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Integrys Energy Group Inc. (NYSE:TEG)

Q3 2012 Earnings Call

November 5, 2012 9:00 am ET

Executives

Charlie Schrock – Chairman, President, Chief Executive Officer

Joe O’Leary – Senior Vice President, Chief Financial Officer

Larry Borgard – President, Chief Operating Officer - Utilities

Dan Verbanac – President – Integrys Energy Services

Steve Eschbach – Vice President, Investor Relations

Analysts

Paul Patterson – Glenrock Associates

Michael Bates – D.A. Davidson

Ali Agha – SunTrust

Ben Sung – Luminus Management

Ashar Khan – Visium Asset Management

Steve Gambuzza – Millennium

Reza Hatefi – Decade Capital

Operator

Welcome to the Third Quarter 2012 Earnings conference call for Integrys Energy Group Incorporated. All lines will remain on listen-only until the question and answer session. At that time, instructions will be given should you wish to participate. At the request of Integrys Energy Group, today’s call will be recorded for instant replay.

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

Steve Eschbach

Thank you very much. Good morning and happy election day to you all. Welcome to Integrys Energy Group’s Third Quarter 2012 Earnings conference call. Delivering formal remarks with me today are Charlie Schrock, our Chairman, President and Chief Executive Officer; and Joe O’Leary, our Senior Vice President and Chief Financial Officer. Other executives, including Larry Borgard, our President and Chief Operating Officer, Utilities; Mark Radtke, Executive Vice President and Chief Strategy Officer of Integrys Energy Group; and Dan Verbanac, President of Integrys Energy Services are also available for the question and answer session at the conclusion of our formal remarks.

The slides supporting today’s presentation and an associated data package are located on our website at www.integrysgroup.com, select Investors, select Presentation, and then today’s presentation. Before we begin, I will advise everyone that this call is being recorded and will be available for audio replay through February 26, 2013.

Before I begin the formal part of today’s program, I want to say I hope this call finds all of you listeners doing well, particularly those of you on the east coast. As most of you know, my shoes are here in Illinois but my roots are back east, and Hurricane Sandy had an impact on my family in Long Island and in Connecticut. They are doing well and I hope that this call finds the same true for all of you. On behalf of all of us at Integrys Energy Group, you are in our thoughts during this trying time.

Now, I need to direct you to Slide 3 of our presentation and to point out that this presentation contains forward-looking statements within the definition of the United States Securities and Exchange Commission’s Safe Harbor rules, including projected results for Integrys Energy Group and its subsidiaries. Forward-looking statements contain factors that are beyond our ability to control and in many cases we cannot predict what factors would cause actual results to differ materially from those indicated by forward-looking statements. Except as may be required by federal securities laws, we undertake no obligation to publicly update or revise any forward-looking statement contained in this presentation, whether the result of new information, future events or otherwise. This slide is a condensed commentary on forward-looking statements and you are encouraged to read and understand the more specific language that is contained in our filings with the Securities and Exchange Commission, including the quarterly report on Form 10-Q we filed, the forward-looking statement section of yesterday’s news release, and Slide 50 in the appendix.

Slide 4 indicates that today’s presentation includes non-GAAP financial information related to diluted earnings per share adjusted, and adjusted earnings or loss. We believe that these are useful measures for providing investors with additional insight into our operating performance because they eliminate the effect of certain items that are not comparable from one period to the next. Please review the text of this slide for more information regarding these non-GAAP financial measures.

I will now turn this call over to Charlie Schrock. Charlie?

Charlie Schrock

Thank you, Steve. Good morning everyone and thanks for joining us on the call today. Let me echo Steve’s comments to those of you affected by Hurricane Sandy. By many measures, this was one of the worst, if not the worst storm in United States history. It had devastating effects on millions of people on the east coast and they are all in our thoughts. The response to restore power from the electric industry has been overwhelming. Over 65,000 utility workers from across the country, including Wisconsin public service line electricians, mechanics and supervisors are helping the local utilities. Our crews are helping Connecticut Light and Power in their restoration efforts. I commend and thank our workers and all of the responders who are working in treacherous conditions to restore power as soon as possible; and as Steve said, for those of you joining us today who were impacted by Hurricane Sandy, on behalf of my fellow Integrys Energy Group colleagues, we hope that your lives soon return to a more normal state.

I’ll begin today by providing a high level overview of our third quarter 2012 financial results, operational highlights over the last few months, and our expectations for the balance of 2012. Joe O’Leary will then discuss our financial results in more detail and provide more information regarding our financial outlook. As usual, we will conclude with a question and answer session.

Please turn to Slide 5. In the third quarter of 2012, we posted diluted earnings per share adjusted on a consolidated basis of $0.55 per share, up $0.13 per share from the same period a year ago. The primary quarter-over-quarter drivers were rate increases for People’s Gas, North Shore Gas, and Upper Peninsula Power, as well as lower expenses at the electric utilities. These items more than offset lower sales volumes at the regulated natural gas utilities due to lower use per residential customer and lower sales volumes from wholesale customers at the electric utility.

For the nine months of 2012, the warmer than normal weather during the heating season had an approximate $27 million or $0.34 per share negative impact on our consolidated financial results compared to normal weather, driving the period over period decline in adjusted earnings. Although the third quarter of 2012 was also warmer than normal, the impact of weather on our year-to-date results did not change materially from what we disclosed last quarter as a decoupling mechanism at Wisconsin Public Service offset the electric sales increase.

Before I move on to our segment highlights, I’m pleased to report that mostly due to continued cost control efforts by our employees, we are expecting earnings to be more than projected in August and are revising our 2012 guidance for diluted earnings per share adjusted upward to $3.22 to $3.38. Joe will provide more detail on this in a few minutes.

