Feb 15, 2008
Executives
Donald Shippar - Chairman, President and CEO Mark Schober - Chief Financial Officer
Analysts
Todd Vencil - Davenport Grant Hopkins - Ferris, Baker Watts Larry Solow - CJS Securities James Bellessa - D.A. Davidson & Company Bob Chewning - Davenport and Company Yiktat Fung - Zimmer Lucas Partner
Operator
Welcome everyone to this conference call announcing Allete's fourth quarter 2007 financial results. Today's call is being recorded.
Your line will be muted for the presentation. Then we will conduct a question-and-answer period.
(Operator Instructions). This conference may contain forward-looking statements within the meaning of the Federal Securities Laws, including statements concerning business strategies and their intended results and similar statements concerning anticipated future events and expectations that are not historical facts.
These forward-looking statements are made pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. The forward-looking statements in the earnings release distributed this morning reflect management’ best judgment at this time.
But all such statements are subject to numerous risks and uncertainties, which could cause actual results to differ materially from those expressed in or implied by the statement therein. Additional information concerning potential factors that could affect future financial results is included in the company's annual report and from time-to-time in the company's filings with the SEC.
At this time, I'd like to introduce the, Chairman, President and Chief Executive Officer, Mr. Donald J.
Shippar. Please go ahead, sir.
Donald Shippar
Thank you. Good morning, everyone.
Today, we announced our fourth quarter 2007 earnings of $0.77 per diluted share. For the year, we earned $3.08 per diluted share, an 11% increase over 2006.
We're pleased to record these results, especially when considering the difficult market conditions that our real estate business operated in, during the year. Our fourth quarter earnings were slightly higher than we had anticipated, primarily due to colder than normal weather in December, which caused increased electric sales to our residential and commercial customers.
Our real estate business earned $2.5 million for the quarter and ended the year with a $17.7 million of net income, which was at the high end of the guidance range we gave you in the fourth quarter. We have been in the Florida real estate business since 1991 and 2007 was its third highest earnings year ever.
In a moment Chief Financial Officer, Mark Schober will go through the financial details. But, I would like to update you on few new developments.
Last Friday, the Federal Energy Regulatory Commission approved the wholesale rate increase request we had had filed in December. The request applies to Minnesota Power’s 16 wholesale municipal customers and two private utilities in Wisconsin, including Superior Water, Light and Power Company.
The FERC made no adjustments to our request, which included an 11.25% return on equity on a 59% equity ratio. The rate increase on an annual basis will generate approximately $7.5 million of additional revenue.
The new wholesale rates will go into effect March 1st of this year. Also last week the Minnesota Public Utility Commission voted to approve Minnesota Power’s electric service agreement with Mesabi Nugget.
Mesabi Nugget would be a new industrial customer for Minnesota Power and plans to begin production later this year. They will initially be a 15-megawatt customer with potential for growth.
We expect to receive the former written order from the MPUC soon. United States Steel recently announced its intent to restart a pellet line in its Keewatin Taconite processing facility.
This line which has been idle since 1980 would be updated and restarted as a part of a $300 million investment by US steel. It’s anticipated it will require an additional 30 megawatts and bring about 3.6 million tons of additional Taconite pellet making capability to the Minnesota iron range by 2011.
All of these new developments bode well for our future earnings growth. At this time I would like to turn the call over Mark Schober and then I will follow up with some additional remarks about the outlook for ALLETE.
Mark?
Mark Schober
Thanks Don, net income from continuing operations was $87.6 million in 2007, compared to $77.3 million in 2006, an increase of $10.3 million. As Don said, our diluted earnings per share from continuing operations were up 11% year-over-year, from $2.77 to $3.08.
I refer you to our Form 10-K we've filed this morning for the details of our financial performance but I would like to summarize the major factors impacting earnings for the year. The three segments in our Energy Business recorded a combined income of $65.9 million in 2007, compared to $52.4 million in 2006.
While income from the non-regulated energy operation segment looks slightly less in 2007, income from both the Regulated Utility and investment in ATC segments were higher. In 2007, income from the Regulated Utility segment increased by $8.1 million, compared to the prior year.
