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Westar Energy Inc (NYSE:WR)

Q2 2008 Earnings Call

August 8, 2008 10 00 am ET

Executives

Tony Somma - Treasurer

Mark Ruelle - EVP and CFO

Bill Moore - President and CEO

Doug Sterbenz - COO

Greg Greenwood - VP Generation Construction

Analysts

Greg Gordon - Citigroup

Shalini Mahajan - UBS

Chris Shelton - Millennium Partners

Michael Lapides - Goldman Sachs

Steve Cambata - Longbow Capital

Operator

Good day ladies and gentlemen, and welcome to the second quarter 2008 Westar Energy Incorporated earnings conference call. My name is Jasmine, and I'll be your operator for today. At this time all attendees will be in a listen-only mode. We will conduct a question-and-answer session towards the end of the conference. (Operator Instructions).

I would now like to now turn the presentation over to the host for today's call, Mr. Tony Somma, Treasurer. You may proceed, sir.

Tony Somma

Thank you and good morning. I'm Tony Somma, Treasurer of Westar Energy. Welcome to our second quarter 2008 earnings conference call. Because some of our remarks will be forward-looking, I remind you of uncertainties inherent in our comments during this call or that may be contained in our earnings release and materials that supplements the release.

This morning we posted the earnings release and supplemental materials on our website at westarenergy com. The supplemental materials include information intended to assist investors in their analysis of our financial release. They can be found under the investor presentations within the investor section of our website. The applicable Safe Harbor disclosures are presented at the end of the release. We filed our 2008 second quarter Form 10-Q this morning.

With that I'll introduce Mark Ruelle, our Executive Vice President and Chief Financial Officer.

Mark Ruelle

Thank you for joining us. On the call with me today in addition to Tony, are Bill Moore, our President and CEO; Doug Sterbenz, our Chief Operating Officer and other members of our senior management team.

In addition to commenting on the second quarter, I'll provide updates on our 2008 earnings guidance and comment on our rate case and other regulatory developments. Tony will then provide more in depth discussion of our financing activities and more details about the quarter and then Bill will finish with an update on our principal construction projects and planning initiatives. After that, we'd be happy to take your questions.

Earnings in the quarter were clearly a disappointment. Today we reported second quarter 2008 earnings of only $0.06 a share, some $0.30 lower than 2007. While we expected a much softer quarter this year than last coming off of year with record production and record margins and then going into a year with more planned maintenance at our base load plants. The disappointment came from the unplanned extensions of those maintenance outages at both our Jeffrey and Wolf Creek power plants, and this hurt us in three ways.

First, for market based wholesale sales, as a result of the outages we sold half a million and fewer megawatt hours at a higher production costs and notwithstanding the higher prices received for the sales we did make margins were down $12 million.

Second, as a result of those extended outages, it was necessary for us to focus more on meeting the needs of our retail customers, than on looking for opportunities in the wholesale markets. At the same time it appears that some of the fundamental dynamics of the market are shifting, and as a result our energy marketing margins were about $8 million lower this year than last, something I'll address further in a moment

Finally, while we have fuel clause for our retail customers, we still have a handful of industrial customers on individual contracts for which the fuel clause doesn't apply. This coupled with higher fuel and purchase power costs stemming from the base load outages meant that our retail margins on these contracts were about $6 million lower. The operative question for investors I think ought to be is are these persistent conditions? And fortunately the answer is no.

Recall that refueling outages at our nuclear plant occur every 18 months with no outage having occurred last year, and while the outage at Wolf Creek went 20 days longer than planned, the plant has been back since May 14th and has operated at full load since its return. Its next refueling in maintenance outage is scheduled for the fall of 2009.

As many of you know, we are installing scrubbers at our flagship three-unit Jeffrey Energy Center and as a result had planned for a long scheduled outage this spring during which the first unit scrubbing equipment was installed. But because the first unit's phase of that work ran behind schedule the outage was extended by 18 days. Since the unit came back on May 13th, it too has been running normally.

With regard to the four contracts with industrial customers not subject to a fuel clause, those are rolling off. In fact the largest of these contracts representing two-thirds of the sales for this group already expired on June 30th. We are now serving that customer on a standard tariff which includes fuel adjustment clause. The remaining three contracts representing somewhere around 40 000 to 45 000 megawatt hours per month expired between December of this year and November of next year.

With regard to energy marketing margins, things look to be improving here as well. The impact of the outages clearly diverted resources away from energy marketing. With the plants now back online and operating normally, we are seeing results more inline with our expectations for the balance of the year. But as a result of year-to-date performance, we expect energy marketing margins or some of you know as our non-asset activities could be as much as 30% below the full year 2007 level of $37 million.