But before I turn the call over to Joe, I’ll summarize the recent developments for our regulated utilities. I mentioned on our last call that our strategy for our electric supply portfolio for Wisconsin Public Service was evolving. As you’ve seen, there has been some significant progress on that evolving strategy with our announcements of the pending purchase of the Fox Energy Center and Dominion’s recent announcement that they will shut down the Kewaunee nuclear plant next year.

Slide 6 addresses our Fox Energy Center transaction. The state regulatory approval process has been initiated and federal regulatory approvals will be requested before year-end. We are on a path for approvals to be secured for a targeted April 1, 2013 closing. Joe will have more to say on the impact of this acquisition on 2013 earnings and financing in a few minutes.

Slide 7 highlights the other developments at our regulated utilities. In October, Dominion Resources announced that they will be shutting down the Kewaunee nuclear plant in mid-2013. Wisconsin Public Service has an electric supply contract for 330 megawatts of electricity from Kewaunee nuclear plant that runs through December 21 of 2013. Dominion has indicated that it will continue to honor its contract with Wisconsin Public Service by providing electricity purchased on the open market after the plant is shut down. The shut down of the Kewaunee plant is not expected to impact reliability as Wisconsin Public Service has sufficient reserves and will continue to have a diversified power supply portfolio that will provide our customers with safe, reliable and affordable electricity.

The accelerated natural gas main replacement program for People’s Gas continues to move forward. The amount of our investment this year is on target; however, we expect that the miles of main we will be able to install this year will be between 130 and 135 miles instead of the 200 miles we had anticipated earlier in the year. Increased compliance requirements in the City of Chicago and changes in our internal processes are adding some additional costs and more work to the project, thus limiting the amount of main that we will replace this year.

Next, our rate cases are proceeding. The Public Service Commission of Wisconsin verbally approved the Wisconsin Public Service rate case settlement. The rate cases for People’s Gas and North Shore Gas are in progress with updates filed for anticipated increase costs primarily related to modifications in natural gas main and service pipe installation procedures, and due to new regulations from the Chicago Department of Transportation. Rates for Minnesota Energy Resources are expected to be final in December 2012. Slides 23 through 26 in the appendix have more details on the rate cases.

Slide 8 provides a brief summary of the developments for our non-regulated energy segment. The highlight is that Integrys Energy Services reached agreements to sell three of its four legacy merchant generation assets – the Westwood, Beaver Falls, and Syracuse generating facilities. We expect to close these transactions over the next several months. As we mentioned previously, these assets are not core to our restructured non-regulated energy marketing business and our plan has always contemplated that they would be sold if appropriate opportunities arose.

For the non-regulated energy marketing business, unit margins for new business remain lower than historical levels and overall realized unit margins are lower compared with the same quarter last year due to continued competitive pressure. However, our contracted future volumes are up substantially for both retail natural gas and retail electric, even though there has been little additional growth within Illinois aggregation since last quarter. We expect to continue to grow sales volumes as opportunities exist not only in Illinois but also in other portions of our footprint.

I will now turn this call over to Joe O’Leary. Joe?

Joe O’Leary

Thank you, Charlie. I’ll cover our financial results for 2012 and discuss our guidance for 2012 diluted earnings per share adjusted. Beginning with Slide 9, during the third quarter of 2012 we recognized GAAP diluted earnings per share of $0.83 for the quarter ended September 30, 2012 compared with $0.47 for the same quarter in 2011. Based upon anticipated pretax proceeds totaling approximately $8 million for the Westwood, Beaver Falls and Syracuse generating units, we recorded an after-tax impairment of these assets of $7.4 million in the quarter, and this is included in discontinued operations.

This slide also sets forth the additions and subtractions we’ve made to arrive at diluted earnings per share adjusted for the third quarter of 2012. The discontinued operations line item relates to the three legacy power plants that Integrys Energy Services has contracted for sale, as Charlie just described. In addition, Wisconsin Public Service was authorized a recovery of $5.9 million related to income tax amounts expensed in 2010 and 2011 as a result of the federal Healthcare Reform Act. As a result, a regulatory asset was recorded at September 30, 2012 and had a positive impact on our third quarter 2012 GAAP results. Our diluted earnings per share adjusted for the third quarter 2012 was $0.55 compared with $0.42 for the same quarter in 2011. More comparative information on the third quarters of 2012 and 2011 is reported by segment on Slides 33 and 34 in the appendix.

For the nine months ended September 30, 2012, we recognized GAAP diluted earnings per share of $2.69 compared with $2.39 for the comparable period in 2011. We’ve also shown the additions and subtractions to arrive at diluted earnings per share adjusted for the nine months in 2012 and 2011. Our nine month 2012 diluted earnings per share adjusted was $2.37 in 2012 versus $2.38 in 2011. More comparative information on the nine month results for 2012 and 2011 reported by segment can be found on Slides 40 and 41 in the appendix.

Note that we have again included separate tables on Slide 9 to show the impact of the unusually warm weather compared to normal weather net of decoupling in both dollars and diluted earnings per share. As we have said in the past, decoupling in each of our jurisdictions is not perfect, and given the Illinois Commerce Commission’s revised amendatory order in the People’s Gas and North Shore Gas 2012 rate cases, our financial results are now more sensitive to weather than they have been in the past. You will note that the weather impact has essentially stayed the same as we disclosed in our previous conference call as the warmer than normal weather during the third quarter of 2012 was offset as a result of our electric decoupling mechanism for Wisconsin Public Service.

On Slides 10 and 11, we show the changes in adjusted earnings by segment for the third quarter of 2012 compared with the third quarter of 2011, and nine months 2012 compared with the nine months 2011 respectively. Additional detail on the key variance drivers for each segment can be found in the appendix on Slides 35 through 39 for the quarter-over-quarter comparisons and Slides 42 through 46 for the nine month over nine month comparisons.

