Melissa Adams – Director, IR
Vince Ammann – VP and CFO
James DeGraffenreidt – Chairman and CEO
Harry Warren – President of Washington Gas Energy Services
Daniel Fidell – Brean Murray, Carret & Co.
Ted Durbin – Goldman Sachs
Aurora Cain [ph] – Zimmer Lucas
WGL Holdings, Inc. (WGL) F3Q08 (Qtr End 06/30/08) Earnings Call Transcript August 5, 2008 10:30 AM ET
Good morning and welcome to the WGL Holdings, Inc. third quarter fiscal year 2008 earnings conference call. At this time, I would like to inform you that this conference is being recorded and that all participants are in a listen-only mode. We will open the conference call for questions and answers after the presentation. The call will be available for rebroadcast today at 1:00 pm Eastern Time running through August 12 at 5:00 pm. You may access the replay by dialing 1-800-642-1687 and entering pin number 56589782. If you do not have a copy of the earnings release, you can obtain one at www.wglholdings.com.
I will now turn the conference over to Melissa Adams, Director of Investor Relations. Please go ahead.
Good morning and thank you for joining our call. This morning's comments will reference a slide presentation on our Web site that you can access by going to www.wglholdings.com, clicking on the Investor Relations tab and then choosing Events and webcasts from the dropdown menu. The slides highlight our third quarter results and the drivers of those results. A reconciliation of our operating earnings with earnings numbers reported in accordance with Generally Accepted Accounting Principles is provided as an attachment to our press release and is also available in the Quarterly Results section of the Investor Relations Web site. In connection with your quarterly year-over-year analysis, please note that at the end of fiscal year 2007 we revised our non-GAAP reporting methodology to exclude unrealized mark-to-market adjustments. Such adjustments were not identified when we reported last year’s third quarter results.
In a moment, Vince Ammann, Vice President and CFO, will provide a brief recap of the quarter with a focus on the drivers that led to our results. Following that, our Chairman and CEO, James DeGraffenreidt will discuss items affecting fiscal year 2008 and our long term performance. James will also provide updated guidance for fiscal year 2008. Also joining us this morning on the call and available to answer your questions are Terry McCallister, President and Chief Operating Officer; Adrian Chapman, Vice President of Operations, Regulatory Affairs, and Energy Acquisitions; Doug Stapler, Vice President of Engineering, Marketing and Construction; and Harry Warren, President of Washington Gas Energy Services.
Finally, we encourage everyone to review our most recent forms 10-K and 10-Q filed with the Securities and Exchange Commission for a more complete discussion of the risks and uncertainties that can cause actual results to vary materially from the forward-looking statements that will be made this morning.
And with that, it's my pleasure to turn the call over to Vince Ammann.
Thank you, Melissa, and good morning to everyone. For the third quarter we reported GAAP net loss of $492,000 or $0.01 per share versus net income of $13 million or $0.26 per share in the third quarter of fiscal year 2007. Please note that all per share amounts referenced are on a fully diluted basis. The current quarter's results include $0.13 per share loss from unrealized mark-to-market derivatives related to our utility asset optimization program while last year's third quarter utility results included a $0.01 per share gain. In addition, last year’s utility results benefitted $0.04 per share from colder than normal weather while this year’s results were weather neutral. We exclude the effects of unrealized mark-to-market gains and losses from derivative transactions in addition to other significant and unusual items in order to provide a more transparent and accurate view of the ongoing financial results of our company’s operations. For contracts that qualify for mark-to-market accounting, there are likely to be continuous paper gains and losses until they close for delivery. When derivatives settle the economic effects are reflected in our operating results when the interim mark-to-market amounts are eliminated. Slide no 26 presents the hypothetical illustration of the variability that occurs during the lifecycle of an asset optimization contract subject to mark-to-market accounting in relation to its economic endpoint for realized value.
As shown on slide 3 after adjusting for mark-to-market adjustments in last year’s weather effect, the current quarter’s non-GAAP operating earnings were $0.06 per share versus $0.14 per share in the same quarter last year. The decrease in year-over-year third quarter non-GAAP operating earnings was primarily attributable to a $0.16 per share reduction in the retail energy marketing results that was partially offset by a $0.06 per share improvement in the utility results and a $0.02 per share improvement from remaining unregulated activities.
