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Earnings Conference Call - First Quarter 2006

by Larry L. Weyers
Chairman, President, and Chief Executive Officer

Joseph P. O'Leary
Senior Vice President and Chief Financial Officer

Mark A. Radtke
President - WPS Energy Services

and

Donna M. Sheedy
Manager - Investor Relations

The Manager Investor Relations speaks.

Good afternoon. Welcome to the quarterly earnings conference call for WPS Resources Corporation. I'm Donna Sheedy, Manager Investor Relations of WPS Resources Corporation. With me today are Larry Weyers, Chairman, President, and Chief Executive Officer of WPS Resources Corporation; Joe O'Leary, our Senior Vice President and Chief Financial Officer; Phil Mikulsky, our Executive Vice President - Development; and Mark Radtke, President of our nonregulated subsidiary, WPS Energy Services.

We are here today to discuss our earnings for the first quarter of 2006 and what you can expect from us in the future. Today, Larry Weyers will provide a few highlights on the quarter and then turn the call over to Joe O'Leary who will discuss our financial results. Larry will then move into operational updates on the regulated utilities, which will be followed by an operational update on WPS Energy Services that will be provided by Mark Radtke. At the end of our prepared remarks you will be given an opportunity to ask any questions you might have.

Before we begin, I need to point out that this presentation contains forward-looking statements within the definition of the Securities and Exchange Commission's safe harbor rules including projected results for 2006 for WPS Resources and its subsidiaries. Forward-looking statements are beyond the ability of WPS Resources to control and, in many cases, WPS Resources cannot predict what factors would cause actual results to differ materially from those indicated by forward-looking statements. I refer you to the forward-looking statement section of today's press release and to our filed Securities and Exchange Commission disclosure documents for further information.

I will now turn the call over to Larry Weyers.

The Chairman, President, and Chief Executive Officer speaks.

Thank you, Donna. Good afternoon, everyone, and thanks for your continued interest in WPS Resources. Let's begin with a few highlights. These are the key issues you may want to take away from our call this afternoon.

Now Joe O'Leary will discuss some details relating to our financial results. Joe…

The Senior Vice President and Chief Financial Officer speaks.

Thanks, Larry.

Before I begin, let me refer everyone to our press release and Form 10-Q that we filed earlier today with the Securities and Exchange Commission for details of our first quarter financial results. I will hit the major financial and segment highlights for the quarter before turning the call back to Larry.

I'll begin with our regulated operations. As Larry mentioned, the electric and natural gas utility operations were negatively impacted by two non-controllable factors—residential customer conservation efforts, which we believe were spurred on by customer awareness earlier in the winter season regarding the high price of natural gas and by a very mild winter season.

The first quarter of 2006 was approximately 11 percent warmer than last year's first quarter. As you probably would expect, our rate case filing related to the new retail electric and natural gas rates in Wisconsin that became effective on January 1, 2006, assumed normal weather conditions and did not anticipate such a mild winter season.

Largely as a result of these two factors, which were partially offset by rate increases, our electric utility margins were squeezed. This resulted in a year-over-year decline of 8 million dollars, or 34 percent, in electric utility earnings to 15.5 million dollars.

Similarly, our natural gas utility segment margins declined by 1.5 million dollars for the first quarter or 3.2 percent below year ago levels due to warmer weather and residential customer conservation efforts, which were partially offset by rate increases. In addition, our operating and maintenance expenses rose by about 9 million dollars, of which 4.1 million dollars was for transition costs associated with the acquisitions of the Michigan and Minnesota natural gas utility assets. An increase in the write-off of uncollectible customer accounts related to high natural gas prices also contributed to the increase in operating and maintenance expense. Together these items contributed to a decline in natural gas utility earnings of 52 percent to 6.7 million dollars.

The operating environment was much better for our nonregulated operations where WPS Energy Services posted a 32 percent increase in income to 37.1 million dollars. This was driven by a 34.1 million dollar increase in margin, partially offset by an 8.3 million dollar decrease in synfuel tax credits recognized and a 3.9 million dollar increase in operating expense primarily due to higher payroll and benefit costs associated with our continued business expansion. A detailed breakdown of the margin growth at WPS Energy Services can be found in our Form 10-Q, however, the major items of improvement were:

These items were partially offset by:

Now, I would like to discuss a few other financial related issues that will have an impact on our future results.