Residential and commercial sales and margins increased primarily due to colder temperatures in the first and fourth quarters of 2007. Demand revenues from industrial customers were also higher in 2007, than in 2006.
We also added two new Municipal power requirement customers during the year. Superior Water, Light and Power had higher rates beginning in January of 2007.
Additionally, we commenced current cost recovery on environmental capital expenditures during the year, and have higher earnings from the allowance for funds used during constructions related to our capital expenditure program. These increases more than offset higher operating and maintenance expenses in 2007, which included those related to outages, storms, and salary and wage increases.
The Regulated Utility also benefited from a lower effective tax rate during 2007, primarily due to higher allowance for funds used during construction. Income from our investment in ATC rose by $5.6 million, as our 2007 investment balance was much larger than in 2006.
We began investing in ATC in May 2006 and reached our approximate 8% ownership level in February of 2007. Our current investment in ATC is approximately $66 million.
Our real estate segment contributed income of $17.7 million in 2007 versus $22.8 million in 2006. The decrease was due to a challenging real estate market.
On the positive side, ALLETE properties closed two significant sales in the second quarter of 2007, which included a large non-residential track in the first base of the Sawmill Creek project at Palm Coast Park. The other segment recorded income of $4 million in 2007, compared to $2.1 million in 2006.
The increase in 2007 included a state tax audit settlement and the release from a loan guaranty for Northwest Airlines. Turning to the balance sheet, our cash, cash equivalent and short-term investment balances were about $100 million lower at the end of 2007, compared to 2006, reflecting our significant capital investment program.
Also, at year end, the debt to total capital ratio was at 36%, highlighting our additional debt capacity. Finally, in relation to our statement of cash flows, I do want to point our continued strong cash flow from operating activities, approximately a $123 million in 2007.
Don?
Donald Shippar
Thanks Mark, ALLETE has committed to earning financial returns that rewards our shareholders, allows for re-investment in our businesses, and sustains our growth. Recently, opportunities have risen which we believe, will allow us to achieve our long term earnings growth goals to our existing businesses.
Therefore we will now focus our business development activities on growth opportunities within our complementary tool, our Energy and Real Estate Businesses. ALLETE properties, we believe that current market conditions will present an opportunity to add to our portfolio, properties for sale.
We expect net income from our real estate business will be approximately 10% to 20% of total consolidated net income over the next several years. This is a significant return, when you consider our booked basis of land is only about $62 million.
Within our energy business, Minnesota Power expects significant rate-base growth over the next several years as it anticipates making approximately $1.5 billion in capital investments by 2012. About half of these expenditures are for environmental, renewal energy or transmission investments that will be recovered through current cost recovery, riders outside the rate case.
In addition, Minnesota Power will be making significant investments in its low-cost generation fleet. We consider the ownership of low-cost generation to be a competitive advantage.
We'll also look for transmission opportunities that strengthen and enhance the regional transmission grid and take advantage of our geographical location between sources of renewable energy and growing energy markets. Several natural resource based companies have been making significant progress to developing new projects in northeastern Minnesota.
Besides Mesabi Nugget, these includes PolyMet Mining, which has executed an electric service agreement with us and is awaiting an environmental permit. Minnesota’s Steel industries and the expansion project at Keewatin Taconite also are projects on the horizon.
If in summer all these projects are completed, Minnesota could serve between 100 megawatts and 400 megawatts of new electric load. We also expect to make additional investments in the American Transmission Company to fund our pro-rata share of ATC’s capital investment program.
I mentioned that our capital investments are expected to be about $1.5 billion through 2012. I refer you to the table in the capital requirement section of our 10-K for a detailed projection for each year.
Now we intend to finance about one half of this program from internally generated funds. About one-third with incremental debt and the remainder with additional equity.
As you can see we have a lot of growth opportunities within our core businesses. The Board of Directors and Management of ALLETE are excited about our future prospects.
Our Board’s confidence was underscored with its recent action that raised our common dividend by 5%. Let me now turn to the expectations for this year.
We expect ALLETE’s 2008 diluted earnings per share will be in the range of $2.70 to $2.90. This guidance reflects the following.