Moving from consolidated results to a closer look at utility operations, slide 4 shows a reported seasonal GAAP net loss of $8.1 million or $0.16 per share versus a net loss of $2 million or $0.04 per share for the third quarter of the prior fiscal year. Slide 5 shows that after recognizing the significant items mentioned above, there was a $0.06 per share improvement in the utility non-GAAP operating earnings. Items contributing to this year’s improvement include $0.08 for new rates and regulatory mechanisms, $0.02 per share from retained net margins from asset optimization, $0.01 per share from carrying charges on higher storage gas inventory valuation, and $0.01 per share from customer growth and a $0.02 net from other items. These contributions were partially offset by $0.02 per share from our reduction and interest income on lower short-term investment balances reflecting an increase in the level of working capital needed to fund the third quarter’s gas purchases. Another offset related to a $0.06 per share increase in operating and maintenance expenses, which was primarily due to a $0.04 per share increase in uncollectible expenses. Uncollectible increase reflects an adjustment in the cumulative reserve made in the prior period to reflect better collections combined with the negative effects of a slowing economy in the current period. After recognizing these adjustments, our year to date utility uncollectible rate remains below 1% of revenue.
I would also like to provide some insight with regard to our customer growth status. We have reported customers’ growth based on changes in active customer accounts or new leaders added plus the net effect of turn off and turn on activity. Despite the weakened economy and how things slow down including a sharp rise in regional foreclosures, Washington Gas has added 10,000 new leaders per day and is projecting to add a total of 13,000 new customers by fiscal year end. Factoring in collection activities, active customer accounts at quarter end were up 8000 over the same period last year; however by year end we expect year-over-year increase in active customer accounts will total 7000 due to the net effect of turn off and turn on activity in the fourth quarter. We have previously forecasted an increase of 13,000 customer accounts at year end. This decrease will reduce previous guidance by $0.01 per share. Year-over-year customer growth is now expected to contribute $0.07 per share versus the $0.08 per share that we forecasted on April 30.
While we are experiencing lower-than-expected customer growth, the most significant driver of the decline in projected active year-end customer accounts is attributable to collection and timing. Customers are taking longer to resolve their delinquencies, which is spending the time it takes to reestablish active service. Accounts that are inactive due to collection activities are generally reactivated during the next heating season once payment arrangements are finalized.
Moving to slide 6, Washington Gas Energy Services or WGES, our retail energy marketing business, reported net income of nearly $8.1 million or $0.16 per share versus net income of $16 million or $0.32 per share in the same period last year. There were non-GAAP unrealized mark-to-market adjustments in both periods. The current quarter’s results reflected unrealized gain of $3 million or $0.06 per share and last year’s third quarter results reflected unrealized gains of $3.3 million or $0.07. After considering these items, retail energy marketing’s non-GAAP operating earnings in the current quarter were $0.10 per share compared to $0.26 in the same quarter last year. Please note that year-over-year quarterly margin recognition patterns for this segment can vary significantly and may not be representative of annual results. Comparisons of full year non-GAAP operating results are more indicative of performance trends. The $0.16 per share decline in operating earnings is primarily attributable to significantly lower commodity gross margins in the quarter. GAAP sales of $112 million therms in the quarter reflected a 15% decline from the same period last year due to warmer weather and a loss of some large government accounts.
Natural gas customer accounts declined slightly year over year with 138,200 customers served at quarter end. This year’s third quarter unit margins of $0.94 per decatherm were lower than last year’s unit margins of $1.15 per decatherm. As we previously forecasted, this year’s third quarter margins were negatively affected by increases in the weighted average cost of gas when compared to the same quarter last year. As mentioned in our second quarter call, these increases related to the injection of gas into storage and rising index prices. Our accounting treatment for gas costs under these circumstances will shift margin recognition into the next fiscal year. This effect grew during the third quarter as gas prices continued to increase. Despite these margin deferrals we expect our full year unit margins to be in excess of $0.45 decatherm in line with our long-term planning range. Please note that our targeted margins exclude unrealized mark-to-market gains and losses.