I might also remind you that with respect to the regulatory arrangements for off system sales made from our units or what we record as market based wholesale transactions, the amount we must credit back to retail customers this year is still fixed with any differences flowing to the bottom line as was the case in the quarter. But due to a settlement approved by the KCC last year, we don't expect that condition to continue into next year. So what does this mean for 08 earnings guidance?

Today, we are affirming guidance of $1 50 to $1 65 per share with a bias towards the low end of the range, not far from where we see most of the published analyst estimates. This reflects the greater number of shares outstanding, but excludes the positive adjustment of about $0 38 per share based on expected year end shares related to a favorable tax adjustment we recorded in the first quarter. As a result, our reported earnings per share are still expected to be significantly favorable to guidance, as the guidance excluded the tax benefits.

As you know our ability to achieve earnings in accordance with guidance is dependent on a number of variables, including the weather, operation of our generating plants, prices in the fuel and also power markets, conditions in the capital markets, COLI income and the funding of our planned capital program among other factors.

Now, let me turn to regulatory matters. In May, we filed a retail rate case requesting an annual increase of $177 million, or just under 15%. The case is more straightforward than recent ones as the largest components of the new rate base have already undergone regulatory scrutiny through predetermination proceedings in front of the KCC. The case is progressing in all respect as planned, some key dates to keep in mind are the staff and Intervener testimony is now due September 29th. A settlement conference is scheduled for October 16th and 17th. Technical hearings are scheduled to begin October 29th and potentially continue through November 14th. And we still expect an order no later than January 23rd.

As for other regulatory developments, let me address favorable developments with respect to a couple of our tariffs. In December, we filed a request at FERC to revise our transmission formula rate, that’s been in existence now for a couple of years. We proposed changes to the formula that would among other things allow us to earn an additional 50 basis points on our authorized ROE and include forward-looking adjustments or expected capital expenditures a step designed to reduce regulatory lag.

In March, the FERC approved our requested increase in the ROE, but set the other changes for settlement discussions and potential hearing. All of the requested changes however became effective June 1st, with only the unsettled matters subject to refund until they resolved. As a result of the approved change to the ROE, our current base ROE for transmission is now 11 3%, with the formula update that became effective June 1. Recall that we have a large transmission project however on which we will earn an incentive ROE of 12 3%.

Kansas law permits an electric utility that recovers transmission costs through a formula rate set by FERC to recover the retail portion of that rate through a separate transmission delivery charge or TDC rider. After some sorting out over the past couple of years, in June we finally implemented a rider that can adjust periodically in accordance with changes to our FERC formula rate.

Consistent with the statute, the initial rider was revenue-neutral, meaning there was no immediate change to the retail rates. On July 3, we filed a request to update the TDC rider to reflect the higher FERC transmission cost to service. The requested adjustment is for an effective annual increase of about $15 5 million reflecting changes in the retail portion of our transmission costs of service since test year end 04. We expect an updated rider to be approved by early September.

Recall that we also update our environmental cost recovery rider or ECRR, each year based on our investment in emissions control equipment as at the end of the prior calendar year. On May 28, the KCC approved the tariff we filed in March and effective June 1st as planned we set our annual ECRR surcharge to recover $27 million up from $5 million for the year ended May 31st. The increase reflects largely the progress on our Jeffrey scrubber installation I mentioned earlier.

Now, I'll give you back to Tony to share a few more details on our financing plan and more details about the quarter.

Tony Somma

Thanks Mark. Our large CapEx program continues with our capital spend estimated about $2 5 billion for 2008 through 2010. Our thoughts about how we financed and have not changed. We will continue to draw on our credit facility until such time as it makes sense to term out with long-term debt and equity in amounts consistent with our target capitalization of approximately 50% debt and 50% equity.

Notwithstanding the volatile capital markets in our second quarter, we were still able to access both debt and equity on favorable terms. On May 15th, we closed on the sale of $150 million of KG&E first mortgage bonds. The issuance consisted of $50 million of 15 year bonds with a 6 15% coupon and $100 million of 30 year bonds at 6 64%. On June 4, we issued the 6 million shares of common stock that we marketed on May 29. We were extremely pleased with the investor response and as a result raised $141 million.

On June 30th, we completed the last step of our forward equity sale agreement that we entered into last November by delivering the remaining 3 million shares and receiving $73 million under the agreement. As a result of this financing activity, at the end of the second quarter common equity represented about 51% of our total capitalization excluding short-term debt.

