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Pepco Holdings Inc. (NYSE:POM)

Q1 2008 Earnings Call

May 9, 2008 9:00 am ET

Executives

Dennis Wraase - Chairman and CEO

Paul Barry - SVP and CFO

Joe Rigby - President and COO

Dave Velazquez - President and CEO of Conectiv Energy

John Huffman - President and COO of Pepco Energy Services

Analysts

Paul Patterson - Glenrock associates

Dan Jenkins - State of Wisconsin Investment

Maurice May - Power Insights

Neal Colton - Wachovia

Operator

Good day ladies and gentlemen, and welcome to the First Quarter 2008 Pepco Holdings Incorporated Earnings Call. My name is Lisa, and I will be your operator for today. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the call over to Ms. Donna Kinzel, Director of Investor Relations. Please proceed ma'am.

Donna Kinzel

Thank you operator. Good morning ladies and gentlemen, and welcome to the Pepco Holdings first quarter 2008 earnings conference call. The primary speakers on today's call are Dennis Wraase, Chairman and Chief Executive Officer; and Paul Barry, Senior Vice President and Chief Financial Officer. In addition, available to answer your questions are Joe Rigby, President and Chief Operating Officer of Pepco Holdings; Dave Velazquez, President and Chief Executive Officer of Conectiv Energy and John Huffman, President and Chief Operating Officer of Pepco Energy Services.

Before Dennis begins, let me remind you that some of the comments made during today's conference call maybe considered forward-looking statements. As such, they should be taken in the context of the risks and uncertainties discussed in the Safe Harbor disclosures contained in our Securities and Exchange Commission filings.

Dennis?

Dennis Wraase

Thanks Donna, and good morning ladies and gentlemen. Thank you for joining us today. We are off to a very good start in 2008 with first quarter consolidated earnings up 92% over the first quarter of last year. Conectiv Energy had an outstanding quarter. Our generating assets, natural gas storage, and pipeline capacity enabled us to capitalize on short-term power and fuel price volatility driving operating income up 121% quarter-over-quarter.

Power Delivery realized the positive impacts of our distribution rate cases and our blueprint for the future initiative recently received another important milestone with the approval of our demand response programs in Maryland. At Pepco Energy Services, we saw 14% electric sales growth reflecting our continued expansion into new markets.

Earnings for the quarter were $99 million, compared to $52 million in the first quarter of 2007. There were no special items in either period.

Paul will discuss the financial results in detail, but first I'd like to address a few items of interest, starting with power deliveries progress on certain regulatory initiatives. Our blueprint filings continue to move forward. On April 18, the Maryland Public Service Commission issued orders approving demand response programs proposed by both Pepco and Delmarva Power. The orders authorize cost recovery through surcharge mechanism. Equipment cost, such as smart thermostats will be recovered over 15 years and the installations related contract support and marketing expenses will be recovered over five years.

The orders also provide for financial incentives to the utility should participation target to be achieved and market earnings exceed program cost. In the future, the direct load control technology will be coupled with our planned advance metering infrastructure. These programs and investments give us the means by which we can do our part to lessen the environmental consequences of electricity production and allow our customers to better mange their energy usage and then average to reduce the energy portion of the bill.

As we discussed previously, our transmission assets are subject to FERC jurisdiction and the transmission rates are set under a formula rate process. Under this process our utilities are authorized to earn an 11.3% return on equity for all transmission facility. On March 18, each of our three utilities vaulted for 150 basis points return on equity adder for 8 PJM Board approved reasonable regional transmission expansion projects within aggregate construction cost of $274 million.

These projects are scheduled to go in service between June 2008 and year end 2012. The projects are major upgrades that improve import capability in to the Mid-Atlantic region and mitigate major load deliverability issues. If approved the total annual revenue impact after the last in service stage is approximately $3 million.