Electric sales volumes declined 13% in the current quarter negatively affecting gross margins. We sold 854 million kilowatt hours of electricity versus 986 million kilowatt hours in the same period last year. At quarter end we were serving 63,600 customers or about 1000 more customers than last year, however the customer mix has shifted with an increasing retail residential base and a declining commercial base. The change in this customer mix has lowered expectations related to sales volume growth for the fiscal year. Quarterly results were also heavily affected by high purchase power costs attributable to unusual warm weather and high spot prices in early June that cause us to fulfill hourly [ph] load obligations at very high cost. Gross margins were also pressured by a combination of moderate weather and low stock market, stock power prices later in the month that cost us to sell off excess power supplies at low prices. The effect of these June results on unit margins is reducing our forecasted full year electric margin expectations to a range of $5.50 to $6.50 per megawatt hour. This is lower than our April guidance but at the high end of our long-term planning assumptions.
Please note that while our hedging strategies continue to provide effective protection against general price and market risks, our strategy of matching retail sales and commodity supply obligations is based on normal weather profiles and therefore cannot fully insure the company from unusual combinations of price and weather like those that occurred during June. Retail energy market’s uncollectible ratios remains at the very low rate of less than three-tenths of one percent of revenue. Improved results of $0.01 per share at Washington Gas Energy Systems, a provider of design build energy efficiency solutions to government commercial customers, despite the successful turnaround of distance [ph]. We also showed a slight reduction in corporate expense.
That concludes my discussion on the quarter and I will turn the call over to James.
Thank you, Vince, and good morning to everyone. Although we have reduced the midpoint of our guidance range by $0.07 per share, we continue to forecast a significant increase in year over year non-GAAP operating earnings growth. The midpoint of our revised range of $2.31 to $2.41 represent a $0.37 per share or 19% improvement over last year’s non-GAAP operating result of $1.99. Strong year to date and forecasted fiscal year 2008 results are directly attributable to a number of recent strategic accomplishments. Regulatory outcomes increased our rates to reflect better the costs we incurred to serve our customers. Implementation of revenue stabilization and/or weather normalization in over 80% of our service area combined with weather insurance in the District of Columbia have substantially improved the predictability of our utility operating revenue and our earnings. The expansion of our asset management program is providing valuable benefits to customers and shareholders.
Retail energy marketing continues to contribute a significant share of total net income and our energy solutions business is profitable and growing. I'm also pleased to report that recent new strategic initiatives such as Business Process Outsourcing, a performance based rate plan in Virginia and an implicit performance based rate plan in the District of Columbia provide us with new opportunities to produce valuable benefits for both customers and shareholders over the next several years. Our BPO transition is on schedule and we are already seeing results. Strategic sourcing actions taken during the last nine months will generate $4.5 million in savings and the initial problems experienced in the customer service area have been resolved. Our most recent customer satisfaction survey shows results that exceed both historical performance and targeted performance. Web service is receiving a 95% satisfaction level. Our high VR or voice recognition system satisfaction level is 84% and (inaudible) levels are running at 87%.
The drivers of this year’s utility improvement compared to last fiscal year are outlined on slide 18. First the cumulative effect of rate increases combined with favorable regulatory mechanism are together expected to contribute about $0.35 per share for fiscal year ’08 earnings. The successful expansion of our asset management program is expected to generate nearly $12 million in fiscal year 2008 revenue and $9.8 million improvement that will add $0.12 per share to fiscal year 2008 earnings when compared to the prior year. New customer additions are estimated to contribute $0.07 per share while the net effect of the District of Columbia and Virginia usage will contribute $0.10 per share. Accounting charges on storage gas were forecast to contribute $0.04 per share. These improvements are partially offset by a $0.13 increase in higher O&M cost which are about 5% higher than our April 30 forecast due to higher uncollectible. We also show a $0.09 per share increase in depreciation, general taxes and other as well as $0.02 reduction in interest income.
