Integrys Energy Group Inc. Q2 2008 Earnings Call Transcript

Integrys Energy Group Inc. (TEG)

Q2 2008 Earnings Call

August 7, 2008 9:00 am ET

Executives

Steve Eschbach - VP IR

Larry Weyers - Chairman, President and CEO

Joe O'Leary - SVP and CFO

Larry Borgard - President and COO, Integrys Gas Group

Charlie Schrock - President and CEO, Wisconsin Public Service Corporation

Mark Radtke - President of Nonregulated Subsidiary, Integrys Energy Services

Analysts

Paul Patterson - Glenrock Associates

Chris Shelton - Millennium Partners

Unidentified Analyst

Steven Strasburg - Longbow Capital

Hasan Doza - Luminous Management

Presentation

Operator

Welcome to the second quarter 2008 Earnings Call for Integrys Energy Group Incorporated. All lines will be in listen-only till question-and-answer session. At that time instructions will be given should you wish to participate. At the request of Integrys Energy Group today's call will be recorded for instant replay.

I'd now like to introduce today's host Mr. Steve Eschbach, Vice President of Investor Relations at Integrys Energy Group. Sir, you may begin.

Steve Eschbach

Thank you very much. Good morning everyone. Welcome to Integrys Energy Group's 2008 second quarter earnings conference call.

Delivering formal remarks with me today are Larry Weyers, our Chairman, President and Chief Executive Officer; Joe O'Leary, our Senior Vice President and Chief Financial Officer; Larry Borgard, President and Chief Operating Officer of Integrys Gas Group, Charlie Schrock, President and Chief Executive Officer of Wisconsin Public Service Corporation; and Mark Radtke, President of our Nonregulated Subsidiary, Integrys Energy Services.

The slides supporting today's presentation and an associated data package are located on our website at www.integrysgroup.com. Select investors, select presentations and then today's presentation. Before we begin, I will advise everyone that this call is being recorded and will be available for replay through November 4, 2008.

I need to direct you to slides 2 and 3 of our presentation and to point out that this presentation contains forward-looking statements within the definition of the Securities & Exchange Commission Safe Harbor rules, including projected results for 2008 for Integrys Energy Group and its subsidiaries. Forward-looking statements are beyond the ability of Integrys Energy Group to control, and in many cases, Integrys Energy Group cannot predict what factors would cause actual results to differ materially from those indicated by forward-looking statements.

I also refer you to the forward-looking statement section of yesterday's news release and to our filed Securities & Exchange Commission disclosure documents for further information. Except as maybe required by Federal Securities Laws, Integrys Energy Group and its subsidiaries undertake no obligation to publicly update or revise any forward-looking statement contained in this presentation, whether the result of new information, future events or otherwise.

Slide 4 indicates, today's presentation includes non-GAAP financial information related to diluted earnings per share from continuing operations adjusted, forward book value, and managerial gross margin.

We believe that diluted earnings per share from continuing operations adjusted, forward book value, and managerial gross margin are useful measures for providing investors with additional insight in to our operating performance and the effects of certain items that are not comparable from one period to the next. Please review the text of this slide regarding non-GAAP financial information.

I will now turn this call over to Larry Weyers. Larry?

Larry Weyers

Thanks, Steve. Good morning everyone and thanks for joining us on the call today. I am going to begin the call by giving you an update on the Brett Favre situation, but now as it has been resolved, so I'll go directly to the text.

I would really like to begin by thanking all of you who participated in our recent investor relations perception study. We learned a great deal from your feedback and we'll be incorporating your suggestions into our future interactions with you.

Please turn to slide 5. Consensus opinion from the perception study established three key areas that we need to clarify regarding prospects for our future. They include how we will expect to grow our regulated utility segment, the opportunities we see for our nonregulated segment, and how we plan to enhance shareholder value.

Let me begin with growing our regulated utility segment, where we have growth opportunities for a number of reasons.

First, regulatory catch-up due to rate case moratoriums stemming from our recent acquisitions will allow us to fully capture our expenses and investments in rates, and improve our opportunity to earn our authorized rates of return.

Second, we are increasing our investment in environmental and electric renewable projects in Wisconsin to help that state reach its proposed environmental compliance requirements and renewable portfolio standards.