At Minnesota Power the new FERC approval wholesale rates will be in effect beginning March 1st. Minnesota Power also intends to file a retail rate case with the Minnesota Public Utilities Commission in mid-2008 with interim rates in effect 60 days after the filing.
Minnesota Power’s current industrial customers comprise about 50% of its kilowatt hour sales. We anticipate these industrial customers will continue to operate at historically high levels in 2008.
Minnesota taconite production is projected to be about $41.5 million tons compared with 39 million tons in 2007. In addition, our paper and pulp customers are expected to run near capacity and our pipeline customer are forecast to operate at record pumping levels in 2008.
We expect increased revenue from current cost recovery riders related to the company's investment in renewable and environmental initiatives. As we grow expect to increased operating and maintenance expenses and increased financing cost.
With respect to our investment in ATC, we anticipate investing an additional $5 million to $7 million during 2008. At our real estate business we expect that a continuation of difficult market conditions will cause it's net income for 2008 to be less than in 2007.
This was the primary reason for ALLETE’s projected lower earnings per share for 2008. Beyond 2008 we see continuing earnings growth because of rate base growth, additional investments in ATC and increased electricity sales to current and new customers.
We also expect that market conditions for our real estate business will improve overtime. At this time, I'll ask the operator to open up the line to your questions.
Operator
(Operator Instructions). We'll go first Todd Vencil with Davenport.
Todd Vencil - Davenport
Hey, guys.
Donald Shippar
Good morning, Todd.
Todd Vencil - Davenport
Looks like you had some cancellations in the real estate business in the quarter. Can you --- am I looking at that right, and if I am, can you talk about this?
Mark Schober
Yeah. We had -- year-to-date we had cancellations of about $22 million.
They started in the third quarter, so we talked a little bit about it in the third quarter and then we had an incremental $15 million that cancelled in Q4. So really not surprising, kind of, as we expected that the market conditions continue to deteriorate, most of these were signed relatively at the peak of the market late '05 and '06.
So this simply comes back in to our inventory. A couple them did have down payments 1% to 2%, we keep that, but comes back in the inventory, and we'll be remarketing it at a later date.
Todd Vencil - Davenport
Are we talking about primarily residential or commercial here?
Mark Schober
A mix.
Todd Vencil - Davenport
A mix. If do the quick math, it looks like it may have been weighted towards the residential, is that fair?
Mark Schober
That's fair, yeah.
Todd Vencil - Davenport
Okay. And was in the development projects or the other land?
Mark Schober
Most of them were in the development projects.
Todd Vencil - Davenport
Okay. Okay, was Lowe in among there?
Mark Schober
No.
Todd Vencil - Davenport
Okay. Is it fair to say, probably smaller developers?
Mark Schober
It's a variety. I don't have the names in front of me Todd, but it would be our typical customers that we had in the past.
Todd Vencil - Davenport
Okay.
Mark Schober
But none of the large ones. No, it is not Lowe.
Todd Vencil - Davenport
Okay. Can you talk about how prices have been trending on the commercial property there?
Mark Schober
We have not. Prices continue to be soft, both on commercial and residential.
But very few buyers. So price at this point, the way I look at it is, is up, its really not the issue.
Just people are not investing at real estate at this point of time. So, we're holding our prices at this point looking for buyers but a very-very few buyers, very little traffic in our communities down in Florida.
Todd Vencil - Davenport
Okay. And then lets talk about the opportunity, you guys mentioned in this market, I mean how -- are you guys looking at purchases of land in Florida, as well as other places?
Donald Shippar
Yes, we're -- we continue to look in certain parts of Florida not, not all over the state but certain areas; which we think still have opportunities in the future and we're also looking into primarily in the North Carolina area.
Todd Vencil - Davenport
Okay. And how close you think you might be as to taking some action there?
Donald Shippar
They are truly hard to predict, I mean we've looked at a lot of different parcels and a lot of different opportunities, we just haven't found anything that we feel is priced appropriately, relative to where the market is today.
Todd Vencil - Davenport
Okay. And final question I guess, how much are you thinking if you have an idea of putting to work on purchases of land, sort of going forward?
Donald Shippar
We really haven't set a sign or earmarked, if you will, any specific amounts. So, I think we'll be looking at typically, maybe property sizes, I don’t know, several hundreds acres, maybe around a thousand acres would be the typical kind of projects we'll be pursuing.