Finally, we are forecasting a $0.05 per share effect from the implementation of performance based rates in Virginia. We expect to generate results that exceed the 10.5% sharing threshold which enables us to share the economic benefits of improved incremental return with both customers and shareholders. We are thinking to extend the benefits of PBR to our Maryland customers and are in the final stages of a Maryland proceeding relating to the adoption of a PBR mechanism and associated earnings sharing proposal. A second Maryland rate matter relating to depreciation is also underway with resolution now expected after the start of the winter dealing season. In Maryland the commission staff has also requested a review of our GAAP purchase practices with regard to asset management and storage injection and we look forward to outlining the benefits that these programs have generated for our customers.
We expect to continue to deliver significant earnings contribution from our unregulated businesses but have lowered our guidance for non-GAAP operating results to a range of $0.24 to $0.28 per share. As since discussed, revised fiscal year 2008 expectations reflect the effect of unusual June weather and higher year to date natural gas and electricity commodity cost on our retail energy marketing business. While we expect continued long-term earnings growth from this business, we also continue to expect that this growth will be somewhat uneven. Looking further ahead, please note that we have modified our five-year capital spending forecast. We have pushed back the expected starting date of the Chillum peaking plant by one year to the winter of 2012, 2013 due to governing and legal challenges. We have raised our estimated cost of the plant to $158 million from $148 million to reflect the rising cost of material and labor. The price has increased to the beneficial location of this plant on company-owned property within our service footprint makes this significantly less expensive than other similar plants under construction in other parts of the country. We remain firmly convinced that the Chillum peaking plant represents the lowest cost and most operationally assisted supply solutions to meet our customers’ needs.
I am also pleased to report that we have achieved a significant legal victory that the Port Washington gave permission to provide safe, reliable natural gas service at a reasonable cost to its customers. On July 18, the United States Court of Appeal for the District of Columbia’s Circuit responded to an appeal that was filed by Washington Gas in January of 2007. The Court of Appeal vacated the Federal Energy Regulatory Commission’s authorization to expand the Dominion Cove Point LNG facility until the FERC is able to demonstrate that the potential safety issues raised by Washington Gas can be effectively resolved. The court action provides an important opportunity for all parties to express and discuss the effects of the Cove Point LNG facility on the Washington Gas system. The safety and integrity of our system is paramount as we continue to work through solutions to address gas leak caused by unblended re-gasified LNG from Cove Point. FERC has scheduled a technical conference on August 14 to discuss these important matters.
In summary, the company continued to make excellent progress and is on track to generate a rolling five-year average annual earnings per share growth target of 6% to 8% per year. We have increased revenues through successful revolution of rate case within all three of our jurisdiction and through the expansion of our asset management program. We have successfully neutralized the effect of warmer than normal weather on utility result. We have protected 40% of net revenue from reduced consumption in Maryland and will file later this year the District of Columbia request seeking to expand this protection to another 20% of our service territory. New and active legislation is often a perspective to result from the implementation of Virginia decoupling by 2011. Our strong balance sheet and support of regulatory mechanism that has helped us effectively manage the ancillary effect of the summer’s very high gas prices without resorting to new rate cases. Our gas administrative charge or GAC facilitates the recovery of uncollectible gas costs while our storage gas inventory accounting charge mechanism allows us to receive timely recovery of the financing cost related to rapidly rising gas storage inventory valuation. We are moving forward with the implementation of a major initiative to improve our service levels and reduce our cost structure and we have implemented a regulatory mechanism in Virginia with a similar proposal under consideration in Maryland that will share these potential benefits between customers and shareholders.
Finally, we have built a solid foundation to support continued profitable growth in our non-utility business. Washington Gas Energy Services continued to achieve success in markets throughout Delaware, Virginia, Maryland and the District of Columbia and Washington Gas Energy Systems has returned to profitability with a backlog of $44 million versus $12 million in the same period last year.
That concludes my remarks and we will now be happy to answer your questions.
(Operator instructions) We will take our first question from Daniel Fidell of Brean Murray, Carret & Co.
Daniel Fidell – Brean Murray, Carret & Co.