Moving to Slide 12, we’ve provided our capital expenditure plans for 2012 through 2014. There are a number of changes that I will summarize for you. At Wisconsin Public Service, the increase in 2013 is primarily related to the recently announced Fox Energy Center acquisition, and the increase in 2014 is due to undergrounding of electric distribution lines in certain areas in Wisconsin. We have increased the projected capital expenditures for People’s Gas and North Shore Gas over the three-year period primarily due to increased costs related to our accelerated main replacement program.

There is also a change in 2013 for Michigan Gas Utilities related to an anticipated increase primarily for main installation and replacement and related equipment. The increase for Integrys business support is for a planned enhancement to the customer support system. Other changes from what we provided in the second quarter include refinements related to the timing and amounts for construction projects at our subsidiaries and the equity contributions for the American Transmission Company. We no longer expect to make equity contributions to INDU Solar LLC in 2012 as it has been able to internally finance its solar projects, so we’ve removed the line for INDU Solar from the table.

Slide 13 shows our expected depreciation expense at the regulated utilities for 2012 through 2014. Our projected rate base for 2012 through 2014 has been adjusted from our projections provided in August of this year and is reflected on Slide 47 in the appendix.

Moving to Slide 14, you’ll see our financing summary for 2012. Changes have been made to our long-term debt transactions expected in 2012. We have refined the Wisconsin Public Service long-term debt financing to a more definitive $300 million from the $250 million to $300 million range that we reported last August. Additionally in October 2012, People’s Gas secured commitments for a $100 million in long-term financing with delayed draw in December of 2012.

Moving to Slide 15, let me give you a summary of how the Fox Energy Center acquisition is expected to impact our financial results in 2013. In our application for a certificate of authority to purchase the Fox Energy Center filed with the Public Service Commission of Wisconsin on October 12, 2013, Wisconsin Public Service is requesting any revenue requirements related to costs in excess of the capacity payments and the cost of imputed debt of $54 million be deferred with recovery to occur in conjunction with future rate proceedings. This would also include equity earnings on the incremental average rate base amount in 2013. Generally accepted accounting principles permit the creation of a regulatory asset related to this for future recovery, but the deferred earnings cannot be recorded as income until such recovery is proved and included in the revenue requirements in a subsequent rate case. The sum total of the regulatory treatment we are requesting is that we expect no meaningful impact on Integrys Energy Group’s consolidated diluted earnings per share adjusted in 2013.

Moving on to our expected financing for the Fox Energy Center acquisition, at closing we will finance this at Wisconsin Public Service using a combination of short-term debt and cash flow from operations. Later in 2013, the short-term debt will be replaced with longer term financing in conjunction with the overall Integrys Energy Group business needs comprised of any of the following: new Wisconsin Public Service long-term debt, new Integrys Energy Group hybrid debt that would receive partial equity treatment in our capital structure, our anticipated balance sheet would support a new issue of up to $400 million of hybrid debt, and if needed up to $150 million of new Integrys Energy Group common equity. Our ultimate goal is maintaining adequate liquidity and financial health while continuing to provide our shareholders with an attractive investment opportunity.

Given that we are early in the Fox Energy Center approval process, we are not prepared to elaborate on specific amounts or pin down any timing of when such financing will occur. This provides more meaningful guidelines for Integrys Energy Group going forward. Our financing plans for Integrys Energy Group are expected to support our current credit rating. Combined with our long-term strategic plan and portfolio of businesses, our current dividend is sustainable. Our dividend payout ratio will decline to utility industry norms as our earnings grow over time.

Turning to Slide 16, we have provided you with our revised and approved guidance for 2012 diluted earnings per share adjusted by segment. If you turn to Slide 17, you will see how our revised guidance improved by comparing it to what we presented to you in August. Improvements essentially come from the regulated electric and regulated natural gas segments, and these upward adjustments are primarily due to lower employee benefit costs and lower other operations and maintenance expenses at the utilities. There are some other slight modifications to diluted earnings per share adjusted for the other segments.

Now I’ll turn the call back over to Charlie Schrock. Charlie?

Charlie Schrock

Thank you, Joe. Before taking your questions, I’ll summarize our key investment highlights which are consistent with what we shared three months ago. Please turn to Slide 18.

Importantly, the execution of our business plan for the regulated utilities remains on track. We have taken steps to ensure our electric customers continue to have safe, reliable and affordable power, and our accelerated main replacement program continues. Our 34% ownership in the American Transmission Company continues to contribute earnings as expected.

We have a solid foundation for growth at Integrys Energy Services. We expect our regulated businesses to contribute approximately 90% of our consolidated net income and our non-regulated businesses, comprised almost entirely of Integrys Energy Services, to contribute the remaining 10%. Our business risk profile today is commensurate with this mix of regulated and non-regulated businesses. Our guidance for 2012 diluted earnings per share adjusted on a consolidated basis has improved to be in the range of $3.22 and $3.38.

Our portfolio of regulated and non-regulated businesses, our operational excellence initiatives and cost control efforts will enable us to meet our revised 2012 consolidated financial objectives. We continue to work toward growth in diluted earnings per share adjusted of 4 to 6% on an average annualized basis with 2011 as the base year through 2015. The events that transpired since our last earnings conference call demonstrate this. Given our solid long-term business plan and our portfolio of businesses, our current dividend is sustainable and our dividend payout ratio will decline to utility industry norms as our earnings grow over time.

We will now open the call for your questions.

Question and Answer Session

Operator

Thank you. We will now begin the question and answer session. [Operator instructions]

Our first question is from Paul Patterson with Glenrock Associates.

Paul Patterson – Glenrock Associates

Good morning. If you guys could just review the financing plans. You went through them pretty quickly and I apologize, but if you could just sort of elaborate a little bit on how we should think about the amount of equity you might need in 2013. I know you said that the timing specifically because of the Fox acquisition might be a little difficult to pin down, but if you could just give us a little bit more flavor on that. I apologize, but if you could just review that again.

