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Hawaiian Electric Industries, Inc. (NYSE:HE)

Q2 2008 Earnings Call Transcript

August 5, 2008 2:00 pm ET

Executives

Suzy Hollinger – Manager, Treasury and IR

Connie Lau – President and CEO, HEI

Tim Schools – President, ASB

Tayne Sekimura – SVP, Finance and Administration, HECO

Analysts

Paul Patterson – Glenrock Associates

Steve Fleishman – Catapult Capital Management

James Heckler – Levin Capital Strategies

Steve Gambuzza – Longbow Capital

Ashar Khan – SAC Capital

James Bellessa – D.A. Davidson & Co.

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2008 Hawaiian Electric Industries Incorporated earnings conference call. My name is Eric and I will be your coordinator for today. At this time, all participants are on a listen-only mode. We will facilitate a question-and-answer session towards the end of this session. (Operator instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host, Ms. Suzy Hollinger, HEI Manager of Treasury and Investor Relations. Please proceed.

Suzy Hollinger

Aloha and good afternoon. Thank you for joining us for an update on Hawaiian Electric Industry. Here with me from management and speaking today are Connie Lau, HEI President and CEO; and Tim Schools, ASB President; Curt Harada, HEI Acting Financial Vice President, Treasurer and CFO; Tayne Sekimura, HECO Finance Vice President; and Alvin Sakamoto, ASB Executive Vice President, Finance are also on the call.

Connie will start today's presentation with a few comments on the second quarter earnings and the Hawaii economy and will then move to an update of the utility operations. Tim will discuss the bank, and Connie will make some closing remarks. At the end of the presentation, we will open it up for your questions.

Before I hand the call over to Connie, I would like to alert you that forward-looking statements will be made on today's call. Please reference Roman IV [ph] of our second quarter Form 10-Q for information about forward-looking statements.

Now, let me turn the call over to Connie to begin the formal comments.

Connie Lau

Good afternoon and aloha to all of you. I'm pleased to report that we had a very solid second quarter. As you know, GAAP earnings were $0.06 per share but included previously disclosed charges related to the successful restructuring of our bank's balance sheet. Excluding the effects of the balance sheet restructuring charges, net income would've been $41 million or $0.48 per share represented by the orange bar in this chart.

All areas of the company contributed to this good performance. Our utility saw continued recovery from very low earnings a year ago while we were waiting for needed rate increases to earn a return on reliability investments and to recover higher operating costs.

Excluding the balance sheet restructuring charges and several other items which helped bank net income by $2 million which we don’t expect to recur each quarter, core bank earnings and profitability improved nicely from the prior quarter and significantly over the prior year quarter. Holding and other company losses were lower primarily due to lower interest and general and administrative expenses.

The financial details of the quarter were included in our second quarter earnings release and Form 10-Q that were filed yesterday and we would be happy to answer any questions you have at the end of the formal presentation.

As many of you know, our operating companies have been keenly focused on improving their financial and operating performance. I'm pleased to report that much has been accomplished since our last call to position our company for improved profitability.

Our utility staff has been working hard to file a 2009 test year rate case for our main utilities that was filed just after quarter end. The requested $97-million rate increase is to recover the cost of a new 110-megawatt peaking unit on Oahu which will be fueled by biofuel and other capital investments and increases in O&M and depreciation expenses since the 2007 Oahu rate case. I’ll provide more detail on the filing later in the presentation.

At our banks, Tim has previously talked to you about a comprehensive performance improvement initiative to improve both operating and capital efficiency by delivering enhanced products and services, productivity improvements, and restructuring the bank’s balance sheet to reduce the size of its wholesale assets and liabilities. As previously explained, the bank’s strategy had been to reduce the less profitable wholesale portion of its balance sheet over time with organic growth of its core franchise business. Earlier this year, we decided to explore (inaudible) reduction more quickly through the capital market. We were very pleased to substantially accomplish this in the second quarter which positions the bank to maintain its earning power but using 20% less capital.

The bank has recently filed an application with its regulator requesting approval to dividend the excess capital to HEI which is expected to total approximately $75 million over the next few quarters. In the near term, we expect to cancel the plans of refinancing of our medium-term notes that matured in March and to pay down short-term debt. This restructuring and de-levering comes at an opportune time as improved financial flexibility helps strengthen the company against volatile markets.

Let me now comment on the Hawaii economy.

After nine years of consecutive growth, the Hawaii economy is showing signs of slowing. This has been most apparent in our visitor industry. Year-to-date air arrivals and visitor days were down 5% and 4% respectively compared to the first half of 2007 due to the Aloha Airlines and ATA Airline closures. The higher cost of travel due to rising fuel oil cost, lower seat capacity and the downturn in mainland markets from which tourists come also contributed to the decline.