Todd Vencil - Davenport
Okay. Thanks a lot.
Donald Shippar
Yeah.
Operator
Thank you and we'll go next to Grant Hopkins with Ferris, Baker Watts.
Grant Hopkins - Ferris, Baker Watts
Good morning
Donald Shippar
Good morning.
Mark Schober
Good morning, Grant
Grant Hopkins - Ferris, Baker Watts
My first question. Your commercial real estate square footage was up, pretty substantial year-over-year up 77%.
Is that just timing of projects or is that indicative of some, I guess, relative strength in commercial square foot?
Mark Schober
You're looking at the sales for the year.
Grant Hopkins - Ferris, Baker Watts
Donald I am just looking at the other, but not in the sales, just the square foot sold.
Mark Schober
Yeah the square foot sold, those are really the two large transactions that we closed in Q2?
Grant Hopkins - Ferris, Baker Watts
No, I am talking about the fourth quarter in particular.
Mark Schober
For fourth quarter those are very small sales. At Town Center, I think, is a movie theatre that we closed there but they are relatively small.
Grant Hopkins - Ferris, Baker Watts
Okay. So it’s just the timing of projects.
Mark Schober
Yeah. Just the timing, yes.
Grant Hopkins - Ferris, Baker Watts
Okay. You gave your breakdown of how you're going to finance your CapEx over the next few years.
What’s your target capitalization rate going to end up being in? How that relates to -- how much you can -- how much more real estate you can purchase?
Mark Schober
Yeah. Our cap structure is really driven by what happens within the Regulated Utility.
We have a very low debt ratio now that I mentioned in my comments. That will be coming up, as the utility grows.
But we'll pretty close to a debt level of about 40%, a little bit higher than 40% as we forward. So we have very little leverage down at the real estate side of business.
So we do have ample room to look for funds, both using debt or equity if there is a significant real estate acquisition.
Grant Hopkins - Ferris, Baker Watts
Okay. I guess everything was pretty straight forward.
Thank you
Mark Schober
Okay. Thank you.
Operator
Thank you. And we'll go next Larry Solow with CJS Securities.
Larry Solow - CJS Securities
Good morning, just a couple of questions on the rate case, first of all on the FERC rate that was already approved since you weren’t getting cost recovery on that, can we expect relative to the Minnesota Power rate, a good amount of that actually to flow to the bottom line to your - something you already had some of those cost related to that. Does that increase revenue from increased pricing?
Donald Shippar
Yes, some of those cost we're already incurring, it captures a period of cost Larry, I can't give you the capital cost, the financing cost, the incremental O&M and then our general cost increases since like [95 or so] that we're incurring. So you are right it need to after tax it and the good portion of it will flow through to the bottom line.
Larry Solow - CJS Securities
And then considering your outlook for basically $200 million plus or $100 million we just take the half of the -- that's not being cost recovery for over the next five years, do we expect weight increase or filings like every other year or something and would that be an appropriate assumption?
Donald Shippar
The timing of our rate cases with the MPUC are driven by our capital cost, so we don't get current cost recovery and so you are right. We are looking at going in sometime in mid ‘08, and then it depends on when we incur these other base capital cost.
So that will drive the timing of the future rate cases. There will be future rate cases, I am not really sure of what the timing will be, but there will be another one in the -- probably 2010, 2011 timeframe.
Larry Solow - CJS Securities
Okay, and then just looking just briefly on the real estate side. I know you guys are somewhat opportunistic when you are out there looking for cheaper land.
So do - reading between the line that you think maybe there is still another, some things now rather to drop, before you really get out there and get after them and or just more to come down?
Donald Shippar
Well again we've looked at several different opportunities down there parcel etcetera and based on the star analysis related, certainly price is a big factor, but also how the land is currently permitted for development, whether it's residential, commercial, a combination, those kind of things -- those all factor into our decision on whether or not we think it's attractive or not. So as I said we really have -- even though we looked at several of them in the various locations, we simply haven't found anything that's either priced right, or has the right development order associated with it that we feel will be good for us and obviously provide earnings in the next several years.