In the past the KCC has updated the capital structure in our rate applications and we anticipate they would do the same in this case. Currently we have about $272 million of issued and outstanding adjustable rate tax-exempt pollution control bonds. Like most, our auctions have failed, resulting in reset rates in a range of 2 4% to 6 2%. We continue to monitor and review our options with respect to these securities. Just recently, the KCC granted us authority to refund or remarket some or all of these outstanding bonds.

Mark discussed the principal drivers for the quarter but I would like to provide a few more details that you might find of interest. Total sales increased $36 million, driven by increased retail sales of $45 million offset which were offset by the reduced wholesale sales and energy marketing previously discussed. A portion of the decrease in energy marketing was a charge of $3 2 million for a refund obligation to one of our energy management customers, reflecting adjustment to RTO allocations. A significant component of our increased retail sales was due to higher prices resulting from higher fuel cost recovery.

Fuel and purchase power expense increased $60 million or 46%, primarily for the reasons previously cited resulting in almost 1 million fewer megawatt hours of coal and nuclear generation which were largely replaced with higher cost gas generation and purchase power. This increased our total production cost per megawatt hour by 52%, thereby reducing margins from wholesale customers and the four industrial customers that didn't have a fuel adjustment clause.

Operating and maintenance expense increased $8 9 million compared to last year. This is due primarily to higher power plant maintenance cost of $6 3 million and a $1 4 million increase in SPP network transmission costs, the latter of which is largely offset by higher transmission revenues.

Now, let me turn things over to Bill Moore, our President and CEO.

Bill Moore

Thanks Tony. And thank all of you for joining us this morning. Before we take your questions, let me update on you several of our major construction projects and planned investments. As Mark indicated, progress on our large scrubber project at Jeffrey Energy Center continues and although the first unit's equipment ran a few weeks behind schedule, we are now scrubbing the unit's emissions. The inability of some of our fixed price contractors to perform as planned and other minor scope increases have put some upward pressure on the costs of the project.

We anticipate an increase of 15% to our previous cost estimate of $360 million, with our share being 92% of that figure. The second unit scrubber system is still planned for this fall, with the third and final unit next spring. With the common equipment now in place for all three units, we expect the two remaining units to stay on their original schedules.

I'm pleased to report that the first phase of Emporia Energy Center, our new 610 megawatt gas-fired peaking station went in service in June, ready to help meet peak summer demand as planned. The first phase is comprised of five turbine generators totaling about 310 megawatts. The two turbine generators for the remaining 300 megawatts in Phase II are already sitting on their foundations and are slightly ahead of their scheduled commercial operation before the summer of 2009. This project remains on budget at $318 million.

Our three wind projects, totaling almost 300 megawatts are expected to begin commercial operation by year end. Construction of tower foundations and tower bases is progressing, with towers and turbine deliveries slated for late summer and early fall. Recall that we will own roughly half of this capacity at a capital cost of about $290 million and purchase the other half through contracts.

Virtually all of this work is subject to fixed price contracts and has received regulatory pre determination with respect to applicable rate making principles. Our key transmission projects are well underway and on schedule. By year end, we expect to energize the first leg, the 40-mile section running from Wichita to Hutchinson of new 100-mile 345 kilovolt transmission line. We expect to get a jump on construction yet this year on the second leg from Hutchinson North to Salina.

Recall that this is the project for which the authorized incentives of a 12 3% ROE and 15 year book depreciation recovery. We have citing authority for our second large, 345 kilovolt project the 50-mile line from Wichita South to Oklahoma. We'll start acquiring right away for this line, as soon as we finish up the same for the second leg of the larger project.

In May, we announced the formation of Prairie Wind Transmission, LLC, a joint venture between Westar and Electric Transmission America, itself a joint venture between AEP and MidAmerican Energy Holdings, that plans to construct and operate high capacity transmission facilities in Kansas.

Prairie Wind is proposing to build approximately 230 miles of 765 kilovolt transmission facilities from the Wichita area west to Dodge City area and then a spur south southwest to the Oklahoma border from a town named Medicine Lodge. More recently OGE and Electric Transmission America announced a similar venture for a project that intends to interconnect with the Prairie Wind project at the Oklahoma border.

The Prairie Wind project is consistent with the SPP’s plans to establish a high capacity network for the region, with the project providing significant benefits, including enabling more development of wind energy, enhancing access to power markets, and improving efficiency and reliability, including cutting line losses.