Rising fuel costs have also worked their way into the price of most consumer goods in Hawaii because 80% of our goods arrive by ocean-going ship. Consumers have reduced their spending and our State Department of Business and Economic Development and Tourism expects inflation to be 4.2% this year. Unemployment has been rising slowly over the last 12 months but at 3.8%, it’s still much lower than the national average of 5.5%.

Real estate remains mixed. Sales volume for single family homes on Oahu had been contracting since 2006. But medium prices have remained relatively stable over those years and for the first half of 2008, we’re down only 2.5% compared with the same period last year.

While our bank's non-performing asset ratios remain near historical low, because of the trends in inflation and unemployment in the real estate market, we remain cautious and are actively monitoring our loan portfolio. Tim will have more comments about credit quality in his update of the banks.

At our utility, earnings are recovering from very low levels in 2007 with interim rate increases. The significant quarter-over-quarter improvement reflects the fact that interim rate relief was largely received in the fourth quarter of 2007 for two of out of three of our utilities.

This quarter’s impact on net income was $11.6 million net of taxes and it’s helping our utilities recover higher levels of O&M and earn on the significant number of capital projects completed in the last several years. Our twelve-month trailing regulatory ROEs now range from 8.2% to 10.4% as compared to allowed ROEs of 10.7% for each of our three utilities.

To further help recover costs and earn closer to our allowed returns, we filed a request for a 2009 rate increase in Oahu, our largest system. The request was filed in July based on a 2009 test year and asked for $97 million or a 5.2% increase in revenue and an 11 – and a quarter percent return on common equity.

If the entire increase is approved, a typical residential/household bill on Oahu will see their monthly bill increase by $6.77. The request is primarily to cover cost for the new biodiesel peaking unit and other capital additions as well as increasing cost for the operation and maintenance of our aging Oahu electrical system.

Like our 2007 Oahu rate case, the request includes tiered residential electric rate to reward customers who practice energy conservation with lower rates for lower usage, and consumers in Hawaii have been conserving especially with high fuel oil prices. Lower usage for residential customer from conservation and energy efficiency has offset modest growth in customer account.

In addition, commercial sales were flat with a return of military load that were undergoing renovations and a new time share on Maui offset by lower sales in the visitor industry segment and a return from abnormally high municipal waste water pumping load in 2007.

Overall, as a result of the Hawaii’s slowing economy, we expect this trend of flat to slightly lower sales to continue. However, despite flat to slightly lower sales, peak demand continues to remain high. The ongoing need to meet this high level of demand continues to put pressure on our generating units especially on Oahu where generation reserves remain tight while our new peaking unit will help when it comes online in mid 2009. The rest of our system continues to age increasing O&M cost.

Like the industry overall, we are also seeing rising cost for materials and services. O&M in the quarter was flat compared to last year’s second quarter with higher operations expense offsetting lower maintenance expense. Operations expense was higher due to higher DSM expense, increased staffing costs, higher engineering costs for planning for the future generation, and higher expense for TND automation work. Maintenance expense was lower due to lower production maintenance expense resulting from the timing and type of units on overhaul, lower vegetation management expense, and lower substation maintenance expense.

We do expect higher O&M in the second half of 2008 due to scheduled increases in production and transmission and distribution maintenance work. Full-year O&M increases should be slightly higher than those experienced in the first quarter which increased about 6% quarter-over-quarter.

To address these needs and to modernize our infrastructure, we continue to make major capital investments in generation and transmission capacity. This includes a new generating unit planned for Oahu in the island if Hawaii in 2009, our East Oahu transmission line in 2010 as well as reliability projects to replace and refurbish infrastructure, and provide better service to our customers.

In total, over the next five years, we are forecasting approximately $1.2 billion in net capital expenditures. We'll continue to focus on obtaining recovery and earning a reasonable return on these increased investments. Approximately $375 million of plant addition are included in the Oahu 2009 rate case.

As a company, we are also committed to helping Hawaii achieve greater use of renewable energy to reduce our state's overall dependence on oil and to help protect our environment. In 2007, we achieved a 16% renewable portfolio standard and we continue to aggressively pursue additional renewables.

On our last call, we mentioned the Hawaii Clean Energy Initiative, a partnership between the Department of Energy and the State of Hawaii, to significantly increase Hawaii’s use of renewable energy. Through the Hawaii Clean Energy Initiative, we will work with Hawaii’s energy stakeholders to develop the right policy to achieve this important goal.

On Oahu, we recently issued a formal request for proposal. We’re up to an addition of 100 megawatts of non-firm renewable energy. We are also continuing to test our Oahu generating unit to run on biofuel following our successful test of our Maui generating unit. And to support our commitment to use locally produced biofuel as much as possible and as soon as possible, and to encourage our local Hawaii Ag [ph] energy industry, we recently signed a memorandum of understanding for joint development of a commercial scale micro-algae facility on Maui to produce biodiesel. While filling the development stages, micro-algae has significant potential as an energy crop with the prospect for very high levels of oil production per acre which would significantly increase local biofuel production capacity given our limited amount of available land.