Charlie Schrock

Okay, Paul. Slide 15 in the deck has kind of a high level summary of that, and I’ll have Joe go through that again with you.

Paul Patterson – Glenrock Associates

Thanks so much.

Joe O’Leary

Well as we mentioned, we’re planning on using some short-term debt and cash flow from operations to close the deal. Right now, we’ve said that we have a target date of April 1, and then later in 2013 as we look at what the rest of the needs are for the rest of Integrys Energy Group business, we’ll look for longer term financing to kind of take out the short-term financing arrangement that we utilized.

So we’ll utilize some long-term debt at Wisconsin Public Service. Right now, we said it’s roughly $440 million – that’s what we had in our press release – so at the subsidiary level, you figure $220 million roughly of long-term debt at some point in the future in 2013. The rest would be an equity contribution received from the parent. Now, that equity contribution from the parent would be financed in conjunction with the rest of Integrys Energy Group’s financing needs for 2013, and for those needs we expect to use a combination of hybrid debt and as needed up to $150 million of new common equity.

Paul Patterson – Glenrock Associates

Okay, so some combination of hybrid or common equity approximately in the neighborhood of $200 million is what we should be thinking about sometime in 2013. Does that make sense?

Joe O’Leary

No, it doesn’t.

Paul Patterson – Glenrock Associates

Okay, what did I miss?

Joe O’Leary

Up to $150 million of equity.

Paul Patterson – Glenrock Associates

Of common equity, but is there any additional—

Joe O’Leary

We can do up to $400 million of hybrid debt in order to handle the total financing needs of Integrys Energy Corp.

Paul Patterson – Glenrock Associates

Okay, and would that be incremental or would that be—would the $400 million, how should we think about the 150 and the 400 million in terms of how they relate to each other? Are they just—is it basically 400 million of hybrid equity potentially and $150 million of common equity?

Joe O’Leary

Yeah, it’s incremental to what we currently have clearly. Up to $400 million of hybrid—

Paul Patterson – Glenrock Associates

Okay.

Joe O’Leary

--and kind of a swing component in all that is the equity. We try not to issue more equity than what we have to, and right now when we look at the various ways of looking at that, depending upon cash flows and the timing of when that deal takes place relative to 2013, if it ends up that the transaction closes later in the year, that may move that equity number around and may even push it into another year.

Paul Patterson – Glenrock Associates

Okay, great. And then just on the tax adjustments for GAAP, how should we think about that going through the rest of this year? You know what I’m talking about? There were some tax adjustments, I guess, that happened actually last quarter but also this quarter as well. Are we sort of through with that, or is that something that’s going to be continuing?

Joe O’Leary

Well, every quarter you have to do what you call inter-period tax allocations, so that’s what we’re referring to there. So it shouldn’t happen when you get to the end of the year, because by that time—

Paul Patterson – Glenrock Associates

By that time, it’s the end of the year. Okay, great. And then just the outlook for the energy services margins, it looked like, I guess, you guys had lower margins but higher volumes. Is that the way to sort of think about this? And what’s your thought going into 2013 as to what the business outlook is, considering the new business and the environment that you guys are dealing with?

Charlie Schrock

Paul, I’m going to have Dan comment a little bit on it, but before he does, as we’ve mentioned several times over the course of the year, we’re certainly seeing the competitive pressures that other retailers are; but by the same token, I think we’ve been pretty disciplined and diligent about not sacrificing profit, if you will, but also based on our customer mix and things like that, maintaining whatever margins we can. But we’re certainly seeing the competitive pressures.

But let me have Dan comment a little bit more on that.

Dan Verbanac

Good morning. Unit margins certainly vary by customer size and region, and obviously the larger industrial customers have the most competitive pressures. But year-to-date 2012, our electric realized unit margins are $6.63 on the power side, which is about a dollar lower than 2011, and our gas margins are pretty much flat this year. You can see that on Slide 30. We certainly expect realized unit margins to continue to drift down over the next couple of years, but remember a lot of our 2013 business was contracted in 2010 to 2011 when margins were higher. We are certainly very disciplined in how we price our products to make an acceptable return, and that certainly won’t change in this highly competitive environment; but we do focus on customers where we can add value beyond commodity price alone, and our target market or kind of our sweet spot on the C&I business has been that small and medium-sized customer.

So as unit margins continue to drift lower over the next couple years, we fully expect we can grow overall margins or top line margins by increasing volume. In most of the regions that we operate today, we have a single-digit market share, so growing 25% or 50% in those regions is certainly not unreasonable, and our contracted forward volumes for the third quarter of this year compared to last year is up 26% on the power side and over 20% on the gas side, so we are seeing significant growth there.

Paul Patterson – Glenrock Associates

Could you give us a feeling for what the margins for the new business are that you’re signing up? In other words, if you were looking last quarter or so, what’s the new business margin as opposed to the sort of blended contracted and whatever else you’re sort of putting in, if you follow me? Could you give us a feeling for what kind of margin you’re getting on the new business?

Dan Verbanac

Yeah, based on what we’ve realized year-to-date, which I reference on Slide 30, for new business that we’ve put on this year we’re seeing—we’re expecting those type of realized margins going forward to be approximately 25% lower than what we’ve realized this year, and that’s based on our experience year-to-date 2012 for new business that we’ve put on in C&I business.

Paul Patterson – Glenrock Associates

Okay, so we look at the 663. You think it’s going to be—how much lower—I’m sorry. You said it’s going to be 25% next year, is lower than the business that you’re signing in this year. Is that correct?

Dan Verbanac

No. What I said is the new business that we’ve put on in 2012, which will get delivered in forward years on a unit margin basis, is about 25% lower; but in 2013, the majority of the business that will be rolling off the books and be realized in 2013 was put on in 2010 and 2011, when unit margins were significantly higher.

