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Executives

Jo Smith - Director of IR

James S. Pignatelli - Chairman, President and CEO

Analysts

Brian Russo - Landenburg Thalmann

Maurice May - Power Insights

UniSource Energy Corporation. (UNS) Q2 2008 Earnings Call August 7, 2008 12:00 PM ET

Operator

At this time, I would like to welcome everyone to the UniSource Energy second quarter 2008 conference call.

Today's call will be hosted by James S. Pignatelli UniSource Energy Chairman, President and Chief Executive Officer. (Operator Instructions)

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

Jo Smith

Thank you and good afternoon everybody. Thank you for joining us. In a moment, Jim Pignatelli will brief you on UniSource Energy's second quarter financial and operating results for 2008.

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

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

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

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

James S. Pignatelli

Thank you, Jo. Thank you all for joining us today. Good morning. Today we are reporting second quarter consolidated net income of $5 million or $0.13 per diluted share versus net income of $12 million or $0.32 per diluted share in the second quarter of 2007.

For the year-to-date, our net income is $2 million or $0.06 per diluted share versus $17 million or $0.46 per diluted share last year. The lower earnings are primarily a result of things which we are addressing in our current settlement.

The primary is the higher fuel and purchase power costs. Our fuel and purchase power for the year-to-date 2008 was $22 million higher than year-to-date 2007. If a fuel and purchase power clause had been in effect, we would have deferred between $12 million and $15 million of this increase.

Second thing that produced lower earnings was the deferral of our CTC revenue. To-date, we have collected slightly over $40 million of CTC revenue, none of which has impacted the bottom line. We expensed $25 million of that revenue and we deferred recognition of $15 million of that revenue.

The third item which reduced our performance was reduced SO2 allowance of sales and I'll discuss that more in detail. There has been both a reduction in the amount of SO2 allowances sold and a diminution in price between periods. We also had rather moderate weather this year and that masks still some underlying growth of our assets.

The fifth item that lowered earnings on a comparative basis was a write-off of the Millennium asset of $2 million. This was a onetime item and I'll bring you up to date on where we stand with Millennium. But our earnings that we are reporting demonstrate the need for the commission to act expeditiously on the settlement which we have achieved with the other parties in the case.

Looking at our growth, TEP is seen about a 1% customer growth that is down from the 2% to 2.5%, which we have historically been reporting. The impact though of cooler weather during the first six months is really what reduced the revenue input.

Cooling degree days were down 10% versus the second quarter of 2007 and actually were 8% below the ten year average. That reduced our retail kilowatt-hour sales excluding mining by about 3.5%.

Mining sales were up 14% during the second quarter, but underlying growth has slowed in our service territory. As I indicated, we are seeing about a 1% growth versus the 2% to 2.5%, which we have historically seen.

Our plant performance was excellent in the second quarter. The equivalent availability factor of our coal generation is up to 92% versus 88% in the second quarter of '07. However, the costs of producing power were extremely high during the second quarter. Gas prices as you all know, spiked up.

The average second quarter per million index was $9.45 in MMBtu versus $6.59 in the second quarter of '07. Without a fuel clause, these increases dropped directly to the bottom line.

Additionally, the cost of purchase power was up dramatically in the second quarter, it was 51% over second quarter of '07. Cost per kilowatt-hour purchases were close to $0.10 a kilowatt-hour versus slightly over $0.06 a kilowatt-hour in the second quarter of '07.

All of these just indicate the need for a purchase power and fuel adjustment clause, which we are very pleased that all parties in the case indicated that it is appropriate for TEP to have a fuel and purchase power clause.

Looking at the SO2 impact, SO2 allowance sales. They were down between $4 million and $5 million in the first half of the year. We sold 4,000 SO2 allowance at an average price of $332, versus last year having sold 7,500 SO2 allowances at prices in excess of $650.

The major reason that we have sold less and the prices have come down is because of a court case which is under appeal, concerning the sales of SO2 allowances to utilities east of the Mississippi.

Actually, the prices today are more in the mid-$100 range and you will not see us sell some for a while. We will retain what excess we do generate. And we have reduced the amount of excess SO2 allowances which we will generate because frankly it costs about $250 in lime cost alone to produce a ton of SO2 allowances. So it's not economically feasible to do that at the present time.

I am pleased to announce or to remind you at least that we did refinance 138 million of our first collateral trust bonds that matured in August. We have concluded that transaction, retired that debt, and the current cost of that debt is in the 3% to 4% range versus a 7.5% previously. So we will see a reduced interest expense as we go forward.