Before I wrap up, let me say a few words about our search for a new president for the utility. In June, Mike May announced his plans to retire after 17 years with Hawaiian Electric. A national search is in progress but in the meantime, we have a solid leadership team in place with experienced senior executives in charge of all key areas. As Board Chair, I will be working closely with them to ensure a smooth transition.

So, to sum up our utility operation, earnings are recovering with interim rate relief for all three utilities, most of which was granted in late 2007. Kilowatt-hour sales are down slightly with lower usage from energy conservation, energy efficiency, and our slowing Hawaii economy, offsetting a modest increase in customer and slightly warmer temperatures. O&M was flat in the quarter. It is expected to rise in the second half of 2008.

Our new biofuel peaking unit for Oahu is under construction and we recently filed a 2009 test year Oahu rate case to recover and earn on that and other investment and higher O&M.

Finally, we are taking significant steps to increase the use of renewable energy for our islands. Overall, our utilities are regaining financial strength and are doing what it takes to be well positioned for long-term success for our investors and our customers.

Now, I'd like to turn the call over to Tim to discuss the banks.

Tim Schools

Thanks, Connie. Good morning everyone and thank you for joining us. ASB had an exciting second quarter which included our most successful home equity and checking campaigns in the history of the company, made continued progress in reducing our operating expenses and embarked on a formal performance improvement project designed to enhance our operational and financial performance.

Of special note, the company elected to reduce the size of its balance sheet causing an after-tax charge tax of $35.6 million related to the early termination of debt and realizing losses on investment securities. This was a strategic decision and a strong first step to showing our commitment towards improved performance.

By reducing our balance sheet, we expect to pay a special dividend of approximately $75 million to our parent AGI over the next three quarters while maintaining our current earnings level and with minimal impact to capital ratios and interest rate risk ratios. The initiative will greatly enhance the company’s return on assets, return on equity, and net interest margin beginning in the third quarter.

Quickly, here is a look at our GAAP numbers. Our second quarter financial results, detailed in the slide, included several items that we do not expect to recur in future periods including the charges related to the balance sheet restructuring. To help you better understand our second quarter results on this slide, I've listed the after-tax impact of these items.

Now let me walk you through the trends of our return on assets and four key drivers. Please note, all periods will be GAAP numbers with the exception of excluding the balance sheet restructuring charges in the second quarter of 2008 and excluding $20.3 million of charges recorded in connection with a tax settlement in the year 2004.

While the trends in the following slides are adjusted for these two items, please be mindful that they are not adjusted down for the additional $2 million of net benefits from the other items shown in this slide. As in past calls, I am comparing our results to industry mediums and refer mostly to the link quarter to emphasize current trends. This quarter we settled on a peer group which includes all public banks and thrifts between $4 billion and $9 billion in total assets and a high-performing group of companies from within that group which demonstrated a higher and more consistent return on assets during the last five-year period.

As I mentioned, our return on assets is heading in the right direction. And it is important to note that we are delivering this higher return on assets through greater net income and lower assets, meaning we’re doing more with less. In fact, on an adjusted basis, return on assets was slightly over 1%, its highest level in at least the last ten years. This is now more in line with the historical Tier group level.

Directionally, you might expect third quarter return on assets to be higher since our average assets at that time will have the full impact of the balance sheet restructuring. We have a number of other exciting initiatives that I am optimistic in time can pushes up closer to the historical high-performing group level.

Now the four key drivers. Starting with revenue, revenue increased 4.9 million from the prior quarter to 73.4 million. The increase reflects a 2.1 million increase in net interest income and a 2.8 million increase in non-interest income. As it relates to net interest income, second quarter net interest income totaled 52.6 million, up from 50.5 million in the first quarter.

The increase resulted from a higher net interest margins which benefited from continued improvement of our earning asset and liability mix including strong core deposit growth as well as lower short-term interest rates.

Next, our net interest margin improved 23 basis points to 3.39%, also its highest points since at least 1998. The net interest margin increased to a 29 basis point decline in total funding costs compared with a five basis point decline in earning asset yields.

The lower funding cost resulted from three things. First, continued strong core deposit growth and more specifically, growth of non-interest bearing deposits. Average core deposits increased $45 million from the first quarter which had already increased previously 13 million over the fourth quarter. $27 million of second quarter’s average core deposit growth was in non-interest bearing checking resulting primarily from the success of the new checking account shown on the first slide.

Second, a reduction in our higher cost average wholesale funding balances and higher cost certificate of deposits of $244 million from the first quarter. This reduction has been facilitated by our strategy to reduce lower-yielding earning assets and our strong growth and core deposits.