On January 3, 2006, Upper Peninsula Power Company filed a request to increase its overall electric base rates by 6.6 million dollars, or 8.1 percent, with an 11.5 percent return on equity, and a 55 percent regulatory common equity ratio. We will attempt to reach a negotiated settlement with our customers and the Michigan Public Service Commission. However, if a settlement is not reached, we anticipate the Commission will act on the request in the fourth quarter of 2006. We also asked for new interim rates to go into effect in the second quarter of 2006, subject to refund, while the Commission reviews the entire request. A hearing with the Michigan Public Service Commission on the interim request took place on April 17, 2006, and an order is expected to be effective in the second quarter. The requested increase is due to costs associated with improving service quality and reliability, technology upgrades, and managing rising employee and retiree benefit costs. Upper Peninsula Power's last retail rate increase was in December 2002.

On March 31, 2006, Wisconsin Public Service Corporation filed with the Public Service Commission of Wisconsin for a 125.1 million dollar, or 14.4 percent, increase in Wisconsin retail electric rates, and a 22.6 million dollar, or 3.9 percent, increase in Wisconsin retail natural gas rates. The major cost drivers behind the proposed electric rate increase are increased electric transmission costs, including MISO Day 2 costs, increased fuel and purchased power costs, the construction of Weston 4, and major planned outages at Weston 3 and the De Pere Energy Center. The major cost drivers behind the proposed natural gas increase are distribution system improvements across our service territory and costs associated with the environmental remediation of former manufactured gas plant sites. These increases are based on an 11 percent return on equity, and a 60.35 percent regulatory common equity ratio. The new rates are expected to become effective on January 1, 2007.

On April 28, we announced the closing on the sale of our one-third interest in Guardian Pipeline, LLC to Northern Borders LP for 38.5 million dollars, which will result in a pre-tax gain for WPS Resources of approximately 6 million dollars.

With regard to issuing equity and debt, WPS Resources plans to issue additional common equity and debt during the latter part of 2006 to fund the acquisition of the Michigan and Minnesota natural gas distribution operations from Aquila and other capital requirements. We expect to issue equity in the range of 250 million dollars to 300 million dollars and long-term debt in the 350 million dollar to 400 million dollar range. In addition, we are considering certain hybrid securities that are treated by credit rating agencies as a blend of debt and equity. If we decide to issue any hybrid securities, they will displace approximately equal amounts of equity and debt. The timing of these issuances depends on when the Minnesota utility acquisition transaction closes. Wisconsin Public Service also plans to issue long-term debt in the 100 million dollar to 150 million dollar range to provide funds for capital growth of utility operations.

Finally, as Larry mentioned earlier regarding our earnings per share guidance, we are increasing our guidance in spite of the first quarter decline in earnings from our utility operations. Our 2006 diluted earnings per share guidance ranges between $3.54 and $3.98, including about 14 million dollars of pre-tax transition costs we anticipate expensing in 2006 related to the acquisitions of natural gas distribution operations in Michigan and Minnesota. It also considers about 6.4 million dollars of increased purchased power costs for WPS Energy Services relating to an 8.2 million dollar pre-tax gain recognized in 2005 from the liquidation of a supply contract for Maine customers.

Now I'll turn the call back to Larry Weyers.

The Chairman, President, and Chief Executive Officer speaks.

Thanks, Joe.

Let's continue to discuss our operating segments.

We expanded our natural gas distribution business when we completed the acquisition of natural gas distribution operations in Michigan from Aquila, Inc. on April 1 of this year.

We paid approximately 315 million dollars for Aquila's operations in Michigan, including estimated closing adjustments, relating primarily to working capital, of approximately 45 million dollars. The transaction is subject to normal post-closing adjustments. The Michigan natural gas distribution operations provide natural gas distribution service to about 161,000 customers mainly in southern Michigan in 147 cities and communities including Otsego, Grand Haven, and Monroe. Annual natural gas throughput is approximately 36 billion cubic feet per year.

In addition to having access to several major natural gas pipelines, Michigan Gas Utilities, our new natural gas subsidiary, owns a 3.6 billion cubic foot natural gas storage field. The assets operate under a cost-of-service environment and are currently allowed an 11.4 percent authorized return on equity on a 45 percent equity component of the regulatory capital structure.