Already Prairie Wind has filed with the KCC for a certificate of public convenience and authority, the first step necessary to build electric transmission facilities in Kansas. Prairie Wind intends to recover its costs of service using a postage stamp regional rate. Our current CapEx disclosures do not yet include any costs for this investment, as we don't anticipate any meaningful spend prior to 2011 with a target in service date in 2013.

Notwithstanding our disappointment with the quarter and the present turmoil in the capital markets, we remain confident in our strategy. Our commitment to the value proposition of being a basic, vertically integrated, rate regulated electric utility is unchanged. Our strategy, and we appreciate it involves substantial growth, centers around the flexible approach to planning, leveraging the attributes of our business and a collaborative and constructive approach to regulation to help us manage the large investment risks necessary to meet our customers' needs.

We will continue to keep you apprised of the progress in our capital expansion plan and the companion regulatory process, as those investments begin serving our customers and producing value for our investors.

We are now ready for questions from the financial community. Members of the media, we invite to you contact Karla Olsen at 888-613-0003 if you have questions.

Operator, would you please open the line for questions?

Question-and-Answer Session

Operator

(Operator instructions). And your first question comes from the line of Greg Gordon. You may proceed.

Greg Gordon - Citigroup

Thanks. Good morning, guys.

Bill Moore

Good morning, Greg.

Greg Gordon - Citigroup

Just to review the earnings for the quarter and try to separate things that were temporary versus things that were more ongoing in nature. It looks to me like you've actually recovered your retail fuel costs and purchase power costs for residential, commercial and industrial that were not subject to these special contracts. So, the $0.10 negative delta quarter-over-quarter and earnings related to gross margins from serving your customers was really related primarily to getting squeezed on those contracts of which the majority have now dropped off?

Bill Moore

Yeah. There are four contracts, Greg. They were I think 10-year contracts that didn't have a fuel clause in them and obviously they are rolling off, but right now there is still some in place. The biggest one rolled off at the end of June and it was two-thirds of the volume of those four contracts.

Greg Gordon - Citigroup

So, because you were purchasing higher cost power because of forced and unforced outages, those flip-flop from being slim positive margin to a massive negative margin in the quarter?

Bill Moore

No, they still made money but obviously not the money we hoped they would make.

Greg Gordon - Citigroup

Okay. They made less money?

Bill Moore

Yeah.

Greg Gordon - Citigroup

So their margins contracted, but the majority of them have rolled of if your plants perform for the rest of the duration of the contracts, historic levels of profitability should be restored?

Bill Moore

Yeah. Let me give you an illustration. Certainly the year before last, and I think even last year those special contracts were actually higher than our basic tariffs.

Greg Gordon - Citigroup

Okay.

Bill Moore

But they didn't have the fuel cost, and obviously when we had the quarter where we had extended outages and higher replacement costs without the fuel costs, obviously that hurt us.

Greg Gordon - Citigroup

Okay. And then the thing was O&M which really is related towards the timing of the outages, right? You're still expecting an overall growth in O&M for the year that's inline with inflation, right?

Tony Somma

Well, Greg. This is Tony. We haven't really given guidance on O&M for say, but the higher O&M was primarily related to the additional planned outages that we have this year versus last year.

Greg Gordon - Citigroup

Okay.

Tony Somma

And the extension of those outages.

Bill Moore

The other thing you have to remember when you look at our O&M is that a significant component of it is pass-through transmission O&M that gets most of it back in pass-through transmission revenues. So, when you see the driver of O&M being higher SPP transmission costs, you have to realize that there is not quite a one-for-one, but the majority of those come back as additional transmission revenue allocations as well.

Greg Gordon - Citigroup

And the tax-rate was it or wasn't that consistent with your expected tax-rate for the year?

Because I know, last year in the second quarter tax-rate was low.

Tony Somma

Greg, it was inline with what our expectations are for the year.

Greg Gordon - Citigroup

Okay. So, the only item that looks to me like it could be structural is lower earnings from the marketing business. Now, my sense is that part of that is related to them refocusing on trying to help you guys cover your short position because of the outages and being less focused on generating unregulated business?

Bill Moore

That's clearly a driver, but I think maybe Doug Sterbenz, our Chief Operating Officer might have more useful things to say about that than I can.

Doug Sterbenz

Yeah. Greg, obviously when we have these extended outages, we are just focusing on meeting the needs of a retail customer. When I say meeting the needs of a retail customer, what I'm really talking about is being out, spending a significant amount of time buying energy from the region.