Now I will turn to our competitive businesses, which are strategic and integral components of PHI’s growth. As I mentioned earlier, Conectiv Energy had a very strong first quarter resulting from the combination our strategy, our assets and favorable market conditions. Based on the results of the first quarter and our projections for the remainder of the year, we expect Conectiv Energy to achieve annual total gross margins result in the upper portion of our 2008 forecasted range. Conectiv Energy’s new power plants at the Delta and Cumberland sites are both on schedule and on budget.

In addition, we have started upgrading our output capability of several of our existing units by almost 160 megawatts in total. And have bid this additional capacity into the 2010, 2011 and 2011 and 2012 PJM capacity auctions. These new units as well as the upgrades to existing units will help me PJM’s growing capacity in energy reform. Pepco Energy services continue to make significant progress in acquiring load in its expansion markets. At March 31st, PES served 875 megawatts in these markets, a 12% increase over year end and a 68% increase over March 2007. Retail electric sales continue to be strong. PES delivered almost 4800 gigawatt hours of electricity in the first quarter of 2008, which represents a 14% increase over the first quarter of 2007 electric sales. Finally, I would like to comment on these issues that have a received a lot of attention over the last few days which is our tax position on our cross border lease portfolio. We continue to believe that we have a favorable set of facts supporting these investments. We had a good business purpose for investing in these leases. The underlying assets, our energy properties that are similar to our core business operations, and these investments provide adequate pre-tax returns.

Based on discussions with our outside advisors in fact are relevant to our investments. We believe our tax position related to these transactions is appropriate. Before I turn it over to Paul, I want to thank you again for all who attended our recent analyst's conference. As our first quarter results show, the strategy we discussed at the meeting is building value. At this point let me turn it over to Paul Barry. Paul?

Paul Barry

Good morning and thank you for joining us today. I hope you had a chance to review our earnings release. I will review, our results and provide some additional detail, will then open the call to your questions.

All three of our major businesses, Power Delivery, Conectiv Energy and Pepco Energy Services posted higher quarter-over-quarter earnings. Consolidated earnings for the first quarter were $99 million or $0.49 per share compared to $52 million or $0.27 per share for the first quarter of last year. Power Delivery earned $0.24 per share in the first quarter compared to $0.17 per share in the first quarter of 2007. The impact of the Maryland and District of Columbia rate case decisions increased earnings by $0.06 per share quarter-over-quarter.

About $0.03 of this was due to higher distribution revenue and $0.03 was a bunch of lower depreciation and amortization expense. Higher network transmission revenue increased earnings by $0.03 per share driven by the higher formula rates in effect in addition to prior year through up ending on May 31st. Another positive factor was an income tax adjustment related primarily to FIN 48 interest, which increased Power Delivery earnings by $0.04 per share but increased earnings of the consolidated company by $0.03 per share. A partially offsetting factor was lower weather related sales, which reduced earnings by about $0.02 per share.

Heating Degree Days were down 9% as compared to the first quarter of last year. The impact of the weather for the quarter versus normal weather is an earnings decrease of $0.02 per share. Finally, higher operation and maintenance expenses in the 2008 quarter, lowered earnings by $0.02 per share. While these costs were higher quarter-over-quarter, they were inline with our expectations as presented our April 4th Analyst Conference.

Conectiv Energy had very strong first quarter results due in part to the operational and fuel flexibility we build into our portfolio of assets. It was our continued active management of these assets combined with favorable market conditions that drove the results.

Earnings were $0.24 per share as compared to $0.10 per share for the first quarter of last year. Merchant Generation & Load Service gross margin increased to $51 million quarter-over-quarter. About $32 million of this increase was a function of four significant drivers.

The first is the fuel switching flexibility of our combined cycle units. We ran the using the below market priced oil inventory instead of natural gas during serve periods cold weather, because it was more advantageous to sell the natural gas than use it to generate electricity. While there are fewer heating Degree Days quarter-over-quarter, we did see some periods of cold temperatures that led the short-term power and fuel price fluctuations.