Third, we plan to increase our investment in natural gas cast iron main replacement in Chicago. This is part of the Rider concept we proposed in our last rate case, and though it wasn't accepted as part of our 2008/09 rate structure, we believe a restructured proposal has a good chance of being approved in our next Illinois rate case filing.

Finally, we are also continuing to invest in the American Transmission Company, in which we own about 34%. Although, this is an equity earning stream, it is in large part driven by the growth in investment and an excellent rate structure afforded by the Federal Energy Regulatory Commission.

We also have a number of great opportunities before us for growing our nonregulated energy services business. And we intend to capitalize on those opportunities. As such, we are continuing a focused expansion into new markets. We are also continuing a gain-to-gain greater expertise in renewables, both from a sourcing and product structuring perspective, and an asset ownership perspective.

As part of our asset management strategy, we continue to evaluate whether our current assets fit our strategic objectives, and what must be done to insure that they do. We approach all of this very conservatively. We accomplish this by selling energy to our customers, hedging our sales to lock in margins as soon as practicable and limiting speculative trading in terms of amounts and market concentration.

We continue to expect that Integrys Energy Services will deliver between 10% and 15% core earnings growth for this segment. Ultimately, we expect to continue enhancing shareholder value for our investors. Maintaining our strong dividend track record is one of the ways we will do this. We have paid dividends for 68 consecutive years and increased our dividends for 50 consecutive years. This is a trend that we expect to continue.

Earnings growth from our regulated and nonregulated segments is both real and achievable. Using 2008 as the base, we expect to increase earnings per share by 6% to 8% on an average annualized basis.

As you can see in slide 6, we continue on track with our merger cost savings and cost to achieve those synergy savings, while our current projections have not changed, the merger cost savings are quite different than what we forecasted when the merger with Peoples Energy closed in February 2007.

The total five-year merger synergy cost savings has increased by $40 million and a total five-year cost to achieve those synergy savings has declined by $31 million. While most of these merger cost savings will be returned to regulated utility customers in the rate-making process, we are quite pleased with how the integration has evolved over the past year.

Now we will take a more in-depth look at how we are accomplishing our goals. Joe O'Leary will discuss our second quarter 2008 financial results, anticipated CapEx spending, financings, and revised guidance. Then Charlie Schrock, Larry Borgard and Mark Radtke will follow with brief operational updates. I will then return to wrap up our formal remarks, and moderate a question-and-answer session.

I will now turn the call over to Joe O'Leary. Joe?

Joe O'Leary

Thank you, Larry. Turning to slide 7, during the second quarter of 2008 we recognized income available for common shareholders of $24.1 million compared with net loss of $16.4 million in the same quarter a year ago. This resulted in diluted earnings per share of $0.31 for the quarter ended June 30, 2008, compared with a $ 0.22 net loss per share for the same period in 2007.

There is seven key items driving the positive $40.5 million quarter-over-quarter change in earnings available for common shareholders. We have presented them in after-tax dollars, and you will find more details in our earnings news release issued on August 6.

Additional detail related to the quarter-over-quarter and year-over-year drivers by segment can be found in the appendix contained in the slide deck and in the Form 10-Q report we filed with the Securities and Exchange Commission last evening.

Moving on to slide 8. Our projected capital expenditures and depreciation for regulated utility operations for 2008 through 2010 are shown. As can be seen in this slide, our net investment in rate-based assets will increase by $756 million over the next three years.

A more detailed breakdown of capital expenditures and depreciation by company can be found in the appendix on slides 29 and 30. Although our equity contributions to American Transmission Company declined to zero by 2010, this is not indicative of reduced capital spending on their part.

Slide 9 taken from the American Transmission Company's 2007 Annual Report projects that their net investment in plant will grow by approximately $1.7 billion from 2006 through 2017.

Assuming the timely filing and regulatory approval of incorporating the net utility plant growth in rates at the regulated utilities, plus, the anticipated growth in earnings from our 34% ownership in the American Transmission Company, resulting from their projected growth in net utility plant, we expect our net income could grow by $15 million to $20 million per year.

Our potential financial plans are included on slide 10 and have not changed since we discussed them during our conference call in May to discuss first quarter results. Now we will move on to our 2008 financial guidance, which is covered in slide 11.