Thanks for the call. Just a couple of questions. I guess the first question is on the regulatory side of the fence in two parts I guess. First, can you give us a little bit more color on the status of the decoupling initiative in DC sort of where that is at and then secondly if you could just discuss a little bit more on the Maryland side review the gas purchasing activity you mentioned?
On the DC decoupling status, there is really not a whole lot to talk about there. We are just waiting for the District of Columbia commission to resolve dip [ph] issues or decoupling in the PEPCO case and we plan to file quickly on the heels of that case’s resolution. I will turn it over to Vince to talk about the Maryland side.
Sure Jim. In Maryland what we have is a staff recommendation to look at the purchasing practices as it relates to our asset optimization activity. There has not been any action taken by the commission yet on that request now. We have met with the staff and explained the processes but we’ll be happy to do it in a more formal setting if that’s what is required.
Daniel Fidell – Brean Murray, Carret & Co.
Okay, great. Maybe just back on the decoupling and DC for a moment, is it I guess the general feeling that perhaps in DC there is starting to warm up to the concept of decoupling?
I think that it is too early to tell and there is going to be some change on the commission but I think that we have finally achieved some common understanding that there is a relationship between decoupling and the promotion of energy efficiency. I think that when you add to that, the fact that the GP rate structure is a flat rate structure, decoupling will be most beneficial in the District of Columbia from a customer point of view because we have decline in blocks in Maryland and Virginia. So there is that added factor that makes the value of decoupling greater when coupled with promotion of energy efficiency.
Daniel Fidell – Brean Murray, Carret & Co.
Right. Then maybe just another quick question or two and I will turn it over to someone else. The status of the implementation of the (inaudible) contract, can you give us sort of an update on how that is going and sort of the next key dates we should be looking at?
I will let Vince add to this but as I indicated we feel that we are ahead of schedule on that front in terms of the business as well as the quality of service issue. We had some early what I would call difficulties in the early going of the transition from doing everything ourselves in terms of customer matters to transitioning over to adventure but we have worked with them really effectively at resolving the vast majority of those issues and as I just reported customer satisfaction level coming in is very high numbers quite superior frankly than our own historical performance. We outsourced many of the billing functions in the last quarter and those have gone without a hitch. So, generally speaking in terms of the financial expectations from the business plan as well as the service quality improvement, we are either on target or ahead of plan.
Daniel Fidell – Brean Murray, Carret & Co.
Okay, great. Thank you for the answers, I’ll step back and let someone else ask questions. Thanks
Thank you Dan.
Your next question comes from Ted Durbin of Goldman Sachs.
Ted Durbin – Goldman Sachs
It sounded like you had some mismatch on the hedging book on the retail side, I am wondering if you can just quantify how much of that impacted the decline in gross margins for electric versus the customer mix shift as well?
Okay, this is Harry Warren. I guess, I would probably characterize the, I don’t know if I will use the word mismatch but characterize what went on in the hedging book there. Our fundamental electric hedging strategy is to buy a quantity of electricity that is targeted to the average use of our customers. So, we are always exposed on a daily basis to having to buy or sell in the hourly spot market because we have to follow their load hourly. So, when we build into our pricing a certain amount of risk that is associated with doing that hourly balancing. We got to this particular month of June and we got some combinations of hot weather and high prices and cool weather and low prices that were outside of our sort of normal expectations on that. So, I think the fundamental hedging strategy is sound. We just know that we are exposed to some weather conditions that can compromise on margins in certain cases. I am afraid I don’t have for you a quantitative breakdown between how much of our lower margin projections there are due to those particular purchasing effects versus some of the lower sales volumes in our prior forecast, maybe we can get something on that later but I don’t have that sort of right now, but clearly both of those factors were in play. We were hoping for some sales growth this summer but a combination of competition and also the fact that we are providing electric prices, it is very difficult to win new customers away from the utility at this particular time. That combines a few compromises in our growth plans.
Ted Durbin – Goldman Sachs
Okay, thanks. Then a question on just what the delay in the Chillum CapEx forecast, how does that make you think about how it might influence the balance sheet in terms of cash for 2009?