Second, we sold excess winter periods spot in short-term firm natural gas using our firm natural gas transportation and storage rights. As we've discussed, over the past few years we have been adding transposition and storage capacity to increase our operating and fuel flexibility. These assets have the added benefit of providing the opportunity for us to capture increased margins during periods of high gas demand caused by cold weather. About two third of the $32 million of gross margin increase was due to the two factors that I just discussed. Our third factor is that at times, Connectiv Energy uses natural gas to economically protect power positions.

Given the significant increase in natural gas prices and the decline in spark spreads, we replace short-term gas contract with the purchase of physical power and marked in the margin. And four, in addition of the fuel flexibility of our units, we also design considerable operating flexibility into our generation fleet. With this operating flexibility, units functions as coal auctions. Based on the probability of the units running, we purchased an appropriate amount of natural gas. Rising gas prices and narrowing spark spreads, which reduce the probability of units running created additional margin.

Note that the magnitude of the margin derived from these activities was greater than has been typically realized in prior winters due partly to very favorable marketing conditions. Another significant driver for the quarter was higher PJM capacity prices, which increased gross margin by about $50 million as compared to the first quarter of last year. Other positive factors were the impact of fuel hedges, power congestion and new Default Electricity Supply contracts with utilities in New England.

Offsetting these increases was the decrease of about $12 million as compared to the first quarter of last year resulted from lower generation margins due to lower coal, spark spreads and less run time. During the quarter, generation output was down by 7% due to lower run time at the Oil Fired Mid-Merit units. The decreased margins are probably due to fuel switching, which I discussed earlier. Another offsetting factor was the impact of Default Electricity Supply contract with the utilities in PJM.

As Dennis said taking into consideration our first quarter results, Conectiv Energy expects to achieve annual total gross margins in the upper portion of our 2008 forecasted range of $380 million to $435 million. In addition, we are confirming our forecasted gross margin ranges of $400 million to $475 million for 2009 and $460 million to $550 million for 2010.

Pepco Energy Services results for the quarter were $0.04 per share compared to $0.01 per share for the first quarter of 2007. The quarter-over-quarter increase is driven by higher earnings from the retail energy supply business. Pepco energy services benefited from more favorable congestion costs, higher capacity prices and higher electric delivery volumes. As Dennis noted, our performance in the first quarter demonstrated the strategic value of our integrated portfolio of businesses as we benefited from the operating flexibility of our generating fleet, our constructive regulatory outcomes, and the continued strength of our retail business. For the remainder of 2008, we remain focused on executing our business plan and building on our first quarter results. With that I would like to open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Paul Patterson with Glenrock associates. Please proceed.

Paul Patterson - Glenrock associates

Good morning guys.

Paul Barry

Good morning.

Paul Patterson - Glenrock associates

Looking at the cash flow statement in the 10-Q, and I'm just wondering with the $38.8 million in net other operating was-- it seem like it was a non-cash benefit of $38.8 million, just wondering what that was referring to?

Paul Barry

There we got somebody checking.

Paul Patterson - Glenrock associates

Okay. The second question I have for you, while they're checking in -- I've been reading sort of the SEC documents on the leverage fess stuffing, well I was just wondering if, just hypothetically if there was no, if this program were to end tomorrow outside of the capital costs associated with anything that the IRS might be challenging. If you would end tomorrow, what would the net income impact be going forward? In other words, how much you are making of this program--?

Paul Barry

On an annual basis, I think we are recording between $25 million and $30 million of net income.

Paul Patterson - Glenrock associates

Okay.

Paul Barry

For PCI.

Paul Patterson - Glenrock associates

Okay. And, that decision with the tax benefit associated with it?

Paul Barry

But actually as we say our, I know there is some of it associated with, not really associated they are actually is a pre-tax earning impact associated with it already, so--

Paul Patterson - Glenrock associates

Okay. And then the oil impact, the oil inventory, how much do you think, I mean just sort of, it sounds like well you had some low cost oil and inventory. The price of oil went up so, as a consequence you sort of benefited from that. Is that I mean is, how continuing is, how much would that continue I guess and how should we think of that going forward?