We expect Integrys Energy Groups 2008 diluted earnings per share to be between $3.33 and $3.53. See our slides, news release and supplemental data package for additional detail relating to this guidance.

Also included in the news release and supplemental data package is the projected guidance range for 2008 diluted earnings per share from continuing operations, adjusted which is anticipated to be between $3.63 and $3.83. See our slides, news release and supplemental data package for further details relating to this guidance.

Slide 12 summarizes the key drivers in the change in the 2008 earnings guidance details just described as compared to what we provided as guidance last May. With respect to the increase in the lower end of the range, there is no single one item that can this can be attributed to.

For the decrease in the upper end of the rage range, an expected decline in electric margin due to decreased demand in weather accounts for a $ 0.15 per share reduction. In the natural gas segment, three items that factor into our change include an increase in margin due to weather reflecting a $0.05 per share increase, and expected increase in bad debt expense reflecting a $0.06 per share decrease, and an expected increase in maintenance expense reflecting a $0.09 per share decrease.

I'll now turn this call over to Charlie Schrock, President and Chief Executive Officer of Wisconsin Public Service for an update on our Wisconsin and Upper Michigan Utilities. Charlie?

Charlie Schrock

Thank you, Joe. And I ask our listeners to refer to slide 13. Key accomplishments recently achieved for Wisconsin Public Service included Weston 4 being declared commercially operational on June 30. The 500-megawatt coal-fired base-load power plant, which is located near Wausau, Wisconsin, was being dispatched by the Midwest Independent System Operator on July 1.

In addition, Weston 4 earned the 2008 Plant of the Year award from Power magazine. If you are interested in reading more about that award, the URL is listed on this slide.

As you recall from our last earnings call, Wisconsin Public Service filed a request on April 1st with the Public Service Commission of Wisconsin to increase retail electric and natural gas rates for 2009, and the details are on slide 31. I won't go through all the details but I will highlight the changes since our call three months ago. We revised our filing to include the 99 megawatt Iowa wind farm.

The Public Service Commission staff has completed its audit of the filing. Based on the audit, staff proposes that we receive about 83% of our combined electric and natural gas request. Commission hearings are scheduled for September with new electric and natural gas rates anticipated to be effective in January, 2009.

On July 4, we were granted approval to increase Wisconsin Public Services 2008 retail electric rates by $18.3 million, or 2% due to increased fuel and purchase power costs. This is part of the mid-year review of the fuel filing we made in February.

Wisconsin's current fuel rules only allow for prospective recovery based upon the effective date of the final rate order. With this additional recovery, and given current projected fuel costs, we anticipate that we will recover approximately 80% of the remaining $16 million of unrecovered 2008 fuel and purchase power cost by year-end.

Initiatives that will drive Wisconsin Public Services value proposition are listed on slide 14, and include construction of natural gas laterals to the Guardian 2 Pipeline in Wisconsin, which we expect to be placed in service by the end of 2008 at a cost of approximately $75 million.

And the acquisition of a 150 megawatt wind farm in Minnesota that we announced in March of 2008, and which is expected to achieve commercial operation sometime after 2012. These projects are in addition to the 99 megawatt wind farm we expect to acquire in Iowa in the third quarter of 2008, and to become commercially operational late in December 2009.

Additionally, we are participating in the legislative discussions to improve the fuel adjustment clause in the State of Wisconsin.

Now I'll turn the call over to Larry Borgard, President and Chief Operating Officer of the Integrys Gas Group. Larry?

Larry Borgard

Thanks, Charlie, and good morning, everyone. Recent key accomplishments in the Integrys Gas Group are indicated on slide 15, and include reaching satisfactory resolution on new collective bargaining agreements for the represented employees of North Shore Gas and Peoples Gas.

Key resolutions included new five-year contracts expiring in 2013, annual wage increases ranging from 3% to 3.25%, and moving on new hires to a defined contribution plan instead of a defined benefit plan. We are very pleased with the initial favorable labor relations we have established with our union employees in Illinois.

Another key accomplishment for our Gas Group was filing with the Michigan Public Service Commission in May, to increase retail natural gas rates by $13.9 million or 5.81% for Michigan Gas Utilities customers. The proposed natural gas rate increase is required because of the cost to environmentally remediate former manufactured gas plant sites, increased depreciation expense, and general inflation.