We anticipate receiving approval from the Minnesota Public Utilities Commission for the Minnesota acquisition, and we expect to close on that transaction this summer.

Construction of Weston 4, a 500-megawatt pulverized coal plant, in Wausau, Wisconsin, continues on schedule and on budget. The plant is scheduled to begin commercial operation by June 2008.

In the first quarter of 2006 we received the Administrative Law Judge's ruling regarding the contested case on the air permit for Weston 4. Overall, the ruling upheld the permit issued by the Wisconsin Department of Natural Resources. However, the judge did impose an additional limit on the scrubber for Weston 4, requiring that it must maintain a 90 percent removal efficiency. This means that 90 percent of the equivalent sulfur dioxide in the coal burned to generate electricity must be captured prior to emission from the plant. Because of the way the control equipment operates, a result of the limit could be that Wisconsin Public Service would be forced to use coal with a higher equivalent sulfur dioxide content than it planned, meaning that complying with the ruling would result in more sulfur dioxide emissions, which is not consistent with the intent of the permit nor our view of environmental stewardship. Accordingly, we have asked for a modification. That appeal is in progress.

Construction of the 220-mile, 345-kilovolt Duluth, Minnesota, to Wausau, Wisconsin, transmission line is well underway. Construction of the Wisconsin portion of the line is about 47 percent complete and is progressing on schedule for a second quarter 2008 completion. A 142-mile portion of the Wisconsin line is scheduled to be in service by the end of this year, at which time, 70 percent of the line will be complete.

WPS Resources committed to fund 50 percent of total project costs incurred for the line, up to 198 million dollars. WPS Resources has the right, but not the obligation, to provide additional funding in excess of 198 million dollars. For the 2006 through 2008 time frame, we expect to fund up to approximately 61 million dollars for our portion of the line, assuming Allete funds 60 million dollars.

WPS Resources expects capital calls from American Transmission Company relating primarily to transmission line projects to total about 164 million dollars for the years 2006 through 2009, with about 61 million dollars relating to the Wausau, Wisconsin, to Duluth, Minnesota, transmission line. We own about 33 percent of the ATC. ATC is allowed a return on equity of 12.2 percent through 2012.

Now, let's take a closer look at our nonregulated operations. Here to discuss this is Mark Radtke, President of WPS Energy Services. Mark…

The President of WPS Energy Services speaks.

Thanks, Larry.

Let's start by taking a quick look at our plants. Our Niagara Falls solid fuel plant capacity factor increased 22 percentage points to 86 percent compared to the first quarter of 2005. Please note that our prior year capacity factor was negatively impacted by a breaker failure at Niagara Falls. We continue to make progress with permitting and testing to increase the amount of tire derived fuel burned at the plant. Our targeted permit limit is 70 percent, and we have completed test burns with up to 65 percent tire derived fuel. This effort not only provides a beneficial use for old tires, it lowers our total fuel cost at the plant. We have been using 20 to 25 percent tire derived fuel in recent quarters, and expect to double our use of that fuel source in the near term.

Sunbury's capacity factor declined by 2 percentage points compared to the first quarter 2005. PJM power prices were slightly higher in the first quarter of 2006 compared with the first quarter of 2005, however, our cost of emission allowances was up significantly in 2006, putting pressure on margins at the Sunbury plant. We did have part of the plant down for economics for a few weeks in January.

Westwood's capacity factor dropped 6 percentage points to 89 percent due to a couple of boiler tube leaks, which will be more fully addressed in the maintenance outage being conducted this month.

Given the spark spreads in New York, our Syracuse natural gas plant dispatched 6 percent of the time, the same as in the first quarter of 2005. Beaver Falls continues to be unavailable awaiting determination of the recoverability of necessary repairs from our insurers. As you may recall, the unit came off-line on June 26, 2005, with a first stage turbine blade failure. We continue to evaluate the future direction of the facility.

With the end of the first quarter comes the end of the transitional Seams Elimination Charge Adjustment or SECA charge. During the first quarter, we expensed 3.6 million dollars of SECA charges.