Now, while that takes resources and time; people time and talent away from the non-asset business, it also consumes a good bit of the economical energy in the region that we normally could resell to others and create non-asset marketing margins. So, if we are the big buyer, if we are the big consumer, we don't have that power to resale to others and make money.

Greg Gordon - Citigroup

I got you. So, last year pre-tax profit in that business was how much? You said it in your script, but I don't recall it?

Doug Sterbenz

Well, I said in number of script but I don't want to characterize it quite the way you did I think I said gross margins of $37 million. That would be before sort of the O&M A&G allocation of $7 million or $9 million or something?

Mark Ruelle

6 or $7 million.

Greg Gordon - Citigroup

Okay. And this year, you are expecting the overall profit to be as a result of this issue?

Doug Sterbenz

We said about 30% lower maybe on the gross margins and obviously the A&G is probably not contracting in the same proportions. So, that’s why we said the margins probably get squeezed by as much as 30%

Greg Gordon - Citigroup

As we look out to 2009 and 2010, do you see the ongoing level of potential profitability of this business being impacted by anything in the markets?

Doug Sterbenz

Yeah, let me talk a little bit about that. Again this is the Doug Sterbenz. Another factor that we are still trying to get our hands around is the changing markets. As these organized markets are starting to mature, more buyers and sellers are transacting directly with those markets instead of engaging in bilateral transactions with folks like us. The SPP for example, where we are located has matured in the last year with the hourly market and is likely to move on to next day markets in the future, just as (inaudible) was done.

So more of our traditional counterparties are transacting with these organized markets or these exchanges, rather than with us. Now, with these new markets, also come new tools, and we’ve been able to take advantage of some of those new tools in (inaudible) for example, last year and even in the first quarter of this year. So I see our business is changing, it’s kind of yet to be determined whether we think it’s going to go up or down significantly. But right now we have a straight line on in through next year.

Greg Gordon - Citigroup

Okay. So, we assume that the level of profitability in this business going forward is more consistent with what you'll earn this year?

Bill Moore

I think it's too hard to tell, Greg. I think, if I had to swag at it, I would say somewhere between what we will actually earn this year and where we were projecting this year.

Greg Gordon - Citigroup

Okay. And my next question is on the scrubbers. Could you say again what you said about what the overall expected cost was and with the 15% increase, how much it is? And how much of that is being borne by Westar?

Bill Moore

Sure. Let me turn over to one of your old friends Greg Greenwood who’s VP of Construction on that. And he can talk about the project and its budget and where we are on it.

Greg Gordon - Citigroup

Thank you.

Greg Greenwood

Thank you, Greg. We are looking at a 15% increase on our previous estimate of $360 million. Obviously that’s disappointing to us, but scrubber projects across the country have experienced, similar even larger increases, and then I know our regulators follow that closely and they know that market as well as us. And it's just a tough construction market out there and we would expect to recover all of those costs through our environmental costs recovery rider.

Greg Gordon - Citigroup

Okay, so those increases are rolling into 8 and 9?

Greg Greenwood

Yes they are.

Greg Gordon - Citigroup

And within the recovery rider mechanism, is there a prudence review? And should we be watching that to make sure that the commission is in fact comfortable with the level of cost?

Greg Greenwood

Yes. There is a prudence review as part of the rider and certainly we would expect the regulators to take a look at that. But we are confident they understand the market as well as us and there’ll be recovery there.

Greg Gordon - Citigroup

Okay Thank you guys.

Greg Greenwood

Thanks, Greg.

Operator

Your next question comes from the line of Shalini Mahajan. You may proceed.

Shalini Mahajan - UBS

Thank you and good morning.

Bill Moore

Good morning

Shalini Mahajan - UBS

I did step away for a minute. I apologize if you addressed it in your comments, but what led to the extended outages at both the Jefferies and Wolf Creek?

Bill Moore

I'll let Greg Greenwood talk about Jefferies since he’s responsible for the construction project out there and then Doug Sterbenz will be happy to make comments about Wolf Creek.

Greg Greenwood

I think that we can really attribute the extended outage at Jeffrey to really two primary components down there, a lot of things you can throw in there. But the two primary components are, the labor productivity on the project was not what we or the contractor thought that it would be. Also frankly, we had some lessons learned. We have massive pieces of duct work that have to be removed and then replaced with new duct work during the project. And with wind dynamics, as they are at the Jeffrey's side, they would say it's not suitable for a wind farm. But I think our contractors would, maybe argue with that a lot of times throughout the outage. And we had trouble getting the duct work assembled and in place, as quickly as we thought we could, per hour schedule.