In the rate filing, we requested a $10.7 million, or 4.44% interim rate increase for immediate rate relief subject to refund.

However, due to the commission staff's work load and the inability to complete an audit of the case until September, we don't expect interim rates to take effect until December at the earliest. We would expect final rates to follow in the second quarter of 2009. This is the first distribution rate increase request since 2003 for our customers in Lower Michigan. Additional information on the rate case can be found in the appendix on slide 32.

On July 31, we filed with the Minnesota Public Utilities Commission to increase retail natural gas delivery rates by $22 million or 6.4%, for our customers of Minnesota Energy Resources. In that filing, we requested the entire rate increase be granted as interim rates subject to refund. And we expect the interim rates to take effect on or about October 1 of this year.

Higher rates are needed in Minnesota, as a result of general inflation, coupled with low sales growth, and increased cost to provide customer service functions. This will be the first distribution rate increase request since 2000 for our Minnesota customers, and we expect final rates to be effective in May of 2009. Additional information on this rate case can be found in the appendix on slide 33.

Initiatives that will drive the Gas Group's value proposition are indicated on slide 16. Now that we have effectively integrated the gas groups, regulated natural gas utilities both, operationally and financially, we're moving forward with rate filings so that our rate base investments and expenses are adequately reflected in rates and we have an opportunity to earn our allowed rates of return.

As a result, you can expect to see us move forward with the accelerated investment in replacing cast iron main in Chicago. Recall that approximately 2,000 miles of the 4,000 miles of main in Chicago need replacement, which amounts to approximately a $2 billion capital project over a number of years.

Now, Mark Radtke, President of Integrys Energy Services will discuss our nonregulated operations. Mark?

Mark Radtke

Thanks, Larry. Our nonregulated business continues to perform well despite challenging economic conditions. Slide 17 illustrates the growth in terms of our physical retail electric volumes delivered in the second quarter of 2007 versus second quarter of 2008.

The Illinois market has been a bright spot for us, as we begin to see top line synergies of the Peoples Energy merger, and contributions of our larger sales team across geographic markets including our mid-Atlantic region, New York and Texas.

Many of our industrial customers in the United States are benefiting from expanded international sales and we have successfully avoided large credit losses thus far in the year through our conservative credit risk management practices and mitigation techniques, which has actually resulted in a slightly favorable financial impact year-over-year, both for the quarter, and six months into June 30.

Now withstanding this, delivered retail natural gas volumes are down slightly compared to last year driven by reduced spot market sales. However, those sales were at very low margins, so the lost volumes had a negligible impact on our financial performance.

Slide 18 depicts our growing forward book sales or backlog. I am encouraged by our continued success in growing the forward book, especially in this rising energy price environment.

Rising prices tend to reduce our customers enthusiasm for making long-term price commitments, instead often choosing to recontract on a seasonal or even monthly basis. This trend was evident once again in the second quarter of 2008.

Electric and natural gas prices peaked around the end of the quarter and have come-off significantly since then. We have begun to see signs of customers returning to more traditional contracting terms as prices have fallen.

As long as prices continue to decline or stabilize, I would expect our forward contracted volumes to increase and I am confident that we are well positioned to successfully continue our market expansion efforts throughout the coming months.

On slide 19, you can see that our managerial gross margin, the metric that we like to use to measure our business performance showed a slight decrease from where it was a year ago. Included in the 2007 results, however, is the value associated with the Peoples Energy merger.

For comparability purposes, removing that 2007 onetime pop-in forward book value results in a $22.3 million increase in managerial gross margin so far in 2008 compared with 2007. I am quite pleased with this result, particularly in a rising energy price environment.

Our wholesale electric origination group produced strong results in the quarter including execution of a multi-year power off-take agreement with the wind generation facility.

We have previously discussed managerial gross margin and how it differs from generally accepted accounting principals or GAAP gross margin, slide 20 takes it one step further by giving a total adjustment that eliminates the volatility that derivative accounting can introduce.

The mark-to-market volatility adjustment line items represent the difference between GAAP and managerial gross margin based earnings. As we have described in the past, this measure removes the timing mismatches caused by derivative accounting rules and provides a better perspective on the value we actually created during the period.