Looking at UNS Electric, we did get an increase in UNS Electric effective June 1 of 2008. That will be on an annual basis approximately $4 million revenue increase. Additionally, we were successful in getting a new fuel purchase power clause in effect and it includes a forward-looking component, which is important in not only for UES, but also in TEPs fuel on purchase power clause which we have reached settlement with Staff on would include a forward-looking component.

That ameliorates the buildup of unrecovered fuel costs in a increasing fuel market. The ACC however, did deny our request to put Black Mountain in the rate base at UNS Electric. However, they approved the totaling agreement between UniSource Energy Development and UNS Electric. And the cost of that tolling agreement will be included in UNS Electrics PPFAC. The unfortunate thing, it's going to actually cost the customer more and give us a little higher return.

That's not unfortunate for the shareholder, but that's what we told the Commission, it was ridiculous not to put it into rate base. But they felt confined and did give us a totaling agreement which actually is better for the company.

I'd like to comment also that we are in the final stages of closing a transaction at a financing transaction at UNS Electric. I hope that it's concluded today.

We are refinancing the debt which we incurred when we purchased these assets, and we are increasing the total financing from 60 million to 100 million which will free up some of our short-term lines at UNS Electric. And that should be concluded today. And the rating agencies have been very responsive on that. We'll be announcing things on that later.

Looking at UNS Gas, we did receive a rate increase $5 million effective December of '07. As I have indicated before, in my opinion that was inadequate and we will be filing a new rate case before the end of the year, probably in the September/October timeframe.

Turning to Millennium, as I indicated, we did have a write-off of $2 million at Millennium. However, we did book some small gains on some other sales in the Millennium account. Currently at Millennium we have $32 million in investments, and we are sitting on $29 million in cash.

The investments were not incurring any additional investments at that and we are in the process of liquidating those. And I believe that they will be liquidated at a premium to that $32 million which is included on the balance sheet.

Looking for the remainder of the year, over the next six to 18 months, we expect to see a continued growth, but at a lower rate than our historical 2% to 2.5%. Expect TEP to grow in the 1% to 2% range. Expect UNS Electric and Gas to also grow in the 1% range, that's down from the 4% to 5% range that those were growing at.

We are reviewing our capital expenditure program as we do continuously. I would expect the capital expenditures to come down slightly. But one of the main reasons and one of the main benefits of the settlement agreement is looking at our current level of capital expenditures estimates over the next five years; we saw adequate internal generation of cash coming from the rates from that settlement to continue to fund those CapEx internally.

As far as where we are on our forward sales, we still have about 200 gigawatt hours in Q4 to sell, and we have about a little over 100 gigawatt hours in Q3 that are still eligible for sale that's excess coal that will be sold in those periods. We have sold 150 gigawatt hours of Q4 ahead at prices slightly in excess of $70 kilowatt-hour and we have sold 50 gigawatt in Q3 ahead at prices in the $54 range. Right now, Q4 is selling $71 on-peak and $64 off-peak.

We have hedged forward at approximately current market. The gas market has come down, significantly gas prices. We have hedged forward 50% of our August to October gas, that's about slightly less than 4 Bcf of gas and it is currently hedged at approximately current gas prices. We anticipate reaching our objectives on our cash flow, consolidated cash flow from operations. We expect that to be in the $285 million range for this year.

Let's turn to the rate case because I know that is really what is on our minds and hearts at this point in time. The case has been concluded as far as the hearings. The ALJ has asked for briefs to be filed on the 29th of this month. There will be one brief filed. There will be no response briefs. I'm hopeful that the ALJ will act expeditiously in this matter and we will see a recommended opinion order in the late September to mid-October timeframe.

This will give the Commission the ability to act in a timely fashion and actually put rates into effect this year. From my mindset, I'm still anticipating rates going into effect 1/1/09 even though I don't think that there is a reason that would hold the Commission from putting them in effect, earlier.

It was a settled case signed on to by all parties with the exception of RUCO. And under cross examination, the RUCO witness indicated his conformance with the majority of the pieces of the case. The only unsettled item is the disposition of whatever we collect under the CTC through the end of the year. As I indicated in my earlier remarks, we have collected and deferred $15 million on that through the end of June.

I would anticipate by the end of the year that number will be closer to $65 million. In my opinion that should be retained by the company. The settlement is based off of costs, 2006 costs and everybody agrees we had deficient rates at that point and time.