Third, decline in deposits and wholesale borrowing costs resulting from the rate cuts experienced earlier in the year. Within our earning assets, our average balances on a lower-yielding investments declined by $202 million from the first quarter largely from the impact of the balance sheet restructuring. This follows a $112 million decline from fourth quarter to first.

Average loans were up modestly from first quarter with increases in commercial, commercial real estate, and home equity and decreases in mortgage and consumer. The decline in the loan yield was essentially offset by an increase in the investment security shield. What is most exciting is if you take interest income over in the period earning assets instead of average earning assets gives you a net interest margin of 4.11%, and a general direction of where you might expect the third quarter net interest margin to be since our average earning assets at that time will have the full impact of the balance sheet restructuring.

Next, efficiency. As with the three previous drivers, you can see efficiency is also heading in the right direction. Our internal target is to achieve a 55% to 60% efficiency ratio. In the first quarter, we heighten the overall awareness and importance of expense control and began monthly controller meetings to review actual vs. budget results with each senior officer and the results have been excellent.

Adjusting for the balance sheet restructuring charges, second quarter non-interest expenses decline $200,000 from the first quarter to $44.1 million. Keep in mind, our second quarter expenses included a pre-tax technology project write-off of $1.9 million. So without that charge, operating expenses must have been down 2.1 million from the prior quarter.

In combination with $4.9 million of linked quarter revenue growth, our efficiency ratio improved from 65% in the first quarter to 60% this quarter and down from 69% in the fourth quarter excluding that quarter's $0.10 adjustment of $8.6 million.

I want to emphasize that our savings today has not come from lay-offs or cost-cutting programs. It comes from the personal initiative and commitment of each of our employees. We see additional opportunity and we'll begin focusing on some specific areas such as automation, equipment, procedures, procurement, and real estate.

Each of the areas we have identified should either be transparent or contribute positively to our customers' and employees' experience. An example would be – we have two contracts. We are re-negotiating at this time that will lower our annual non-interest expense by approximately $3 million to $3.5 million every year going forward. None of these is in our current numbers. We expect to start seeing bank heads in the third quarter with the slow impact of benefits expected by January.

Lastly, credit quality. Our credit quality indicators remain strong and have only increased modestly off the recent historically low-levels, this, attributable to a stable economy and a lower risk balance sheet profile. However, we do remain cautious about the local economic outlook.

Provision for credit losses in the second quarter was $1.2 million compared with $900,000 than the prior quarter. Net loan charge-offs in the second quarter increased to 1.4 million or 14 basis points of average loans held for investment compared with $484,000 or 5 basis points for the first quarter.

The charge offs were dispersed among all loan categories except commercial real estate. At quarter end, non-performing assets increased to $8.6 million or 21 basis points of loans held for investment and foreclosed property were $7.3 million from $7.3 million or 18 basis points at prior quarter end.

The increase of non-performing assets was primarily attributable to $a 1.5 million increase in the residential mortgage loan portfolio and a $577,000 foreclosed residential loan. The allowance for credit losses totaled $30.4 million or 73 basis points of loans held for investment at quarter end compared with $30.6 million or 74 basis points at the end of March.

The allowance coverage of non-performing loans totaled 3.5 times at quarter end compared with 4.2 times at the end of the first quarter.

In closing, I hope you can tell there's a lot of good things happening within the bank and that we are heading in the right direction. It's certainly is an exciting time to be a part of ASB as a shareholder, employee, or customer.

Now I'd like to turn it back over to Connie.

Connie Lau

Thanks, Tim. To sum up, we've had a very good second quarter earnings excluding the bank balance sheet restructuring charges were strong and much was achieved to position the company for increased profitability.

Interim rate relief received in 2007 continues to help our utility earnings recover. We recently filed a 2009 test year rate case for Oahu utility to recover and earn on our biofuel peaking unit which is scheduled to go into service in mid-2009 as well as other capital additions and higher expenses since the prior 2007 rate case.

We continue work on critical reliability project and are focused on recovery of these investments in earning a reasonable return through the rate case process. We are very excited about our leadership role in reducing Hawaii's dependence on fossil fuel and supporting more energy from renewable sources, and we are working closely with the DOE in the state of Hawaii to establish workable, clean energy policy under the Hawaii Clean Energy Initiative.

Excluding the bank balance sheet restructuring, our bank performed well in the second quarter. The said easing of interest rates this year continue to have a positive impact on our margins and credit quality remained good, and with the balance sheet restructuring substantially complete and execution, productivity improvement, and product enhancement strategies underway our bank's position for improved profitability and capital efficiency. The bank intends to return excess capitals of holding companies that will be used primarily to pay down short-term debt.