Paul Patterson – Glenrock Associates

Okay. Thanks so much.

Charlie Schrock

Paul, thank you.

Operator

Our next question is from Michael Bates with D.A. Davidson.

Michael Bates – D.A. Davidson

Good morning. As I go through this slide deck, I’m looking at your CAPEX outlook and it seems like if you strip out the 440 million for the Fox Energy Center, we have WPS’ CAPEX through 2014 actually being lower despite the incremental investment in T&D. Can you talk about what exactly is happening there?

Charlie Schrock

Yes, Michael. Our CAPEX schedules – I think the one you’re looking at is probably Slide 12 in our deck. Is that right?

Michael Bates – D.A. Davidson

Yes.

Charlie Schrock

Yeah. So it may be more of a timing thing, because over time we’ve had projected costs for things like the environmental controls on our power plants and some things like that, that ended up being delayed a little bit. So because of that—and another example of that is the Columbia plant had (inaudible) and those were also delayed a little bit. So we had projected a certain amount of CAPEX but then it dropped a little bit because of those delays, and then you’ll see it come up again in later years.

And Larry, any additional comments on that?

Larry Borgard

No Charlie, I think you’ve covered it well. It’s primarily the delay in the Columbia approval process and therefore the spend.

Michael Bates – D.A. Davidson

Okay, and is it still your expectation that the Columbia project would be done kind of the mid-2014 time frame?

Larry Borgard

Yeah, there’s no delay in the completion date for the additional pollution control equipment.

Michael Bates – D.A. Davidson

Okay. And as you look at your highlights on Slide 18, you talk about the 90% regulated, 10% unregulated mix. As we think about the later years, toward 2015, ’16 kind of time frame, how do you expect that mix to evolve as the various lines of business are expanding at different rates?

Charlie Schrock

Yeah Mike, it’s a good question. We actually look out in time, and our intent—you need to understand what we’re trying to do with that mix. It’s really all about our risk profile, maintaining credit quality, and having a company that for us is within the appropriate or suitable risk profile. So over the longer term, we would expect to maintain that 10%-90% ratio with our utilities being the predominant 90% portion of our business.

Michael Bates – D.A. Davidson

Okay. And then several of your peers are expecting lower pension discount rates as they talk about 2013, which would lead to higher pension expenses. Can you talk about your expectations there or any other key drivers you’re thinking about in terms of 2013?

Charlie Schrock

Those are things we look at closely all the time. I’ll have Joe comment on that.

Joe O’Leary

With regards to discount rates, yeah, we’re seeing lower discount rates as well. Trying to project where we’re going to be at year-end is not something we’re prepared to do at this point, and trying to project on impacts on 2013, I think we can clarify that more when we give our guidance for 2013.

Michael Bates – D.A. Davidson

And is that going to be part of the fourth quarter and year-end earnings release?

Joe O’Leary

Well typically that’s when we’ve done it in the past, is giving out our earnings guidance around that time. Just keep in mind that the lowering of the discount rate and the incremental impact on pension costs was one of the items that was covered in our recent rate case settlement for Wisconsin Public Service, and we’ve also worked in some estimates as it relates to that in the pending rate case for People’s Gas and North Shore Gas.

Michael Bates – D.A. Davidson

Thank you.

Operator

Thank you. [Operator instructions]

Our next question is from Ali Agha with SunTrust.

Ali Agha – SunTrust

Thank you. Good morning. Charlie or Joe, either one of you, when I look at your guidance progression through the year, in the second quarter you cut your guidance by $0.32 if I take the midpoint. This quarter you’ve raised it by $0.22. I mean, these are huge swings in just a matter of three months. I’m just wondering what gives you the confidence that this time around the numbers look pretty solid, given those kind of swings just in two quarters alone.

Charlie Schrock

Yeah Ali, I’ll start the discussion here and let Joe or Larry Borgard kind of fill in some more details. But I think it’s important to think about why we changed the guidance back in August first, and at that point in time you’ll recall that we had what I would call an adverse order or an interpretation of an order from the ICC that really made us more vulnerable to weather impacts, and we’ve talked about that’s a pretty big impact. And at the same time, we had Integrys Energy Services facing the competitive pressures, so we reduced he guidance there. And at that point in time, we didn’t really have a lot of insight into what we might be able to do with O&M cost controls and other trends that we were seeing.

So cast forward to today, I think the good news is we challenged ourselves as an organization, because we didn’t like where we were there, to see what we could do with cost control, and that’s been primarily the reason that the utilities are doing better. In addition to your question on confidence, it has a lot to do with the fact that we’re three more months into the year, so we have nine months of good data now. And frankly, the data is all pointing to these numbers that we’re sharing with you today.

Joe, anything else?

Joe O’Leary

Ali, I do have—if you could go to Slide 17—

Ali Agha – SunTrust

Okay.

Joe O’Leary

--in the slide deck, and I take it that when you’re referring to the midpoint, you’re just taking it right off the regulated natural gas utilities segment, the midpoint between the $1.21 and $1.27 for gas and $1.32 and $1.34 for electric?

Ali Agha – SunTrust

Yeah, I mean, more simply I’m taking the $3.22 to $3.38, right, adjusted – I’m just taking the midpoint there, which is about $3.30 if my math is right. Obviously the big swing is in the utility business, but yeah, so I guess the bulk of it is coming from the utility side.

Joe O’Leary

Yeah, a couple things that impacted that – our active medical costs are down significantly from what we had originally anticipated. We were just starting to get some indications of that prior to our last call, but now we’ve got a more solid trend in place. So medical is down by about $0.06. There’s another couple cents related to defined contribution retirement plan costs. I mean, that’s $0.08 of it right there.

Ali Agha – SunTrust

Okay.

Joe O’Leary

And O&M costs, a lot of smaller cats and dogs type of things.