All of the other numbers on this schedule are reflected in our reported actual earnings per share information that Joe referred to earlier.

Slide 21 demonstrates the future impact on GAAP gross margins related to the large derivative accounting gains we have recorded to-date. As you can see in the far right hand column, most of our mark-to-market timing differences related to contracts terminating in 2008 will reverse out during the remainder of the year.

With that being said, we cannot predict the impact that derivative accounting treatment might have on transactions that settled beyond the current year. It is important to note that these amounts are based on current contracts and do not reflect future business or further optimization of our portfolio of assets.

Slide 22 highlights some of the initiatives we see for the continued growth of Integrys Energy Services. During the quarter, we announced our definitive agreement to sell our 50 megawatt coal-fired stone and power plant located in Wisconsin, and we have since closed on that transaction.

This is consistent with our focus on more environmentally friendly projects. We mentioned last quarter that we created a new group focused on renewable energy, efficiency and conservation. We discussed the Winnebago Energy Center, a 6.4 megawatt landfill gas to electric project in Rockford, Illinois.

Additional projects we are working on include a number of customer sighted solar projects, as well as a dedicated landfill gas delivery pipeline for a customer that values this source of renewable energy.

And finally, we rolled out our renewable energy product in New York that provides customers the opportunity to purchase renewable energy bundled with rebates to invest in energy efficiency and conservation measures that are most relevant to their specific business. This can include upgrades to process equipment, tightening building envelopes, or deploying more efficient auxiliary equipment.

We continue to expand our presence in new and existing markets. Last years opening of our Denver office not only enabled us to penetrate new markets in the west, but has given us experience with renewables and allowed us to develop relationships that have significantly enhanced our customer-based origination capabilities in all markets.

Now I will turn the call back to Larry Weyers. Larry?

Larry Weyers

Thank you, Mark. Let me remind you of the key points from today's discussion relating to the drivers of our future earnings growth. First, excellent investment potential and the rate case processes at our regulated utilities will drive growth.

Second, we have great opportunities for growing our nonregulated energy services business which we intend to capitalize on, and which we project will deliver between 10% and 15% of core earnings growth for this segment.

Third, we expect to continue enhancing shareholder value for our investors through dividend increases and by increasing our earnings per share by 6% to 8% on an average annualized basis.

Finally, as set forth in slide 23, our earnings guidance for 2008 for diluted earnings per share from continuing operations adjusted is between $3.63 and $3.83. We appreciate you listening to our prepared remarks.

Now I would like to open the floor to questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Paul Patterson with Glenrock Associates, you may ask your question.

Paul Patterson - Glenrock Associates

Good morning, guys.

Larry Weyers

Hi, Paul.

Paul Patterson - Glenrock Associates

Just a few quick questions. The goodwill impairment on North Shore, a little surprising, happening so sooner after the acquisition. Could you just elaborate a little bit more on that?

Joe O'Leary

Sure, Paul, this is Joe. What ends up happening is that you are required to do -- as part of the goodwill impairment test, you have to reevaluate what the fair value is. When you initially set the goodwill back as of the merger date, it's based upon your estimate of fair value with all the information available at that point in time that was prior to any kind of rate case activity having taken place at North Shore Gas.

The impairment test that we did this year was as of April 1st, using more recently made available information including the fact that we did get a rate decrease at North Shore Gas, and then there are some other factors as well relative to the rising interest rates and impact on discount rates used in the overall calculation of the fair value.

Paul Patterson - Glenrock Associates

Okay. In terms of the changing guidance, the $0.15 I believe because of electricity, lower demand there and bad debt, and gas O&M. Do you think that any of the regulatory activity that you guys have in place right now will address this with the demand reduction that you guys didn't previously, I guess, expect in your previous guidance?

Joe O'Leary

When I'm looking through the various items, those are just changes from the last guidance that we gave but overall, as part of the rate case process, there is that catch-up that takes place to alleviate the regulatory lag on the expenses. So that clearly can help with regards to maintenance expense overtime depending upon the timing of the rate cases in different jurisdictions.