The reduction in the capital expenditure program in 2009 only puts downward pressure on any additional capital needs that we might have to fund the capital expenditure program. Probably what is top on the mind for a lot of folks these days is the financing requirements for gas inventory purchases for this upcoming heating season. So, before we get out to 2009 probably the cash flow impact that a lot of gas distribution companies are looking at relate primarily to what we need to spend in order to get ready for the winter heating season. So, on that front we are currently looking at our short term cash forecasting requirements and evaluating what is the most cost-effective way to finance those working capital requirements. To that end we do have a decided advantage in that through our regulatory mechanism the amount we are investing in gas and storage does work into our rate recovery mechanism so we’ll get recovery on that average balance as we make those investments. So, although it is a short-term cash requirement, we don’t see that as being necessarily a negative thing other than that we are concerned about the impact on our customers. So, I think those are the factors that we are evaluating as far as cash flow in the next 18 months we are more focused on the cash required for those working capital needs and the construction program for the LNG plant.
Ted Durbin – Goldman Sachs
Okay, thanks. If I could just ask one more on the outlook for ’08, I was just looking at slide 18, correct me if I am wrong, it looks like your O&M expense expectations are $0.06 higher, it was $0.07 the last presentation and a negative $0.13 this presentation, what is behind that? I guess I would have expected that it went the other direction given the outsourcing but maybe I am wrong.
The change in the operating and maintenance expense item for the current quarter versus the prior quarter is primarily driven by the adjustment we discussed relative to our bad debt expense that we reported an additional amount in this quarter associated with our bad debt expense. So, that is the primary driver of the change from the prior quarter and as we indicated at the analysts conference in March as it relates to the offsetting effect from the outsourcing arrangement, we really see the benefits from the outsourcing arrangement to be inuring sometimes the greatest benefit starts to inure sometime in the future not in the early implementation months because of the way in which the contract is structured. So, we were looking at probably the biggest benefit in the short term from outsourcing arrangement arising in fiscal year 2010 and in the early years of the implementation either slightly negative in some months or cost neutral as it relates to what our expenses would have been for our O&M expenses. So, our primary interest in the short term was getting the implementation right and setting ourselves up for the long term.
Ted Durbin – Goldman Sachs
Okay, great. Thanks a lot.
Before you get away, this is Harry Warren coming back with – we may have dug up some data here on your question about how our lower forecast for electric margins live between a lower unit margins as opposed to lower margins on volume due to lower sales forecast and it looks like the effect is about two thirds on the unit margin and about a third on lower sales volumes than previously projected. So you can kind of apply that to some of the members in the slides with the deltas and the EPS I think to get the answer here.
Ted Durbin – Goldman Sachs
Okay, that’s helpful. Thank you very much.
Your next question comes from Aurora Cain [ph] of Zimmer Lucas.
Aurora Cain – Zimmer Lucas
Follow up on the unit margins on the electric side, I think they came down around $1.50 per megawatt hour, in the past you guys had talked about sort of $5.50 per megawatt hour for longer term margin on the electric side, I was wondering are you going to see a similar decline in your long-term forecast or do you still maintain the $5.50 sort of level?
This is Harry. I think our long-term forecast we are still feeling good about. Again, even with the decline that we have seen in the projections over the past couple of months, we are still at the high end of the range that we talked about in our analysts’ conference back in the spring. We target that $5.50 and we figure that that could be plus or minus a dollar based on different sorts of weather and pricing outcomes but we are still at the high end of even that range at this point.
Aurora Cain – Zimmer Lucas
Okay. Thank you very much.
Again I would like to remind everyone that you can listen to a re-broadcast of this conference call at 1 pm Eastern time today running through August 12 at 5 pm. You may access the replay by dialing 1-800-642-1687 and entering pin number 56589782. If there are no further questions, I would turn the call back to Ms Adams for any additional or closing remarks.
Thank you for joining us this morning and again, if you have any additional questions, please do not hesitate to give me a call at 202-624-6410. Thanks very much.
This concludes our conference call for today. Thank you all for participating. All parties may disconnect now.
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