If we were investing in stocks and bonds rather then in power assets, we wouldn't decide today what stocks we will be buying next quarter or next year. But rather what we do is, we apply our investment philosophy in criteria against the opportunity set that we saw at the time and in a difficult market we might choose to keep more of our position in cash to help manage risks and make sure that we were positioned to jump into the market if we saw the right opportunity. I think there is lot parallels here for how we think about our situation now. So, I appreciate the interest in where dose the cash go and again we really comment this from, in our view maintaining that flexibility, doing this in a prudent way makes a lot of sense. Hopefully, we have described to you very clearly that methodology and approach that we are going to take in making those decisions, but we don't want to get out from ourselves in terms of making those or committing to a time-table up on which we will make them that just doesn't feel like that, our shareholders best interest

Brian Landrum - Executive Vice President and Chief Operating Officer

Michael, this is Brian on your Appalachia coal and we are not really in a position to give you our long term price view recall, what we can say is what we said before which is and we are seeing demand from sources that had not been in the market partly because of supply disruptions in other parts of the world on coal supply and that seems to have driven up prices. We think our view is that kind of the fundamental demand base hasn't change dramatically, and so the issue tends to in a question of when the supply disruption gets resolved in those other parts of a world and that will be the timing we see coal prices come back what we think a more equilibrium. There is also a point I would like to make about RRI operations which is in response to of these some increase in coal prices we've taken plans to about 20% PRB are in the process of operating that way and looking from additional opportunities to switch or blend in PRB in other stations. On your question on 221 Ohio we have to get back to you on that with some more specifics what I would say about my sale in general though is that the four conditionally accepted misers Phase 2 resource adequacy program which comes with and what's conditionally about it, as it comes with specific, unfortunate and compliant provisions for the load serving entities. And so we think that has possibilities for us to see a better more well structured capacity market we even the bilateral market we had today in MISO we think that this will provide benefits for that market structure.

Michael J. Lapides - Goldman Sachs

Okay thank you, just my question on the cash issue wasn't really an issue; one just came in the framework of how you do it, it's kind of more along the line of thinking about how long will you wait until you make a decision, because at the end of the day, if I am an investor, that cash is sitting on the books, earning a 4 to 6% rate of return right now?

Unidentified Company Representative

Yes, and again I appreciate the question and again I think, it's premature, Michael, for us to commit to when will we make the decision for cash that we don't yet even have in the Company and this is what we seeing for the last recent update in our outlook here, commodity prices can play a big role in kind of a timing that we see to cash. So, I think you are more likely to see us actually get the cash, and as I said part of what I have also tried to discuss here, a lot of that gets into the market environment, if we turmoil on the market uneasiness, this today continues to present us, we are going to be a little bit more conserved if just in terms of the timing upon which we are going to make decisions, and what we are going to do.

Michael J. Lapides - Goldman Sachs

Last time, you posted about 377 million of gap net income. What is that to the RP packet?

Unidentified Company Representative

Mike, come to that part [ph] it increases by about one half of that. So, its right round 60 million now.

Michael J. Lapides - Goldman Sachs

Okay, thank you.

Unidentified Company Representative

Peter will take one more question.

Operator

Your final question will come from the line of Vikas Dwivedi with Morgan Stanley.

Vikas Dwivedi - Morgan Stanley

Guys, actually, all 36 of my questions were asked and answered, so I appreciate it.

Unidentified Company Representative

Thank you Vikas.

Unidentified Company Representative

Thanks Vikas.

Operator

We will be glad to take another question.

Unidentified Company Representative

No. We appreciate your participation in our call and replay will be available in about two hours.

Operator

Ladies and gentlemen, this concludes today's teleconference. You may all disconnect.

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Source: Reliant Energy, Inc. Q1 2008 Earnings Call Transcript
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