Paul Patterson - Glenrock Associates

Okay. But I mean the decline in margin due to the decreased demand, I guess I'm wondering is that, since demand seems to be; A. I mean, do you guys think it doesn't look like its weather from what I can see. It looks like there is some well, maybe you can elaborate a little more what's causing that decline? But what I'm wondering is, you have I guess, in Wisconsin you have an order yet to come out.

I guess what I am wondering is, do you think that that if this decline, do you see this decline continuing I guess? What's causing it? And if it is, is there any regulatory mechanism that can address that or the rate cases so far along that you have to deal with that later if this were to continue. Do you follow me?

Charlie Schrock

Yes, Paul, this is Charlie Schrock. I guess a couple of comments. First of all, we did see a decline in the residential and in small commercial sector in June, but our large industrials are kind of holding their own in the economy right now.

We do have a nice variety of different businesses in Wisconsin here. Manufacturing sector is actually doing pretty well. You might have seen a recent announcement of the Manitowac, a crane company out there got, bought out by an Italian company that has real high prospects for it. And we are seeing that sector hold us on.

As far as going forward, we do project in our rate cases a tempered sales projection. So we try to factor that into our rate cases. So I think that will kind of counterbalance what you are seeing, what we saw here in this quarter.

Paul Patterson - Glenrock Associates

Okay. Then in terms of the balance sheet, the assets from risk management activities, both, current and non-current, basically in the liabilities have really increased in the last six months. Is that totally because of prices? Could you just elaborate a little bit more on that?

I mean, it's a big, big increase from the beginning of the year. I noticed there was an increase at the end of the first quarter, but it seems to have really grown a lot. Could you just elaborate a little bit more on that? And sort of working capital themes that you guys might be thinking about going forward in terms of this big increase?

Mark Radtke

Paul, this is Mark Radtke. From the nonregulated perspective, certainly it was a function of price, and then also the volume of business that's in the portfolio. But at the end of June, prices really were at historic highs, certainly in natural gas and generally in power as well, around the country. Couple that with the derivative accounting treatment and that's the effect that you see on the balance sheet.

In terms of capital requirements, certainly high prices have an impact on that as does volatility. And the capital impacts there can increase or decrease in rising and falling markets; it really depends on where the market is at relative to the average hedged level with our customer portfolio.

So, if customers have locked in and we've gone into the market and procured supplies for that and then prices rise, that actually has a negative capital requirement for us, if we've customers hedged in at higher prices and markets decline that has an increased capital requirement.

Paul Patterson - Glenrock Associates

Sure. So I guess with the prices having I guess, decline somewhat from the end of the quarter, I mean I'm calculating so because the $4.8 billion here, do you expect that now to have declined? Is that what you mean in other words is this sort of leveling-off here or --?

Mark Radtke

Yes. But in terms of the risk management asset liability, you need to focus there on the net. But --

Paul Patterson - Glenrock Associates

Well, absolutely but the net hasn't grown that much in comparison to the gross. I mean the gross is really, I just was trying to get some proportion as to how big that can get. Maybe we can follow-up offline, we'll just cover it then later. I'll let somebody else ask questions.

Mark Radtke

Okay.

Joe O'Leary

Paul, thanks for your interest. I would remind you on your first question that the impairment charges are non-cash items.

Paul Patterson - Glenrock Associates

Sure.

Joe O'Leary

Yeah.

Paul Patterson - Glenrock Associates

Okay. Thank you.

Operator

Chris Shelton with Millennium Partners, you may ask your question.

Chris Shelton - Millennium Partners

Good morning. Paul actually took care of my questions. Thank you, though.

Joe O'Leary

Thanks, Chris.

Operator

One moment please for the next question. Eric McCarthy, (inaudible) Asset Management.

Unidentified Analyst

Hey, guys. Thanks for taking my call. I have two quick questions. The first, could you discuss bad debt expense, particularly in Illinois?

Larry Weyers

Yeah, I think I'll ask Larry Borgard to respond to that.

Larry Borgard

Sure. I think you're familiar with the fact that obviously 2008 is a tough year for our natural gas customers given the fact that the weather was colder than normal, but the prices were higher than we've seen historically, and the economy is not as robust as it has been. I tell you though, that there is some good news kind of on the horizon for bad debt in Illinois.