Ali Agha – SunTrust

But those contributions you referred to, Joe, you did not have that visibility two, three months ago?

Joe O’Leary

Well, in terms of what our actual contributions had to be, the matching contributions and such, that’s somewhat dependent upon what people actually put into those, and it’s coming out to be a little less than what we anticipated.

Ali Agha – SunTrust

Okay. A separate point – again, if I look at the electric utility guidance that you’ve given us now for 2012 and I run the math, if my math is right, you are significantly over-earning your authorized ROE on the electric side in ’12. How sustainable is that, and how should we think about that going forward? Are there any clawback issues? How should we think about that, given that you are over-earning fairly significantly in ’12 now on the electric side?

Charlie Schrock

Yeah Ali, first of all, just a reminder – you’ve got to take out the Medicare Part D as part of that equation, so that’s almost $0.07 there that it doesn’t—you take that out, and yeah, it does look like we could be over-earning.

In terms of sustainability, and you understand the process as well as anybody, when you go in for rate cases you basically reset your O&M to your latest best guess. So as I think about sustainability, this is all great for our customers because our efforts are keeping our costs low, but over time our actual costs will be reflected in rates.

Ali Agha – SunTrust

Okay. And then lastly, Joe, just wanted again to understand the Fox Energy acquisition impact in ’13. You’re going to have to pay for that acquisition, so the capital has to be deployed whether it’s equity or hybrid or what have you, so the cost of that capital is going to impact you in ’13. So I’m not quite clear again on how it ends up being earnings neutral. Can you explain that again? Are all the equity returns being deferred there, so how should we think about the dilution that it will incur whether you do a hybrid or an equity, and the implications to the bottom line from that?

Joe O’Leary

Good question, Ali. Let me see if I can take a shot at that. With regards to the utility, we’re looking for deferral of any difference between the increased cost and what’s currently built into the revenue requirement for the existing Fox Energy Center power purchase agreement. We’re looking for those costs to be deferred and would be handled in a future rate proceeding, and included in that would be the return on the assets as well. On the parent company level, there are some costs associated with debt, but for the most part the difference—you know, short-term debt is relatively inexpensive right now, and we think we can carry it in short-term for a while and delay the longer term financing until a little later in the year, and the equity, the timing of that would—again, as I mentioned before, that’s kind of the swing component in the overall financing plan. I would expect that that would also be later in the year as well, so if issued in 2013 should minimize the dilutive impact.

Ali Agha – SunTrust

I see. So just to be clear, for 2013, a part of the next rate case, Fox Energy Center is going to be continuing to be booked as if the PPA is in effect. Anything above that is being deferred. But any capital that you are raising would have bottom line implications, but you’re suggesting that would be at the back end of the year so the impact would be minimized that way. Is that a fair way to think about it?

Joe O’Leary

That’s a fair way to think of it.

Ali Agha – SunTrust

Okay. Thank you.

Charlie Schrock

Ali, thanks for joining us today.

Operator

Thank you. Our next question is from Ben Sung with Luminus Management.

Ben Sung – Luminus Management

Hi. I was wondering if you could just dig into the delta in the guidance numbers a little bit more. I think I heard medical was about $0.06, pension was about $0.02. How much of the—I think the press release alluded to fewer storms and sort of the lower storm cost. Are there any other large chunky items that you can kind of point to and give us a little more color on that?

Charlie Schrock

Yeah Ben, thank you for joining us today as well. I’ll have Larry give us a little more detail on that, but at a high level, it’s primarily utilities as you heard on the call here, and primarily the active medical and pension contributions, and then O&M may be the largest single portion.

But Larry, you want to comment on that?

Larry Borgard

Sure, Charlie. Thanks. So I look at the guidance from August 9 compared to the guidance from today, the utilities segments – natural gas and electric segments combined – it’s about a $0.19 or $0.20, $0.21 differential. And the way I break that down is there’s about $0.08, as Joe described, between active medical as well as defined contribution retirement benefits. That’s $0.08 of that, let’s say, $0.20; and then there’s another $0.10 from utility operations and there’s a whole mix of cats and dogs in that related to plant maintenance, distribution costs, and bad debt. So of the $0.20 or $0.21 differential in utility segments, you’ve got $0.08 from the benefit package, about $0.10 from the utility operations, and that relates to the challenge that Charlie put before us back at the end of the second quarter.

So that’s kind of how I break down that $0.20, and then there’s a couple of pennies here and there.

Ben Sung – Luminus Management

Okay. And the O&M savings of roughly the $0.10 and the bad debt and the plant maintenance, are those sort of ongoing or is this kind of one-time in nature? How should we think about that?

Larry Borgard

Well, we always seek to have long-term savings in our costs, but as you know, we’re relatively frequently in for rates cases so even if there are long-term savings, they’re going to be trued up in the rate case process, so they end up being short-term savings.

Ben Sung – Luminus Management

Okay, got it. Okay, thank you.

Operator

Thank you. Our next question is from Ashar Khan with Visium Asset Management.

Ashar Khan – Visium Asset Management

Good morning. I just wanted to go over, Joe, just on that hybrid thing that you explained. Could you just explain one more thing – is there a way that you could avoid equity for the purchase and just do hybrid, or no?

Joe O’Leary

I’m not sure I’m understanding the question there. Can you try again?

Ashar Khan – Visium Asset Management

Yeah. The acquisition, you had mentioned you are going to fund it with, of course, debt, hybrid and equity. Is there a way just for acquisition that you could just do hybrids and no equity?

Joe O’Leary

Well, when you’re looking at the company, a hypothetical question like that—

Ashar Khan – Visium Asset Management

Well, I’m looking at in terms of what your rating agency goals are, right, so I’m just trying to understand it.