I think there is a strong argument that we should be entitled to keep the $65 million. I'm optimistic that the Commission will accept the settled case and we can go on about our business of continuing to supply safe, reliable power to Tucson.

With that, I'll open it up to any questions you might have.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first audio question comes from the line of Brian Russo, Landenburg Thalmann.

James S. Pignatelli

Good morning, Brian.

Brian Russo - Landenburg Thalmann

Good morning. Just curious, Millennium, can that cash ever be dividend up to the parent company for other uses? Why exactly is it sitting at the subsidiary level?

James S. Pignatelli

I can let Kevin answer more in detail. He just likes to have a extra set of cash sitting around, I think. No that can come up, in fact, we dividend though some earlier, and we will be dividending that up overtime. Do you want to respond to anything further, Kevin?

Kevin Larson

Well, we dividended up maybe about 15?

James S. Pignatelli

It is about $15 million last year to my recollection.

Kevin Larson

I would anticipate actually Brian, that we will dividend some of that up this year.

Brian Russo - Ladenburg Thalmann

And when do you think the remaining investments will be monetized, and should we expect further write-downs or onetime hits on that?

James S. Pignatelli

We have a put on one investment carrying on the books at 14 million. We have a put at 20 million on that, and I think that can be monetized this year. I don't see really much impairment in any of the other possibilities. The one that was impaired which could reflect some additional onetime hit was really an investment that we made in an emerging business fund, emerging technology fund in Tucson. It was really more in the nature of supporting local business development. This was only a $5 million investment and that was what was impaired the two.

So right now, it's probably only about $2 million, $2.5 million left in it. I could see maybe some impairment split in that but it's more than the reason why we made the investment.

It wasn't made to hit a home run or anything. It was made to increase business activity in the community, and we pick up the benefit of that in sales. The rest of them, we will just clean up as we go forward. As I said, we have a 6 million profit locked in one of them that we probably will exercise later this year.

Brian Russo - Ladenburg Thalmann

Okay. And then, on the SO2 allowances and future sales, I know you used those sales to support your cash flow and ultimately capital expenditure and then also I believe in the settlement 50% of the SO2 sales would go against the PPFAC, is there any issues now that SO2 prices have fallen so dramatically?

James S. Pignatelli

No, the only issue is a minor amount now, as you can see. The most we would generate on an annual basis is about 9,000 credits. We will probably generate fewer than that because the market price for those is lower than the cost of producing them. There will be some resolution to that court case which will probably cause a little bit of an increase in the value of SO2 allowances.

So I am not in a big hurry to sell them. We will just harvest those when it is appropriate. If I was an investing man, I would go out and buy some SO2 allowances because I think they are under priced at this particular point in time.

Brian Russo - Ladenburg Thalmann

All right, and then just on the forward sales. I may have missed this, but could you remind us how much you have to sell in fourth quarter and third quarter?

James S. Pignatelli

Sure. In third quarter, we have today remaining 115 gigawatt hours. And today remaining in fourth quarter, we have 200 gigawatt hours. We have already sold 50 gigawatt hours in Q3 ahead, and 150 gigawatt hours ahead in Q4. And those will be reflected coming through the income statement in Q4.

So we still have 200 remaining, and as I indicated, the prices in Q4 have a tendency to be pretty flat in the daily, the on-peak price today for Q4 is $71 and the off-peak is $64. I would imagine if we sold those today they would shape in the $67 range probably.

Brian Russo - Ladenburg Thalmann

I assume that's meaningfully higher than the price sold at in third quarter and fourth quarter of last year?

James S. Pignatelli

I don't recall what they were in third quarter, fourth quarter of last year to be honest with you. I imagine they will be higher because gas prices still remaining higher than it was in that period, and they generally follow gas price.

Brian Russo - Ladenburg Thalmann

All right, great. Thanks a lot.

James S. Pignatelli

Okay. Thanks, Brian.

Operator

(Operator Instructions)

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

Maurice May - Power Insights

Folks.

James S. Pignatelli

Hi, Maury, how are you doing today?

Maurice May - Power Insights

I am doing fine. Busy day, busy day.

James S. Pignatelli

Good.

Maurice May - Power Insights

I have a couple of questions. First of all, there is obviously a slowdown in housing starts in the Tucson area, a national trend. And I am interested in trying to ascertain the impact on capital expenditures, you said it might have a slight impact on capital expenditures. Can you elaborate on that?