David Velazquez

This is, David Velazquez. The oil inventory we had was lower price in current market as we were replacing that at current market prices, that sort of gain would only occur if oil were to continue to increase dramatically that has over the past year or so.

Paul Patterson - Glenrock associates

Okay. And how much with that as a benefit?

Dave Velazquez

I think, it was somewhere in the range of let's say $3 million to $5 million.

Paul Patterson - Glenrock associates

Okay. Okays and you guys will get back to me on the 30 April?

Dave Velazquez

If we don't--

Donna Kinzel

Yeah. I'll get back to you Paul.

Dave Velazquez

Donna, will get back to you Paul.

Paul Patterson - Glenrock associates

Thanks a lot.

Operator

Your next question comes from the line of Dan Jenkins with State of Wisconsin Investment. Please proceed.

Dan Jenkins - State of Wisconsin Investment

Good morning and congratulations on a good quarter.

Dennis Wraase

Good morning.

Dan Jenkins - State of Wisconsin Investment

I had a couple of questions related to the sustainability of the results, obviously the rate order stuff should continue and the DC went in tough factor, looks like about half way through quarter, such kind of case, what we should think about going forward for the benefit from the rate orders?

Dennis Wraase

Well I think, I mean, whatever they've ordered they are going to continue, so--.

Dan Jenkins - State of Wisconsin Investment

Right.

Dennis Wraase

Have another rate decision except for when we file a new formula rate at FERC which will be till May or June.

Dan Jenkins - State of Wisconsin Investment

And, I guess, how much--

Dennis Wraase

Till then don’t expect any other rate changes.

Dan Jenkins - State of Wisconsin Investment

Right, but how much higher would say the first quarter have been, I would say the rates have been in the flat for the whole quarter and then---

Dennis Wraase

Donna will have to get back. I don’t think we have that calculation in the top of our head, so--.

Dan Jenkins - State of Wisconsin Investment

Okay. And then, you also had sales in New England, what kind of impact do you expect from that going forward to new contracts you had in New England?

Dennis Wraase

Yeah, I think, this is Dave Velazquez. The best way to characterize that I guess is we have included those ongoing sales from New England in the gross margin ranges that we provided and I have just confirmed.

Dan Jenkins - State of Wisconsin Investment

Okay. And then, on that I missed I didn’t get it down when you said what you expect for ’09 and 2010, if you could give me that again?

Dennis Wraase

Sure. Yeah, that was part of the analyst presentation we made on April 14 but I will--

Dan Jenkins - State of Wisconsin Investment

Yeah, I wasn’t there.

Dennis Wraase

The range, Dave has it, go ahead Dave.

Dave Velazquez

The range for 2009 for annual total gross margin for Connectiv Energy is range of $400 to $475 million and for 2010 $460 to $550 million.

Dan Jenkins - State of Wisconsin Investment

Okay. Then the last I was wondering as no if you could give us update on the transmission project and if you are going to need to come to market for any financing or related to the CapEx?

Dave Velazquez

Well, we covered that on the analyst day, but we will repeat it. We don’t have any plans for equity this year. There probably would be some debt issuance this year, some of which is refinancing, but we announced that the analyst meeting that we would intend to issue equity in 2009.

Dan Jenkins - State of Wisconsin Investment

Okay. And, then the status of the transmission?

Dave Velazquez

Well, it's really hasn’t changed. It's been approve by PJM. We still have, we have not file for this Certificate of Public Convenience and Necessity, which we have to do in Maryland which will be filed later this year. We have begun environmental studies necessary to support that application. So, at the moment it’s still on a track to be done and is scheduled as contemplated.

Dan Jenkins - State of Wisconsin Investment

Okay. Thank you.

Operator

Your next question comes from line of Maurice May with Power Insights. Please proceed.

Maurice May - Power Insights

Yes. Good morning folks and congratulations on a very good quarter. I would like to get some background on the recent developments on cross border leases. I have missed some of that. I would appreciate some color on the issue?