We continue to recognize the importance of the dividend to our shareholders. Our dividends yield at around 5% remains attractive. Yesterday, we announced that our board has continued a quarterly dividend $0.31 per share payable on September 10 to shareholders of record on August 18. Next dividend will be August 14.

All in all, we were very pleased with this quarter and look forward to demonstrating additional good performance this year. This now concludes our formal remarks and we will be happy to answer 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.

Connie Lau

Hi Paul.

Paul Patterson – Glenrock Associates

I wanted to touch base with you guys on the provision for loan losses. You mentioned that your overall loan portfolio credit quality remains good but you say that you remain cautious and are actively modeling a loan portfolio. Are there signs that the local economy and the real estate market is slowing? What do you mean – you guys did describe what you saw there, obviously economically you are happy with – is there anything more you’d like to sort of – is there anything else that sort of on the horizon that you’re seeing or it seem like a cautionary statement, I just was sort of wondering what you’re feeling out there?

Connie Lau

You know, Paul, that’s a discussion that a lot of executives around town has been having because it’s clear that our Hawaii economy is slowing particularly the visitor industry but we aren’t seeing it every time [ph] with the numbers just yet. So there maybe a (inaudible) that is going on. So that’s a reason for the cautionary note.

Paul Patterson – Glenrock Associates

Okay. But there’s no specific loan or something that you feel might be in trouble or is there anything like that happening?

Tim Schools

No, because the way the provision rules work from an accounting standpoint, if there was a loan that we felt was in trouble we would have to write that down. We have a rating scale of one to ten and as you rate things down you have to go ahead and provide for that now. So if there was some loan that we felt was going from a risk grading six to risk grading eight, we would be required to set aside more provision today. You don’t wait before it's charged off. So the provision is a good indication of our outlook for credit at his time, but as Connie said, unfortunately, in credit there’s always underlying effect [ph]. So we see everyday articles come out here as it relates to tourism in Hawaii and then Connie has mentioned sort of the airplanes and the cruise lines.

Paul Patterson – Glenrock Associates

Okay.

Connie Lau

To be at the asset quality ratios that we are at today is just amazing. As Tim mentioned and it’s still near historical load and intuitively it doesn’t seem right given what’s been happening nationally and then also in the Hawaii economy but it is the way Tim described it.

Tim Schools

And it’s really two things for us that’s why I tried to make that point. You really need to take the time to understand a bank’s asset mix. One is Hawaii, in general, tends to be more stable over time. So at this point, we’ve not experienced what the Mainland has experienced. We don’t know if it will come here. But number two, our balance sheet is very different and even the local banks here. The vast majority of our assets are in 30-year fixed rate mortgages. So it’s not a secondary loan, it’s not a car loan, or home equity loan, or credit loan. So those tend to be the last ones that people default on [ph] is on their house.

Paul Patterson – Glenrock Associates

Sure. The service expenses that went down by $3.7 million and just – I think, year-to-date, they’ve been about almost twice that, I think. And you mentioned the consulting and litigation expenses and you also mentioned that you guys are basically undertaking the cost initiative and the key is here, you guys were transforming and these expenses were growing quite a bit, it didn’t seem when I asked you about it whether or not they were transitory, it seems that felt a lot of them were sort of big. I was wondering, what’s specifically – was there a specific accounting – excuse me – specific consulting or litigation expense that we should be thinking about in the first half of the year or just sort of a run rate, should we be going back to 2006 to 2005 run rate number? I’m just trying to get a sense as to where you think that number can come and then you mentioned that contract, just one contract, it sounds like $3 to $3.5 million you can save money on. Just how should we think about that?

Connie Lau

Paul, let me start off and then I’ll let Tim finish up. Historically, you are correct. I had talked about the services expense which was at that time primarily consulting continuing because we were transforming a company. We’re still transforming a company and so we have always used a lot of consulting expense. I think what Tim on board now, the philosophy is different where we are really trying to strengthen the management ranks to be able to do a lot more ourselves. And so that’s a lot of what is happening as you’re seeing that expense shift and let met now let Tim talk about where he’s headed from here with that.

Tim Schools

I agree with that and I guess the way I think about it is last year. Big picture. I don’t remember the exact number but our annual expenses were around a $184 million and I think Alvin’s here, but I think there was roughly $9 million that was related to some legal expense for some of the litigation that we had. So you could say that core operating expense may have been in the 175 range and one of the things – when you do these scripts you go to so many versions. Something got taken out but the one point I wanted to point out was that for our size banks in that peer group, we – Alvin and I studied the six banks that are generally around our size and everything’s going differently. Every bank has different cost of labor, cost of real estate, but in general, the banks that were $5.5 billion in size, their non-interest expense was about a $150 million to $160 million. So we were about 184 last year. If you take out 9 for the litigation, that puts us at 175. If you take the 44 that we had in the second quarter and you multiply that by 4, that’s getting lower and so, I hope that we can find – you take the $3 million that I just mentioned to you that we found on the contract, I would hope that we could get somewhere approaching that 160 number the others are at. We do not have all the answers yet but that’s the kind of stuff we’re studying now that the balance sheet is done.