I'll remind you that last year we were struggling with bad debt in Michigan and Minnesota. But this year our Minnesota and Michigan bad debt is actually lower than our bad debt was this year, and that's a function of us jumping kind of on the process. We're working the process in Illinois.

So what I would expect our future bad debt to improve and just an indication of that, is that, if you look at our 120 and 150-day arrears buckets for our Illinois properties, they are actually lower in 2008 on a dollar basis than they were in 2007.

So, we know what we need to do with respect to bad debt. We're jumping on the process in Illinois. And our leading indicators would suggest that we're going to do better in the future than we're doing this year.

Unidentified Analyst

Okay. And the second question is how was Texas in the quarter. And could you discuss margins in that side of the business there?

Mark Radtke

Sure Eric, this is Mark. Texas, there has been a lot in the news about the extraordinary high prices, and the record high ancillary services costs in Texas. And that did have an impact on us as well. Clipped us about $1 million in margin over the course of the quarter, and that was a combination of about two-thirds of the impact on the higher ancillary services costs from that.

We've taken another look at our approach to managing the risks associated with ancillaries, and there was some risk that we were carrying in the portfolio that we didn't need to. It was hedgable, and so we've made some adjustments to that going forward.

And then, the very high prices that we're seeing in the late May, early June timeframe, with the very warm weather, caused us, and I think a lot of other market participants to be in the market buying incremental supplies to meet the peak requirements of customers. And that procurement was obviously at very high prices.

So that eroded margins there and it caused us to step back and look at the amount of optionality that we build into products to protect against those outlier events.

Unidentified Analyst

Okay, great. Thanks guys, appreciate it.

Larry Weyers

Thank you.

Mark Radtke

Thank you.

Operator

Steven Strasburg with Longbow Capital, you may ask your question.

Steven Strasburg - Longbow Capital

Yes. Can you just give us the status of outlook of legislation in Illinois that might rollback in coupling?

Larry Bogard

Sure, this is Larry Borgard. I think we talked about this on prior calls but the legislation really hasn't moved any in the Illinois legislature since our last call. There is a series of readings that have to happen and it is effectively at the same place today as it was on our last call, so there has been no forward progress on that.

If I could just comment on the regulatory process, all of the appeals and such from the rate case that granted decoupling have run their course. So, there really are no regulatory processes going forward to repeal the decoupling.

Steven Strasburg - Longbow Capital

So, in terms of the legislature, it's pretty much just a wait and see or is there someone actively, you know what I am saying, is there someone actively push this?

Larry Bogard

Well, clearly there are some folks that have introduced it in the legislature but it just hasn't moved in the last three months since our last call. I can tell you though that some folks have suggested that they will go to the courts, and any court challenge had to happen after the ICC process had run its course and that has recently run its course.

Steven Strasburg - Longbow Capital

Okay. Thanks for the update.

Larry Weyers

Steve I would add, you know, that there is a national movement to support decoupling and the proposed legislation that surfaced in Illinois really is in counter to that national movement. So, we think there is a lot of good reasons why decoupling is good for customers and provides benefits for customers. So we've got good arguments.

Steven Strasburg - Longbow Capital

I understand, thank you.

Operator

(Operator Instructions)

Hasan Doza with Luminous Management, you may ask your question.

Hasan Doza - Luminous Management

Good morning, guys.

Larry Weyers

Good morning.

Hasan Doza - Luminous Management

Couple of quick questions, one on the energy service, maybe a question for Mark or Joe. Can you guys confirm your current year core earnings base for energy services again for this year, the earnings base that you expect to grow from the 10% to 15%?

Mark Radtke

Hasan, this is Mark. The core earnings base that we expect at the end of this year and we talked about that at the year-end 2007 results is $66.5 million of core earnings. From there we expect to grow 10% to 15%.

When I look at how we're progressing on achieving that from the, about $46 million of core earnings last year, we're doing really well. We're at about $32 million halfway through the year. And the second quarter was a much stronger quarter more than recovering for the slow first quarter that we had. So I feel pretty good about 2008.

Hasan Doza - Luminous Management

Mark, refresh our memory. You guys have talked about a $20 million contract reversal for GAAP purposes in 2008. Has that contract been impacted in your P&L so far year-to-date?