James S. Pignatelli

Well, we're seeing a decrease in the CapEx mainly at UNS Gas and Electric. Those UNS Electric as I recall was in the $35 million CapEx range and that's probably come down to the $25 million range. We have not reforecast our TEP distribution and transmission expenses. We are going through our 20 year plan currently.

One impact of the rate settlement is, that there is no more free footage allowance. I think, it will cause the developer more cost in developing the home which could have an impact on reducing growth also, but it also reduces our CapEx. I would anticipate that CapEx is going to come down in the $20 million to $25 million range because of the free footage allowance removal.

Maurice May - Power Insights

What does free footage allowance mean?

James S. Pignatelli

Before, currently, I should put it that way. From our installation to the house, from our street to the house we wouldn't put in the infrastructure at no cost.

Maurice May - Power Insights

Okay.

James S. Pignatelli

And they got a free footage of allowance, if I recall it was in the 500 feet, up to 500 feet. We would absorb that as a capital expense.

Maurice May - Power Insights

Okay. Now that goes on to the developer.

James S. Pignatelli

That is correct. And that's the same in APS's territory.

Maurice May - Power Insights

Okay

James S. Pignatelli

But we never had the growth rate of 6% at TEP. I mean, way back maybe, but we haven't for many years, it's not like APS sees over Nevada Power sees. Our growth rate has been consistent in the 2% range.

About additional growth because of new construction and remodeling basically using more power, the newer homes use more power than the older ones and so the per customer usage was going up. We still, I doubt that we will drop our planning to anything lower than 1.5% to 2%. So, it is not a significant decrease in our planning horizons.

Maurice May - Power Insights

Okay.

James S. Pignatelli

But I want to reiterate Maury, the important thing to me, one of the important things about this settlement is that the internal cash flow in that settlement still enables us to, or will enable us to internally fund the CapEx at the current levels of estimates.

So, I just feel very good about the position of the company vis-à-vis it's construction budget. And I feel very good about the company that we still have, although it's slightly lower growth, still a good growth trajectory for an electric utility.

Maurice May - Power Insights

Okay. And I guess even if there is slightly slowed growth that would not impact the deferred transmission investment that you are making on an on going basis?

James S. Pignatelli

No, I think some people might question my logic on this. However, I think we will continue to push forward with the transmission. Transmission is extremely hard to permit. You don't want to get behind the curve on your transmission, and then have to face trying to permit transmission through populated areas.

I just think if you are still expecting growth, if you let yourself say, well I don't really need the transmission now, but I am going to need it in five years or ten years. You are going to look in five or ten years, and you will not be able to permit it, because there will be houses there.

Maurice May - Power Insights

Yes, okay.

James S. Pignatelli

And I just think that we need to continue to provide that transmission. The other thing on our transmission, a lot of the transmission expenditures that we make, are so we can access cheaper sources of power to get more out of hubs that we see, if we might be able to access it cheaper than building generation. A lot of our transmission expenditures are really surrogates for generation.

Maurice May - Power Insights

Okay. And then one second question, a short one. On the UNS Gas general rate case, you are going to file again in September and October. But you did try to file a second one last spring, didn't you and it got bounced by the staff? And can you tell me, can you refresh my memory why it got bounced and how you plan to fix the problem?

James S. Pignatelli

Well, the problem fixes itself with time. The staff did not want to address the case because they believe that you need to have the rates in effect for a 12-month period to have a test year. In other words, you have to have a historical test year that is based on the revenues from the increase.

And they have that issue or had that issue with APS filing a case. And I think that we sort of got caught up and that they were disputing APS's filing and felt that they had to throw ours back also. Plus, they were in a period I think that they just did not see how they could adequately adjudicate the case, they were getting too many cases in front of them.

Maurice May - Power Insights

Okay.

James S. Pignatelli

Timing, one, the rates have been in effect for an entire cooling season or heating season. So I think that we have a much better chance of getting it accepted and like I say time has healed part of their issue. A matter of fact, Ray was in talking to the staff yesterday about us filing this case.

Maurice May - Power Insights

Okay, great. Thank you, folks. Thank you, Jim.

James S. Pignatelli

Okay.

Operator

(Operator Instructions)

James S. Pignatelli

Well, thank you all for participating with us. I hope that the next time we talk one we will have a recommended opinion and order, and hopefully a final decision to talk about. I look forward to seeing you all in the future. And thank you for your continued support.

Operator

Thank you. This concludes today's UniSource Energy second quarter 2008 conference call. You may now disconnect.

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