Now, we have taken some lessons learnt from that, Unit 1. Now we have a whole new lifting strategy for the duct work that's serving us very well and Units 2 and Units 3 already. And we don't anticipate that being a problem going forward on the remaining two units.

Bill Moore

And as far as Wolf Creek goes. First of all, let me tell you that this was not just a standard outage to refuel the reactor. This outage was a large and complex outage which involved the replacement of some particular equipment and the control systems that go along with that equipment, that have been in since the plant was built and had never been replaced before.

In addition to these large projects, we had a lot of unforeseen additions to the scope that happened after the outage had already started. Now that's never a good thing, but if you take these scope additions and you combine that with an already very complex outage. It proved too much to complete inside the original schedule.

Nevertheless, we do feel like we should and can do a better job with that schedule in the future. The three owning companies govern the plant, through the board of directors. I am one of the members, here at Westar that's on that board. I can tell you that we have put initiatives into place that will address these improvements as we plan for the next refueling outage in 2009

Shalini Mahajan - UBS

Okay. I mean my only concern is this; some of these issues could have been anticipated in advance and hedging done around it. I realized, we did see a pretty high commodity price environment in the quarter that probably drove a lot of the high fuel and purchase of our expenses. But I'm, kind of just trying to gauge how much could you have anticipated in advance and then planned around it?

Mark Ruelle

Well, Shalini this is Mark. Obviously I described it as it is, which is, it's disappointing. Which means we are not pleased with the quarter either. We too, think there was improvement that we could have and should have brought to bear. Having said that, we knew it was going to be a soft quarter for the reason we have talked all about, but you are right. We wish those wouldn't have been extended and we are doing the things necessary to make sure they are not extended in the future.

Shalini Mahajan - UBS

Okay. And then, I think you highlighted about $0 17, $0 18 of one-time impact because of these outages. And I know, you've mentioned the guidance now more towards the lower-end. I'm just curious, if you see any offsets in the second half that might allow you to recover some of the lost earnings here?

Mark Ruelle

Well, I mean it's, here's how we are sort of looking at that. First of all, you have to remember that when you look at it on a quarter last year, to quarter this year basis. It's obviously more dramatic than the difference when we look at guidance because last year was a year of record production at the base load plants and record off system margins as a result. This year, we knew it was going to be softer. But you have to remember we are really a third quarter company, and that's even more so the case, this year. As we have made mid-year adjustments to three very important tariffs.

On June 1, we updated the FERC formula rate. On June 1, we updated the Environmental Cost Recovery Rider. And within a month, we expect an update to the transmission delivery charge. And then we obviously expect and hope that the softness in the energy marketing and the base-load plants are behind us. That's really the driving factors to keeping us maintaining guidance. But I hope everybody heard, we were directing you to the lower end of that guidance.

Shalini Mahajan - UBS

Okay, thanks. Appreciate the color.

Operator

Your next question comes from the line of Chris Shelton. You may proceed.

Chris Shelton - Millennium Partners

Good morning, guys.

Mark Ruelle

Good morning, Chris.

Chris Shelton - Millennium Partners

Wanted to just elaborate on one thing and I know you've discussed it in the past. But with regard to the wholesale sales, excluding or aside from these industrial contracts, can you just remind me how the wholesale sales arrangement is proposed to be fixed for the commission? I mean is it just going to run through the fuel clause going forward?

Mark Ruelle

Sure. This is Mark. I'll try it and I'll see and have my colleagues keep me honest if I miss, because it's kind of complicated and there are different categories of them. For what we book in our financial statements as tariff based wholesale, you can really think of those more like rate regulated retail contracts with wholesale customers and those have a fuel clause.

Chris Shelton - Millennium Partners

Okay.

Mark Ruelle

For things that are opportunistic wholesale sales made out of our assets or what we book on our financial statements as market based wholesale, obviously we are not going to make those sales unless they are covering the cost of production and giving us a margin.

Chris Shelton - Millennium Partners

Okay.

Mark Ruelle

Those margins were squeezed but they were still obviously positive margins. I think maybe Chris, what you are getting at is how does the benefit of those market based margins ultimately flow back to the retail cost of service?

Chris Shelton - Millennium Partners

Right. And I just wanted to know how it goes; since you implied in your opening comments that some of this would probably not happen post the fix.

Mark Ruelle

Right. So here's what's happening today. Today we have a fixed amount of a credit that we have to give back to our retail customers. And I believe it's about $52 million this year, based on the margins that were the average of the three years ending last June, the year ago June. Okay. So we are giving back $52 million whether we make $1 million, $20 million or $100 million.