Joe O’Leary

Oh well, now I’ve got a little more indication of where you were going with this. Overall, we try to keep our equity at roughly between 50 and 55% at the holding company level on a consolidated basis for Integrys Energy Group. So when we’re thinking about the 50 to 55% equity, we take into consideration hybrid debt, which is treated as it has equity attributes provided by either Moody’s or S&P, differing amounts but nonetheless it does have some equity attributes. So as we increase the balance sheet for the acquisition, as the balance sheet grows from that acquisition, we end up have the capacity to take on additional hybrid debt that we didn’t have without that acquisition, so it does kind of open up that financing capability for us.

Ashar Khan – Visium Asset Management

Okay. So you said you can take on 400 million of hybrid debt, right?

Joe O’Leary

Right, and that’s not just for the acquisition. That’s in conjunction with all the financing needs of Integrys Energy Group.

Ashar Khan – Visium Asset Management

Okay, so how much—that’s what I was trying to do, was to isolate it to try and figure out how much debt can you attribute to the acquisition?

Joe O’Leary

Well, if you—I guess if you want to pull out the acquisition, you’re looking at what our CAPEX needs are and such, the best way to think about it is we would try to maintain that 50 to 55% equity component, taking into consideration our existing hybrid debt that’s already on the books.

Ashar Khan – Visium Asset Management

Okay, okay. Fine. I’m just trying to narrow down—you have an up to equity number, right, that you mentioned on the slide. Am I correct? That’s the maximum?

Joe O’Leary

That’s correct. Right.

Ashar Khan – Visium Asset Management

Can you tell us what—let me ask the question in a different way. Can you tell us what could be the minimum?

Joe O’Leary

You know, a lot depends on the timing of when that Fox transaction closes, so—

Ashar Khan – Visium Asset Management

Well, you already mentioned that you’re going to do it—

Joe O’Leary

(Talkover) the business, progress on construction projects.

Ashar Khan – Visium Asset Management

Yeah, but you already told us that you’re going to fund it with short-term debt and then do permanent financing at the end of the year, right? So—

Joe O’Leary

Well, it could be anywhere from zero to 150.

Ashar Khan – Visium Asset Management

So the minimum could be zero?

Joe O’Leary

Right.

Ashar Khan – Visium Asset Management

Okay. Okay, fine. That helps. Second question – Charlie, I just wanted to get your thoughts, and this goes back to, I guess, the variance in guidance. I guess this was more regulatory up and down, but why do you think that Integrys needs to be in the energy services business? What is the edge that Integrys has to be in that business, and why does that business is essential or is attractive to Integrys management?

Charlie Schrock

Ashar, thanks for the question. I like being in our non-utility businesses, and it starts out that we start with being in energy and energy-related businesses. We have developed a very good skill set in that business and it provides us, what I would call a complementary earnings stream. But by the same token, we’re also focused on maintaining credit quality, maintaining the appropriate risk profile for our investors, so we want to keep it in that 10% range of our total.

But kind of going back to why we like it, it gives us a little bit of optionality from a corporate consolidated standpoint, and I think it helps us understand the markets out there and utilize those skill sets that we’ve developed over time.

Ashar Khan – Visium Asset Management

Okay. But Charlie, I’m just saying—I don’t know. You are a utility business, you are a dividend payor. You have a high payout which is substantiated by your regulated business. The profile is for a utility with stable earnings and no optionality. That is what your retail investors and institutional investors want. I just find having a business where margins go up and down, which is totally opposite of what the utility businesses where margins and ROEs are flat except for the weather variance, the two businesses don’t comply with each other. And especially with the dividend that you pay and everything, to me this all noise, nuisance, and very hard to model for a utility management company.

So I look at WEC as your competitor because the other third utility is in Iowa and Wisconsin. They are a pure utility company, have the highest multiple. They never miss guidance. They never go down guidance; they always go up, and they have been doing to for four or five years in a row and the reason is because their businesses are reliable, it’s a utility business, it’s a certainty. Here, we have guidance going up, down, up, down, up. Some of it is about the utility business; some of it is from the retail. I just don’t understand how the Board can have a business which has so much ups and downs on margins and all that tie in with a regulated business which is 100% certainty, gives you a pure dividend from which your stock. I just understand how they mesh with each other. I just don’t.

Charlie Schrock

Ashar, I certainly appreciate your comments. It makes for a good discussion, but frankly we have a lot of different investors that invest in us. As I said, I like the optionality and the incremental earnings that we get out of our non-utility businesses while at the same time maintaining, to me, a very attractive risk profile. So we understand where you are coming from, but these are decisions that we make that I think help us overall as a company.

Ashar Khan – Visium Asset Management

Okay, sir. Thank you.

Charlie Schrock

Thank you for your comments.

Operator

Thank you. Our next question is from Eli Kraser (phon) with Millennium.

Steve Gambuzza – Millennium

Good morning. It’s actually Steve Gambuzza. I just had one quick follow-up on the financing discussion. I know there’s been a lot of questions on this, but as I understand it, roughly $450 million of consideration for the acquisition at the WPS level and roughly half of that will be funded at debt at the WPS level. Is that correct?

Joe O’Leary

It’s correct in terms of at the subsidiary level. Half is done with debt, half is done using an equity contribution from the holding company.

Steve Gambuzza – Millennium

From the parent – okay. And basically the source of that equity contribution from the holding company will be some combination of actual common equity and/or hybrid equity.

Joe O’Leary

It will be a combination of hybrid debt, which has equity-like attributes, and as needed common equity, and that would be done in conjunction with the financing for the total company and all the consolidated company needs.

Steve Gambuzza – Millennium

Okay. And I guess as you weigh through the consideration of whether you issue straight common or you issue a hybrid, whatever gives you credit, in terms of having that equity reflected on the WPS regulatory capital structure as common equity, do you see any issues with issuing it a hybrid at the holding company and infusing that into WPS as common equity, or do you think that doesn’t really weigh in the decision as to what form of financing you choose?