Paul Patterson – Glenrock Associates

And that includes all the non-interest expense categories that you’re talking about or is that specifically out of services or – that are possibly – very specific area that you see that being majority coming out of or –?

Tim Schools

Where we see opportunity?

Paul Patterson – Glenrock Associates

Yes.

Tim Schools

Across the whole enterprise. A lot of opportunity is in automating our branches. Our branches, I think you would find our customer service scores at least equal if not higher than much of the competition in Hawaii. We get very high marks on our customer service but our automation would be lacking. So there’s a lot of opportunity to install automation which hopefully will drive more revenue because you don’t want to increase efficiency just from cost cutting. So hopefully that will drive more revenue but also hopefully it will bring a better employee experience and customer experience by better automation.

Paul Patterson – Glenrock Associates

Okay.

Connie Lau

Paul, if you think about what we have been doing is we’ve been focusing a lot on building out the commercial banking, commercial real estate part of the business so that we could help diversify the balance sheet and add on the higher yield, ensure the duration assets. And while we had done some of this type of work in the past, the biggest opportunity is on the retail side of our business and transforming that. And that’s really what Tim’s getting at today in the basic operational areas as well as taking a look across the entire enterprise.

Tim Schools

Paul, just in closing again, the three numbers I’d write down is 184, I think is the run rate last year. We had roughly 9 million save legal. That puts you at 175. The 2004 expense level was 164. That was the 2004 level, and that had like no legal in 2004. And if you take our second quarter, I just told you it’s 44.1. Remember that includes the $1.9 million for the EPA technology project write-off. You subtract 1.9 from that 44.1, you’re at 42.2. Multiply that by 4. That’s a $168-million run rate. So at a $168-million run rate we are approaching the 2004 expense run rate. And then if you take that 168 and subtract the 3.5 million that we’re going to get in this contract re-negotiations, you’re down to 165. So we are, by January – it’s not unrealistic that we could be approaching the 2004 expense run rate.

Paul Patterson – Glenrock Associates

Okay great. Then just finally on the Oahu rate case, intervener testimony when is this supposed to come out? Do we have a schedule on that yet?

Connie Lau

There’s no schedule out currently.

Paul Patterson – Glenrock Associates

Okay. Thanks a lot guys.

Operator

Next question comes from the line of Steve Fleishman with Catapult Capital Management. Please proceed.

Steve Fleishman – Catapult Capital Management

Hi. Connie, can you hear me?

Connie Lau

Yes, I can.

Steve Fleishman – Catapult Capital Management

Hi, how are you?

Connie Lau

Good.

Steve Fleishman – Catapult Capital Management

Question on the quarter at the utility. If you look at the fuel and purchase power recovery both in rates and then in costs, it looks like you got about $25 million more in revenue for fuel and purchase power than you got in cost going up?

It looks like the revenue was $175 million, I think, higher but then fuel and purchase power went up $150 million.

Connie Lau

Yes.

Steve Fleishman – Catapult Capital Management

What would you explain that? Is that a timing issue or because that obviously seemed – if I am calculating this right to have a pretty big impact from the quarter?

Connie Lau

Yes, Steve, let me start and then I will turn it over to Tayne to give you the detail, but basically one of the primary reasons in there is that we have an efficiency standard in the use of our fuels and so we’ve actually been able to achieve – I mentioned all of our companies have been looking at improving their operating our financial performance so our generation guide has been really focusing on the efficiency of the unit and so that is a big part of that.

Tayne Sekimura

The other part of the difference there is the revenue taxes that we pay so that would be the difference. Revenue taxes amount to close to 9%.

Steve Fleishman – Catapult Capital Management

9%, so essentially all that $175 million increase, you would have 9% higher taxes on that? Okay. Total higher revenue?

Connie Lau

Actually included in that amount are the revenue taxes, the 175.

Steve Fleishman – Catapult Capital Management

Okay, but then the taxes are there below the line in the other taxes that go up.

Connie Lau

That is correct.

Steve Fleishman – Catapult Capital Management

Okay, so I think if you net that out, you’re still up – it was a smaller number. You are up more like $0.06 or $0.07 from this, okay.

On the efficiency rider [ph], does that – I think you mentioned you might have more average time in the second half. I do not know if that was average time or that was just more general cost timing. Does that impact the efficiency measures?