Mark Radtke

Actually with the rising prices, we have continued to see derivative accounting non-cash gains. And so, when we talk about core earnings, really the only way I can get my mind around that is by looking at the managerial gross margin adjustment that we have on the slide depicted, which slide is it here?

On slide 20, that's the adjustment that you would apply to the $60 million that is reported at this stage. With the reversal that is outlined I think on slide 21 from a GAAP perspective, we would expect to see that $20 million yet flow through later in the year.

Hasan Doza - Luminous Management

Okay. That's helping. Just to make sure, if the $20 million did reverse which would be a negative, so on a GAAP basis if the $20 million in your income statement, your GAAP earnings would be $46 million? I am asking does the $20 million is included in the 66.5 or is it excluded?

Mark Radtke

Yeah, the way to think about it is that, if we hit core earnings $66.5 million and there is no additional derivative accounting impact in the course of 2008 versus 2007, we know that's a wrong assumption. But if it was only that $20 million that reversed out, then yes, that would be a $20 million hit to, GAAP earnings would trail core earnings by $20 million.

We fully expect there will be additional mark-to-market activity, because of derivative accounting and that's why we don't attempt to factor that out when we talk about guidance in the non-reg, we'd focus more on core earnings as illustrated by managerial gross margin.

Hasan Doza - Luminous Management

Mark, one more question on this. In terms of earnings distribution, historically is second quarter kind of the largest contributor to earnings for Energy Services when you look like 2006 and 2007, historically?

Mark Radtke

No, actually, we're not terribly seasonal. The electric business performs pretty strong in the third quarter. Gas business is strongest in the first and fourth quarters, second quarter tends to be to the extent there is a lull, but second quarter tends to be that low quarter.

Hasan Doza - Luminous Management

Okay. Guys, one last question on the Wisconsin Public Service. I know on your presentation slides you guys had presented a staff recommendation which is around 53% equity. Lear, I think you guys had asked for 58%? Can you give some color as to the reason for the discrepancy? And what's your actual equity layer in Wisconsin Public Service?

Joe O'Leary

Yes, just hold a second. Let me see if I got this with me.

Larry Borgard

I think it's toward the end of your presentation slides, slide 31.

Larry Weyers

Yeah, slide 31 covers the information. Hang on just one minute, we're clarifying something here.

Hasan Doza - Luminous Management

Sure.

Joe O'Leary

Okay. So we've got one of the reasons that caused this 1% off the base and then we have also got some off-balance sheet type items with regards to long-term purchase power agreement and such that, the treatment of that by the staff has an impact on that equity percentage as well.

Hasan Doza - Luminous Management

Okay. So what's your actual equity if you look at the balance sheet? What's your actual equity in Wisconsin public service?

Joe O'Leary

Well, you should try to keep it on a GAAP basis; it would be around the 56% range. And then I think on that, and that's also where we're at currently with regards to on a regulatory basis as well.

Hasan Doza - Luminous Management

Okay. And the reason you're saying the staff is proposing something that's below your actual levels is because of some adjustments?

Joe O'Leary

Yeah, one of the reasons why they allow us the equity that we had in our current rates is that the commission in the past has imputed certain debt to our balance sheet as it relates to long-term purchase power agreements such as, we have one on the long-term purchase power agreement related to Kewaunee, as an example.

And, so they imputed that debt on to the balance sheet in terms of calculating what the allowed equity percentage should be. The commission in the past has been supportive of strong balance sheet for the utility, and by imputing that data on there that helps with regards to return on equity. I'm sorry, in the equity allowed at our calculation of return on equity.

Hasan Doza - Luminous Management

Okay. I'll follow-up offline. But thank you for the explanation.

Larry Weyers

Okay. Thanks, Hasan.

Operator

At this time there are no further questions. I would like to turn the call back to Steve Eschbach.

Steve Eschbach

Thank you for being part of our second quarter earnings conference call. A replay of this conference call will be available until November 4, 2008, by dialing toll free, 800-308-7858. I repeat, 800-308-7858. The text for today's presentation is available on our website at www.integrysgroup.com, just select investors and then presentations. If you have any additional questions, you may contact me at 312-228-5408 or Donna Sheedy at 920-433-1857. Thank you.

Operator

Thank you for participating in today's conference call. Please disconnect at this time.

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