Chris Shelton - Millennium Partners

Okay.

Mark Ruelle

So as a result this year any delta to that $52 million obviously falls to the bottom line and in the first quarter, it fell to the bottom line, it's hurting us.

Chris Shelton - Millennium Partners

Right.

Mark Ruelle

What we have done to simplify that process and yet still give the regulators and our retail customers the assurance they are getting the full benefit of those assets there and rates, is that starting next year and as we file with our rate case we expect to simply refund whatever the margins are that we make, essentially contemporary in this with the same year's results.

Chris Shelton - Millennium Partners

Okay.

Mark Ruelle

And that settlement came out of the pre determination process for the Emporia Energy Center. And so, when we went in and got pre determination on Emporia Energy Center, obviously one of the questions came up was; you are adding 610 megawatts, might that affect your ability to make additional wholesale sales and what should be the retail customer's share in those wholesale sale. The resolution that came out of that settlement was simply that we are going to file, to instead of this three year averaging mechanism or some sort of a bonus plan or a structured incentive plan or anything like that, we are simply going to refund what we make.

Chris Shelton - Millennium Partners

Okay

Mark Ruelle

So that’s what we file with the rate case and that’s what we would expect to be in place with the rate order next spring

Chris Shelton - Millennium Partners

Okay. So going forward this quarter, it was the $52 million was somehow prorated in this quarter?

Mark Ruelle

Right.

Chris Shelton - Millennium Partners

And so, you had to take an accrual on that as a headwind. Whether it's going forward I guess that, you'll just refund whatever you would have made this quarter in to the fuel clause over to your customers.

Mark Ruelle

I think that's right. But let me clarify one thing, its not an accrual, we are actually giving back $52 million in cash this year, whether we make it, make more than it or make less than it.

Chris Shelton - Millennium Partners

Right. And I guess the clarification was what did you give back this quarter?

Mark Ruelle

Is it based on a megawatt hour basis?

Greg Greenwood

It's based on a kilovolt hour basis, backed into the retail clause.

Chris Shelton - Millennium Partners

Okay. All right. Thank you very much, guys. Actually, I have one other question, on the energy marketing clarification you guys were talking about the maturation of the markets.

Mark Ruelle

Yeah.

Chris Shelton - Millennium Partners

When you said, I know you guys are still feeling out how the market is, but when you said, you would expect results between last year and this year, is that including the distraction, if you will from this quarter for the energy marketing?

Mark Ruelle

Yeah, let me just clarify that. Just a few minutes ago we said that, in the guidance or sort of the expectation that those margins could be 30% lower than what they were last year.

Chris Shelton - Millennium Partners

Okay.

Mark Ruelle

And what that reflects is the disappointment year-to-date and the fact that things looked to be back on track year-to-go.

Chris Shelton - Millennium Partners

Okay. Thank you very much guys.

Greg Greenwood

Sure.

Operator

Your next question comes from the line of Michael Lapides. You may proceed.

Michael Lapides - Goldman Sachs

Hi, guys. Handful of questions, one easy one, when you think about the energy marketing business, except for your presence in the market meaning being a co-owner of one or more of the larger assets, what is your competitive advantage in that business?

Doug Sterbenz

Yes, this is Doug Sterbenz. Obviously having a presence in the marketplace and having a physical reason to be in there already gives you access to power and access to markets that you would otherwise not have. In other words, we are out there buying power everyday and selling power off our resources everyday. I think that’s our single greatest asset, of course, we think we’ve assembled a pretty talented group as well. But I'm not going to try to tell you that we are just going to make money because we are smarter than everybody else. I think we have a strategic advantage because we have a reason to be in the markets. Now this quarter that hurt us, because the reason we are in the markets distracted from our other business. In other words, we are buying all that power that we would normally resell and sinking it right here in our system for our retail customers and that worked as a hindrance for us this quarter. Normally our system is long. Therefore we are selling a little bit of power all the time that allows us to resell other people's power in the marketplace pretty successfully.

Michael Lapides - Goldman Sachs

We are four or five months away from the beginning of 2009 and I know that over the last call or two you all talked about not having any kind of financing needs for 2008. Can you talk a little bit about next year, in terms of what you are thinking about financing needs thrown going on?

Mark Ruelle

Sure, this is Mark. I'll give you some general comments and then Tony will let you know what’s on his mind more specifically. Really, no plans on how we intend to finance this business with it. Target equity and debt ratio are basically 50-50. And that means that we will, so long as we are investing and growing our business that we'll continue to tap more debt and equity markets in the proportion needed to maintain something in the neighborhood of that 50-50 ratio.