Over the past 18 months, we have been adding significant business origination and support resources to focus on organic growth of our customer based natural gas and electric business. That focus is generating results that are evident this quarter in the growth of our forward contract business volume, or business backlog as it is sometimes referred to. Our natural gas forward contract volume increased 32 percent compared to March 31, 2005. That growth is nicely balanced across our wholesale and retail business and is even stronger in future years than for the next 12 months. Our electric business grew even more with a 75 percent increase in forward contracted business, again heavier in future years than in the next 12 months. As we expected, our total retail electric forward contracts fell off because of the long lead time needed to replace Ohio and the declining Michigan business.

Part of that replacement effort is in Texas where retail electric development continues on schedule. We are in the process of testing the system capability of our information technology infrastructure. We anticipate being ready to deliver physical energy to retail customers on July 1. Because of the partial year of commercial operation, we don't anticipate a material contribution to income from Texas in 2006.

Texas is the most vigorous electric market expansion we have underway. In other markets we are preparing and delivering products as market conditions allow, and that is beginning to take shape in a few New England and Midwestern states.

While our core commercial and industrial natural gas business experienced limited impact from weather, our residential and small commercial mass-market business did experience a 15 percent decline in volume due to the 15 percent warmer than normal weather experienced in the Ohio market. Our risk management strategy protects us from this risk of declines in consumption, so the financial impact of this demand reduction was minimal.

We have expanded our natural gas mass-market business, which has been primarily residential and small commercial customers in Ohio, and are now adding service to small commercial customers in Michigan. This market expansion leverages our experience and analytics developed and demonstrated in the Ohio market.

We continually evaluate our asset portfolio to add or divest assets in a manner beneficial to our customers and shareholders. On April 12 of this year we completed the sale of WPS-ESI Gas Storage, LLC, which owned our Kimball 27 natural gas storage field that we developed and placed in service in 2001. The sale will contribute about 9 million dollars of pre-tax income in the second quarter, and we received approximately 19.9 million dollars of cash proceeds from the transaction. The absence of the field will have a negligible impact on forward results because we already obtain the majority of our storage needs through contracted assets.

Managing our synthetic fuel tax credit phase-out risk continues to work well. To date, we have spent a total of about 12.4 million dollars as we have finished hedging our residual 2006 phase-out risk, and 3.3 million dollars to minimize 40 percent of our 2007 risk. The facility continues to operate well, with our share of production at historical levels. We are managing production each month in 2006 based on the expected annual average price of oil for the year. If oil prices cause a full phase-out and we cease production, that savings in production cost would be a benefit as we are hedged against the phase-out risk. We are monitoring legislation relating to potential tax code changes around the reference year issue, and will evaluate how to manage our position in 2007 based on the outcome of this legislation.

Now, I'll turn the call back to Larry.

The Chairman, President, and Chief Executive Officer speaks.

Thanks, Mark.

In 2006 we will continue to manage our portfolio of businesses to achieve utility and nonregulated growth. However, we are placing an emphasis on regulated growth. We demonstrated this commitment to regulated growth with the expansion of our generation fleet and our acquisition of retail natural gas operations in Michigan and the anticipated acquisition of retail natural gas operations in Minnesota.

We also will continue to reduce our risk exposure for the benefit of shareholders and customers. And our asset management strategy will continue to deliver shareholder value.

We have embarked on a cost reduction initiative called Competitive Excellence that is based on lean principles. It is a process approach that gives employees the tools and knowledge to eliminate waste and work more efficiently. We expect this focus to lower our costs for many activities.

Our long-term diluted earnings per share growth rate target remains at 6 to 8 percent on an average annualized basis, with fluctuations that may be above or below that target. Our 2006 guidance was increased to between $3.54 and $3.98 diluted earnings per share, assuming normal weather for the remainder of the year, availability of our generation units, completion of asset management sales, and successful completion of the acquisition of the Minnesota natural gas distribution operations.

To recap key points of this earnings call:

Now, Joe, Phil, Mark, and I are available to answer your questions about our financial picture and plans for the future.

Thank you for being a part of our first quarter earnings conference call. A replay of this conference call will be available through May 18, 2006, by dialing toll free 866-354-2025.

The text for today's presentation is available on our Web site. Just select Investor Information and then Presentations.

If you have additional questions, you may contact Joe O'Leary, at 920-433-1463 or Donna Sheedy at 920-433-1857.