Larry Solow - CJS Securities
Okay, then just a quick housekeeping type of question. I see there is $1.4 million in other income in real estate, what was that for the quarter?
Mark Schober
We have in the other real estate segments is our earnings on a couple of things, our finance receivables is in there and also the earnings on our shopping center that we have in Winter Haven.
Larry Solow - CJS Securities.
Okay.
Mark Schober
Bulk of that.
Larry Solow - CJS Securities.
Has that normally been -- that’s normally been in that same line item?
Mark Schober
Yes.
Larry Solow - CJS Securities.
Okay, great. Okay, thank you.
Mark Schober
Thanks.
Operator
Thank you. We'll go next to James Bellessa with D.A.
Davidson & Company.
James Bellessa - D.A. Davidson & Company
Good morning.
Mark Schober
Morning.
Donald Shippar
Good morning.
James Bellessa - D.A. Davidson & Company
Follow-up on that other income question. By my calculation perhaps $0.06 of your positive variance was explained by that in the two segments that you called out as being better than expected the Regulated Utility and the real estate.
So could you just explain other income that’s, what's in that bucket for real estate? Can you explain why you had $1.4 million other income item for the year in real estate that's the only time it hit any quarter?
Mark Schober
Now the other income in real estate, as I just mentioned, that is the ongoing or the run rate that we have for those two items, for both the receivables and a shopping centre. The other income, if you look at the consolidated other income, there's some unusual events in there that's why we didn't record our tax benefit.
Back in Q2 we talked about that, so we had a resolution of a state tax issue, and we also have a resolution of our Northwest Airlines, in the other income, but that's in the other segment. Within real estate its primarily driven by the shopping centre in our finance receivables.
James Bellessa - D.A. Davidson & Company
And yet in the previous quarter of the last two years, '06 and '07, you have had not had any other income, and then, all of the sudden in the fourth quarter, you get this other income?
Mark Schober
Yeah, I'd have to look into the details, Jim. I guess I don't know exactly what that would be there.
James Bellessa - D.A. Davidson & Company
And then on the Regulated Utility side, you called out that there was colder temperatures in December but also there was a swing there of other income. Is there an explanation for that?
Mark Schober
The other income was in the utility, that's primarily now driven by some of our tax benefits that I talked too, I believe.
James Bellessa - D.A. Davidson & Company
And that perhaps, bolstered the fourth quarter?
Mark Schober
Yeah, so that adds to it, the other income is really coming from our AFUDC, that's related to our capital expenditures, so that's recorded in other income for the utility. That's the primary change year-over-year.
And you'll see that running into '08 because of our capital expenditure program continues to run at a higher level.
James Bellessa - D.A. Davidson & Company
Okay, and then, you've given a range for guidance for '08 of $2.70 to $2.90 and then you've given yourself a band, for what the real estate might be able to produce; 10% to 20% of the total. When I look at the potential for the real estate, the band there is wider, $0.30 between upper and lower end.
If the band there is wider than in your overall guidance, can you comment on that?
Donald Shippar
Well I think largely it’s just the uncertainty in the real estate market. I mean we obviously aren’t predicting that we're going to have any kind of a broad recovery this year, we certainly expect to be profitable but it’s really hard to forecast when any kind of recovery will occur and obviously how quickly that will happen and how quickly buyers will come back into the market.
As Mark mentioned we haven’t seen many buyers and the traffic has been reduced significantly. So that’s really the driver for the wider outlook there.
James Bellessa - D.A. Davidson & Company
Thank you very much.
Operator
Thank you we'll go next to Bob Chewning with Davenport and Company.
Bob Chewning - Davenport and Company
Good morning.
Donald Shippar
Good morning Bob.
Bob Chewning - Davenport and Company
With regards to the Minnesota rate case. Will you intend to use 2008 test year you did with FERC on that?
Mark Schober
Our test year for the 2008 rate case in Minnesota will be a split test year. So as we look forward it depends on the file but would be a portion of 2008 and a portion at 2009.
Bob Chewning - Davenport and Company
Okay. If one were to extrapolate if you had requested 7.5 in the FERC case and they roughly 17% of assets.