Dennis Wraase

Well it has just been some, Maurice, there has been some recent announcement of some companies that have taken reserves against some of the, some of their lease portfolios. And so, there was some question about what would happen in our standing public service and their phone call had something and I believe a couple of the banks and we were just reaffirming that our leases are different and then in our position we have taken to date, we believe is the accurate one.

Maurice May - Power Insights

Okay which public service is that?

Dennis Wraase

I thought it was public service of Electric and Gas in New Jersey.

Maurice May - Power Insights

Okay. Okay, and what is the differentiating factor between your cross border leases and those that are getting reserved against.

Dennis Wraase

Well that everybody’s fact to circumstances are different, but I guess and I hate to use the terms. But, I guess the answer is that everything that has been done today relates to something called LILOs and either SILOs.

Maurice May - Power Insights

Can you go a little bit further and tell me what a LILO is and SILO?

Dennis Wraase

LILO is lease in lease out. SILOs are sale in and lease out.

Maurice May - Power Insights

Okay. Okay, I will hit my accounting books. Thank you, folks.

Operator

Your next question is a follow up from the line of Paul Patterson with Glenrock Associates. Please proceed. Mr. Patterson, please proceed.

Paul Patterson - Glenrock Associates

I am sorry, can you hear me?

Donna Kinzel

Yes.

Paul Patterson - Glenrock Associates

I am sorry guys. I am sorry if I missed this, but the favorable congestion cost at Pepco Energy services, what was that, what caused that, could you just elaborate a little bit more about that?

John Huffman

Sure this is, John Huffman. What we, we hedged congestion risk in our retail business by purchasing firm transmission rates from PJM and the performance of our firm transmission rights performed very well compared to the last year's quarter in 2007 and so that's what that's about.

Paul Patterson - Glenrock Associates

And, what caused that FTR benefit, any particular activity or market conditions that made, I mean is there anything, is it just something that happened, or I guess was there any unusual market event that so caused that?

John Huffman

Nothing unusual, I mean, there are number of factors that are going to the performance in any given period of time weather and other things. So, but nothing unusual that stood up.

Paul Patterson - Glenrock Associates

I noticed that there was a gain in the unrealized gains on derivative contracts in, I guess on the balance sheet. Could you sort of describe a little bit of that and how that improves the income statement if it did?

John Huffman

Dave?

Dave Velazquez

We'll have to get back to you -- to get all the details.

Paul Patterson - Glenrock Associates

Okay great, thanks a lot.

Operator

(Operator Instructions) Your next question comes from the line of [Neal Colton] with Wachovia. Please proceed.

Neal Colton - Wachovia

Good Morning.

Dennis Wraase

Good Morning.

Neal Colton - Wachovia

I want to follow up on the SILOS again. Are there any ongoing court cases dealing with the SILOS that we could be looking at?

Dennis Wraase

There are some queued up for this year but I don't know the specifics but it's something that we follow but I don't know the specifics but we know there are some.

Neal Colton - Wachovia

Okay, okay, well thanks

Operator

Your next question is a follow up from the line of Dan Jenkins with State of Wisconsin Investment, please proceed.

Dan Jenkins - State of Wisconsin Investment

I just had one other, I've noticed your cash balance is up to over $300 million, is, do you have like something that you would for that designative point or what's behind that?

Dave Velazquez

It's just the timing of cash flows as we've said, we have a large construction program and so our intent would be that's what it will be used for.

Dan Jenkins - State of Wisconsin Investment

Okay, so you basically pre-finance that thing?

Dave Velazquez

Oh, it's also some of the, some of that is also related to the merit funds, as you know we filed -- where some of the merit funds will be returned to customers and that's all pending. So, piece of that is that component as well. But, there is nothing specific other than anytime we have a positive cash flow you could probably anticipate we'll be using it to fund our construction program.

Dan Jenkins - State of Wisconsin Investment

Okay, thanks.

Operator

There are no additional questions at this time. I would now like to turn the presentation back over to Mr. Paul Barry for closing remarks.

Paul Barry

Again, thank you all for joining us and have a good day.

Operator

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

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