Connie Lau

Actually, it is even sustained. What impacted the efficiency measures are the types of units that we have on overhaul and depending on the timing of those overhauls. So in the second half of the year, we are going to see some overhauls on our reheat units which are more efficient units and so that is where you have this efficiency kind of issues that come up. So, in another way Steve, the units that were out for maintenance in the first half of the year were our less efficient unit.

Steve Fleishman – Catapult Capital Management

Okay. So if you have the more efficient unit, you might get less of the fuel benefit?

Connie Lau

Correct.

Steve Fleishman – Catapult Capital Management

Than in the second half? Okay. And then just to clarify, your rate relief flows through evenly. The interim relief flows through evenly throughout the year?

Connie Lau

Once the interim increase goes into effect, then rates are increased and so you have to back up to the dates of those interims. The HELCO one was at the end of the first quarter. The big HECO increase was October 22, and I believe Maui was December 13.

Tayne Sekimura

To give a little bit more details, the rate relief that comes in is really the function of sales that come in throughout the year, Steve.

Steve Fleishman – Catapult Capital Management

Okay, so it isn’t going to be even, it is more?

Connie Lau

No, it is not even.

Steve Fleishman – Catapult Capital Management

Okay. Thank you.

Operator

Your next question comes from the line of James Heckler with Levin capital Strategies, please proceed.

James Heckler – Levin Capital Strategies

Hi, good morning.

Connie Lau

Hi.

James Heckler – Levin Capital Strategies

I was wondering if you could talk about the rate increases that customers might have been experienced throughout the year given oil price increases year to date. I understand significant portion of your generation is oil-fired.

Connie Lau

Right. If we were to look at the average Oahu bill year over year, it has been about a 50% increase on net cost and that is primarily coming from the increase in the fuel.

James Heckler – Levin Capital Strategies

Do you supposed that will – you had want too [ph] in the rate case that you currently filed in achieving the matrix that you are targeting?

Connie Lau

Raising rates is always a very difficult thing to do especially when a community in total is being hit quite hard by fuel increases but it’s very important for us to put in the peaking unit on Oahu and that will help in some of the O&M increases that we have been experiencing because of the aging infrastructure. So there are trade-offs in the rate case and that’s why the total increase that we’re requesting is about a 5% increase which we think is in a reasonable range. Our gas company just recently filed for about an 8.4% increase.

James Heckler – Levin Capital Strategies

I see. Thank you.

Operator

Next question comes from the line of Steve Gambuzza with Longbow Capital. Please proceed.

Steve Gambuzza – Longbow Capital

Hi, how are you?

Connie Lau

Hi!

Steve Gambuzza – Longbow Capital

A question on the facility [ph]. You mentioned that O&M was flat this quarter but I think it should be full year O&M numbers is expected to be up about 6% versus ’07, is that correct?

Connie Lau

Yes, slightly higher than 6 which is what we experienced in the first quarter.

Steve Gambuzza – Longbow Capital

So really, you’re going to have an accelerating O&M. Second half is going to be significantly higher than the first half.

Connie Lau

Correct.

Steve Gambuzza – Longbow Capital

Okay. And then on the bank, you mentioned in your remarks that deposit growth was positive in the quarter, core deposit growth, but in the 10-Q, I believe it indicated that there were some decline in deposits.

Tim Schools

That’s because people report deposits different ways. Total deposits would include CDs and in my comments, my comment is that we are strategically reducing our wholesale funding and our CD balances. CDs would be your highest cost consumer deposit.

Steve Gambuzza – Longbow Capital

Okay.

Tim Schools

And so most people use a core deposit definition. So you have total deposits and you have core deposits. Core deposits would be more of your transaction accounts, you money market accounts, savings accounts, checking accounts; deposits that you more likely can cross-sell. On CDs, I’m just learning Hawaii, but in the Southeast like in Florida, you got people that – you go get a doughnut and coffee at every branch in the morning just to get five basis points more, and they’re not really looking for relationships. So, most banks focus on core deposits.

Steve Gambuzza – Longbow Capital

Okay. And then, it appears that – I know there was some discussion of the issues regarding the reserves. It appears that the actual amount of reserves has actually declined relative to the average loan balance and then on non-performing assets sequentially, which kind of implied that the credit quality is actually not deteriorating but is actually getting better. Is that the (inaudible) we’re looking at?

Tim Schools

I’m not sure – Are you referencing the coverage of the allowance to NPLs?

Steve Gambuzza – Longbow Capital

The non-performing loans as well as the average loan balance.

Tim Schools

Well, I mean it’s essentially flat to a loan balance, right? 74 and 73 basis points. I guess I would call they were short of neutral. I don’t think it really improved. I don’t think it worsened. If you – the key indicators on that slide I pointed out is that there is two things that people typically look at. Your allowance to loans was 73 basis points this quarter and it was 74 basis points last quarter. So that’s essentially covering our total amount of loans for the same amount. But then you’ve got to look at what’s our analysis of those loans. Are they getting better or worse? So, the second thing people look at is the coverage to NPLs, what we are calling non-performing loans. And our coverage went to 3.5 times and it was 4.2 times in the first quarter so that measure actually is modestly down, but in any one quarter it can go up a little bit and down a little bit so that movement does not alarm me.