Should we imply - what gets in the way of that” I know that half of your CapEx is being recovered through causes, but how should we be looking at that?
Mark Schober
You really can’t extrapolate that and you’ve touched on the biggest reason a big chunk of that 7.5 has to do with our current cost recovery that we do not get on the wholesale side of the business, that we do have already in our rates for the retail side of the business. So you really can't extrapolate that and make any assumptions on our level of success on an MPUC rate case.
Bob Chewning - Davenport and Company
Okay. And when filed the rate case with MSPC, does it also include recovery of what you already getting under the causes and so its removed out of the cost and it's on…
Mark Schober
At the end of day, yes. And those were the -- we get current cost recovery for them.
As we go in for a rate case the commission will be looking at those expenditures and build those capital cost into our base rates, so once the final order comes out sometime in mid '09.
Bob Chewning - Davenport and Company
Okay. But you would be putting, the revenues into effect basically under bond pending final outcome.
Mark Schober
Yeah. Interim rates will go into effect 60 days after the filing dates, yes, subject to review and refund based on the final order.
Bob Chewning - Davenport and Company
Okay. All right thank you.
Operator
(Operator Instructions). We go next to Yiktat Fung with Zimmer Lucas Partner.
Yiktat Fung - Zimmer Lucas Partner
Good morning gentlemen.
Mark Schober
Good morning.
Donald Shippar
Good morning.
Yiktat Fung - Zimmer Lucas Partner
Congratulation on a terrific year.
Mark Schober
Thank you.
Yiktat Fung - Zimmer Lucas Partner
My first question can you comment on the outlook for the major industries in Minnesota to which the company is sensitive and also can you also comment on how sensitive the company’s revenue is to sales volume or is sales to initial customers under more fixed or variable rate?
Donald Shippar
Well as you mentioned the outlook for the large industrial of customers and in the taconite, the papers and the pipeline company is very bullish. They continue to project record production levels and also several are making capital investments, longer-term capital investments we referred to the Keewatin Taconite to US steel plant that's they’re proposing to invest $300 million into.
There are also investments for expansion going on at the [Cliffs Northern] mining project. So from the perspective of those customers, what their projections are continue to be very strong, and bullish.
Our contracts with them do have a certain amount of do or “take or pay” basis baked into their agreement. In other words they pays us, X amount regardless of their operating commissions, but the majority of their electric usage, and obviously the cost, if you will, associated with that is tied to their production.
So, there in an element of take or pay, but it is small overall. And the majority of their costs are related to the level of production for those clients.
Yiktat Fung - Zimmer Lucas Partner
My second question pertains to the FERC rate case that was just approved. Was the timing of this approval, I guess ahead of company's expectations when you first issued 2008 guidance in the forth quarter?
Mark Schober
No. That was really baked into our guidance.
We anticipated the changes, we anticipated that we get interim rates, but what happened is that FERC gave us a final reorder that came out. So it's really just a matter of final rates versus interim rates, so the overall impact on earnings is negligible.
The key point here though is that that regulatory risk is now gone. We've got a final rate order from FERC, and we can move on and focus on the Minnesota case now.
Yiktat Fung - Zimmer Lucas Partner
And my final question now with regards to the fourth quarter results. It seems to me that there is a pretty significant pick up in gross margins at the Regulated Utility.
Can you comment a bit on that? Was it mainly weather driven or usage driven?
Donald Shippar
Yeah, that primary driver in Q4, we touched on, if you went through our comments was, we had some really, really cold weather in the beginning of December. So, our sales were up substantially to our residential and commercial and even a little bit in to our municipal customers.
So that was the biggest driver.
Yiktat Fung - Zimmer Lucas Partner
Thank you.
Operator
And there's no further questions. I'd like to turn the conference back to Mr.
Shippar for any additional or closing remarks.
Donald Shippar
Well, thank you all for joining us this morning and for those who are unable to join our at our analyst lunch next Tuesday in New York. I invite you to listen to the webcast replay which will be posted on our website www.allete.com.
We look forward to speaking to you again when we report our first quarter's earnings results in 2008. Thank you.
Operator
Thank you once again, ladies and gentlemen. That will conclude today's conference with you.
We thank you for your participation and you may disconnect at this time.