Joe O’Leary

Well typically in the past, that hasn’t become an issue during regulatory proceedings with Wisconsin Public Service. I mean, they have an allowed equity component of the capital structure, and as to how we go about meeting that need has not been an issue assuming that we maintain high quality credit ratings, which we always strive to do.

Steve Gambuzza – Millennium

Great. And then I just had a question on the main replacement in Chicago. It seems like your CAPEX actually went up for People’s, but you highlighted that the number of miles of mains being replaced are being down and the reason is cost inflation. Is that correct?

Charlie Schrock

Not exactly, Steve. As I mentioned in my remarks, what we’re seeing are some increased requirements from the City of Chicago as well as some changes in processes that we made, for good reasons; but it increased the cost per mile. And let me have Larry kind of complete the sentence after that.

Larry Borgard

Yeah. So clearly our costs per mile have increased, but we did have some carryover restoration work from 2011 that we did in 2012, and in addition to that we’ve picked off some high pressure main to do earlier in the program, and high pressure main is typically significantly more expensive to replace than the low pressure main. So those three components combined together are really the answer to your question, I hope.

Steve Gambuzza – Millennium

Okay, so it’s kind of a mix issue. You’re replacing les miles this year, but the miles you are replacing cost a little bit more.

Larry Borgard

That’s correct.

Steve Gambuzza – Millennium

Okay. And how do you see the issues that have led to the reduction in miles playing out going forward at People’s in terms of the—I know this is a very long-term program you have with main replacement that you’ve laid out. You have a long-term schedule. Has the long-term schedule changed?

Larry Borgard

I would not think so. I mean, if you think about when we started this program, we said we had about 2,000 miles of main to replace over 20 years. Last year, we replaced about 155 miles; this year, we’ll replace, I think, 130 to 135 miles. So if anything, we’re a little bit ahead of schedule, not behind schedule.

Steve Gambuzza – Millennium

Okay, and then I just had one final question on the benefits, the changes to the benefits cost assumption. It sounds like the variable that led to the change reflects kind of the participation of your employees in the plans, not any kind of change in actuarial assumptions. Is that a fair statement?

Joe O’Leary

Yeah, the two drivers of the benefits cost, one was a medical cost, and what we’re seeing there is the number of claims being filed is down and the severity per claim is down as well, so in actual dollars the expenses associated with that are coming in better than anticipated last August. That’s probably the biggest component of that benefit, and then there’s this much smaller component related to the defined contribution plan and employee participation and contributions to that, that require matching.

Steve Gambuzza – Millennium

Okay. And do you make changes to these assumptions often? I’m just wondering – it seems like it’s kind of a hard thing to predict the severity and cost of the claims. Is that something that you change frequently, these assumptions, or is it—how often do you revisit these cost assumptions?

Joe O’Leary

You know, we do it periodically. We typically are inclined to do it more towards the end of the year rather—based on experience rather than trying to do it earlier in the year with multiple changes in that.

Steve Gambuzza – Millennium

Great. Thanks for your time. Appreciate it.

Charlie Schrock

Thank you.

Operator

Thank you. Our next question is from Reza Hatefi, sitting in for John Ali of Decade Capital.

Reza Hatefi – Decade Capital

Thank you very much. I just wanted to clarify an earlier question. I guess the gas utilities have had $0.28 negative weather this year, and you were able to offset that with some of the O&M moves that you mentioned earlier as well. Again, just to clarify, how is this all going to play out in the coming rate case, these O&M savings, how is that going to flow, I guess, with the rate case and the ROE, et cetera, because I would assume they would normalize weather when looking at the test year.

Charlie Schrock

That is correct. Weather is normalized, and also we use a future test year, as I recall, so when we look forward we project our cost to the best of our ability. That is audited, by the way, by an independent auditor, and then we go through a series of reviews with the Commission staff to come down to a final number for those things. But the important thing is it’s based on our projection of a future test year.

And Larry, any additional comments on that?

Larry Borgard

I don’t think so, Charlie, unless there’s an additional question.

Reza Hatefi – Decade Capital

So the O&M savings was—is it fair to just think of that as making up for the weather shortfall in 2012, or is it something that’s sort of ongoing? I guess I’m trying to rectify that from a modeling standpoint, given the test year with the rate case.

Charlie Schrock

Well as we mentioned earlier, I don’t think you can cast a net over the whole thing as one particular kind of savings. As Larry said, we try to have sustainable long-term or permanent savings with all the things that we do, but those get reset every time you go in for a rate case. And then there are always a few things that you can do over the course of a year that are one-time things, but fundamentally we try for the longer term stuff.

Reza Hatefi – Decade Capital

Thank you. And then just looking at Slide 12, your unregulated CAPEX sort of steps up in 2013 and ’14 versus 2012. Could you talk about that, or what’s the strategy there, I guess, and what the CAPEX is for?

Charlie Schrock

Hold on just a second – I want to pull up that slide. Yeah, I think what we’re looking at there are some solar investments as well as some of our transportation fuels business. For the Integrys Energy Services line, it’s primarily solar-type investments.

Reza Hatefi – Decade Capital

Okay – basically solar. Okay, thank you very much.

Charlie Schrock

Thank you.

Operator

Thank you, and I’m currently showing no further questions. I would like to turn the call back over to Mr. Steve Eschbach for closing remarks.

Steve Eschbach

Thank you for being a part of our third quarter earnings conference call. A replay of this conference call will be available until February 26, 2013 by dialing toll-free 800-513-1175. The full transcript for today’s conference call will be available on our website at www.integrysgroup.com before the end of the day on Monday, November 12, 2012. Just select Investors and then Presentations.

If you have any additional questions, you may contact me directly at 312-228-5408 or Donna Sheedy at 920-433-1857. Thank you.

Operator

Thank you for participating in today’s call. The conference has now ended. You may disconnect at this time.

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