What we said at the time we marketed the last equity offering is that we are just going to stand down through the remainder of ‘08 until after we know what the rate case looks like before we decide specifically what we'll do with regard to future equity issuances. But we want everyone to know, we are certainly not hiding from the fact. If you are investing in Westar, you are understanding that we are going to raise additional equity as we fund the capital growth plan of the size that it is relative to our size. Tony, you have more specific thoughts?

Tony Somma

Hi, Michael, just to elaborate on what Mark said, next year we will be hitting the capital markets. You have, as well as all of our investors have, what we are going to be projecting to spend next year and you can model what our cash flow is and that delta is going to have to come from a little bit of retained earnings as well as external debt and equity. And I would look for us to do something similar as we have the last year or two which is hit the equity markets as well as the debt markets with first mortgage bonds.

Michael Lapides - Goldman Sachs

Got it. I want to ask a question, this is an operational question. Wolf Creek outage, I mean that's on a regulatory cycle just like every other nuclear plant. When you think about risk management of the fleet and scheduling, having booked the Wolf Creek and the Jeffrey. So essentially your two largest sources of power, out at the same time for what I think were both, I thought they are both planned activities and they extended a little bit, but originally planned, is that not, when you think about managing risk of needing power and just kind of global commodity prices? Do you not view scheduling those as overlapping or even within the same financial quarter as being a little bit more risky?

Doug Sterbenz

This is Doug. Absolutely, you bring up a great point. In the case of two long outages followed by the need to do all three Jeffrey units, we could not avoid having one of those, at the same time as the Wolf Creek outage. It was just completely unavoidable. But first of all, we would like to avoid that. Now going into that, we generally go out and buy packages of power to try to cover that which we did as well this time. But during most that have outage, we were without about 1000 megawatts of our lowest cost base load unit. We knew that going in; we planned for that during the normal outage. We did not plan for both of those outages to be extended some 18 days or 20 days. And that was the piece that really hurt us, the extension not the fact that we had them. We planned for that, we knew that was going to happen. The extension is the piece that really hurt us.

Michael Lapides - Goldman Sachs

Got it. Okay thank you, guys.

Bill Moore

Michael, just so you are aware the next two outages. We do not have coinciding with any other large power plant outages.

Doug Sterbenz

Good point. We don't have Wolf Creek at the same time, as we are cutting in the other scrubbers. Good point.

Michael Lapides - Goldman Sachs

Okay, got it. Thank you.

Operator

(Operator instructions). Your next question comes from the line of Steve Cambata. You may proceed.

Steve Cambata - Longbow Capital

My question has been answered. Thanks.

Bill Moore

Thanks, Steve.

Operator

Your next question comes from the line of [Oliver King]. You may proceed.

Unidentified Analyst

Hi, guys.

Bill Moore

Hi.

Unidentified Analyst

Sorry if I missed this, but on the four 10-year contract you are talking about, how much load are we talking about here and how much of the contracts have already expired and when are the rest of the contracts expiring?

Bill Moore

Well, the biggest one already expired on June 30th. So we are serving it on normal tariffs.

Doug Sterbenz

And that was two-thirds of the load.

Bill Moore

Yeah. That was two-thirds of the amount that was not covered under fuel clause. What remains is about some where between 40 000 megawatt and 45 000 megawatt hours a month. And the remaining three contracts, the next one expires in December of this year and the last one expires I think in November of next year, and I can't remember when the middle one expires, somewhere in the middle.

Unidentified Analyst

Okay. So, besides these four contracts everything else you have is a full pass-through?

Bill Moore

Yeah. We recover fuel on all of our tariff-based wholesale and obviously under market based wholesale, we don't make the sales unless it covers it, and these were the ones that were excluded simply because they were long-term contracts that extended beyond the date within which we installed the fuel clause a couple years ago.

Unidentified Analyst

So these are included in your market based wholesale?

Bill Moore

No. I was just answering the question basically all of it's covered by fuel except those.

Unidentified Analyst

Okay, understood. Thank you.

Operator

There are no further questions at this time. I'd like to turn the call back to Mr. Bill Moore for closing remarks.

Bill Moore

Thank you all for joining us this morning. We appreciate your questions. If you have any follow-up questions, you can contact Bruce Burns, our Director of Investor Relations at 785-575-8227. Thank you for joining us today.

Operator

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

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Source: Westar Energy Inc Q2 2008 Earnings Call Transcript
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