Steve Gambuzza – Longbow Capital

Okay.

Tim Schools

So I would call it even, if it were me.

Steve Gambuzza – Longbow Capital

Okay. Thank you very much.

Operator

The next question comes from the line of Ashar Khan with SAC Capital. Please proceed.

Ashar Khan – SAC Capital

Good morning. I just want to check, is there anymore rate cases toward the planned from now on to next year.

Connie Lau

We don’t have any other rate cases that are currently planned; however, we do have other large facilities that are being built. I mentioned that we have SP7 going on the Big Island and also our East Oahu transmission lines which is scheduled for service in 2010. So as we get closer to those in-service dates, we’ll be reevaluating whether the rate case is needed.

Ashar Khan – SAC Capital

Ms. Connie, if you look at future – only revenue increasing in ’09 will be this income case that gets filed [ph], is that correct, which will have interim hike somewhere in the middle of the year or something like that next year?

Connie Lau

Yes, that’s correct.

Ashar Khan – SAC Capital

And then, we should kind of like forecast – you don’t expect anything revenue enhancing until 2010 in terms of a rate case decision or interim decision. Would that be fair?

Connie Lau

Well, the way the rate case process works is that an interim decision should come within 10 months if there is no hearing and 11 months if there is a hearing, and so that would put us into June of 2009. And then you are correct, the final decision will just follow and there is no time (inaudible) on that.

Ashar Khan – SAC Capital

Right. But if you plan to file on any other jurisdiction, results on that won't happen until somewhere in the middle ' 010 or something like that. Would that be correct?

Connie Lau

Yes, that is correct if we follow our normal filing schedule when we file six months in advance for the test year. That's correct.

Ashar Khan – SAC Capital

Okay. Thank you very much.

Operator

Your next question comes from the line of James Bellessa – D.A. Davidson & Company. Please proceed.

James Bellessa – D.A. Davidson & Co.

Good morning. You know why does the vegetation not growing in even basis throughout the year?

Connie Lau

Oh that is actually a –

James Bellessa – D.A. Davidson & Co.

Vegetation management expenses different from quarter to quarter?

Connie Lau

That's a great question, Jim. You must have been here. I don't know if you remember but we have the 40 days and 40 nights which was very unusual for Hawaii in the spring of 2006 and so actually that really has impacted the vegetation schedule because it relates to the rate of growth of the vegetation which does relate to rainfall and so the rain that fell in early 2006 really impacted vegetation management expenses in late 2006 and into 2007, and then now it's just about that time for us to be going back again to maintain that vegetation.

James Bellessa – D.A. Davidson & Co.

How about the timing of the overhauls. They aren't evenly spaced throughout the year?

Connie Lau

That is also something that is quite lumpy. A lot of our larger units are on the five to six-year overhaul schedules and so it really depends on what units are coming up and as we mentioned earlier in particular our two neighbor island utilities overhauled units last year and did not have those this year although we are expecting some in 2009.

Suzy Hollinger

In addition to what Connie said, the overhauls from our independent power producers can also impact the schedule as well.

James Bellessa – D.A. Davidson & Co.

I was reading in your local newspaper that you are going to be a partner in algae to biodiesel plant.

Connie Lau

Yes.

James Bellessa – D.A. Davidson & Co.

Tell us how much you might be investing? What are your commitments there?

Connie Lau

Yes, actually, it's at of the memorandum of understanding stage and at the moment we are looking at principally providing the CO2 from our plant at Mount Waialeale which the algae really used to grow and the land owner in the area that owns the land adjoining our plant is one of the partners in this consortium and their contribution would be the land and they are possibly looking at the capital investment. The remaining partner is the original developer who is a scientist from the University of Hawaii and he has been talking with various venture capitalists about providing the capital for the plant.

James Bellessa – D.A. Davidson & Co.

Are you just going to send them all your fuel gas or are you going to be able to separate the CO2 up?

Connie Lau

We are looking at being able to separate out the CO2.

James Bellessa – D.A. Davidson & Co.

And are you making that capital investment or is this other entity who is putting together the plant making that capital investment?

Connie Lau

At the moment all of that has not been determined yet. We're still in the discussion stages.

James Bellessa – D.A. Davidson & Co.

Thank you very much.

Operator

(Operator instructions) It appears we have no more audio questions at this time.

Connie Lau

Thanks everyone for being on the call.

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Source: Hawaiian Electric Industries, Inc. Q2 2008 Earnings Call Transcript
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