CenterPoint Energy Inc (CNP) 2005 Q3 法說會逐字稿

Good morning, my name is Crystal and I'll be your conference facilitator today.

At this time, I would like to welcome everyone to the CenterPoint Energy third quarter 2005 earnings conference call.

After the speakers' remarks there will be a question-and-answer session. [OPERATOR INSTRUCTIONS] Thank you.

Miss Marianne Paulsen, you may begin your conference.

Thank you very much, Crystal.

Good morning, everyone.

This is Marianne Paulsen, Director of Investor Relations for CenterPoint Energy.

I'd like to welcome you to third quarter 2005 earnings conference call.

Thank you for joining us today.

David McClanahan, President and CEO, and Gary Whitlock, Executive VP and Chief Financial Officer will discuss our third quarter results and will also provide highlights on other key activities.

In addition to Mr. McClanahan and Whitlock, we have other members of management with us, who will be here to answer questions following our prepared remarks.

The third quarter 2005 earnings release, as well as, the Company's report on Form 10-Q filed earlier today, are posted on our website which is www.centerpointenergy.com, under the investor's section.

I would like to remind you that any protections or forward-looking statements made during this call are subject to the cautionary statements on forward-looking information in the Company's filings with the SEC.

Before Mr. McClanahan begins, I'd like to mention replay of this call will be available until 6:00 p.m. central time through Thursday, November 10, 2005.

For access the replay, please call 1-800-642-1687 or 706-645-9291.

And enter the conference ID number 9953872.

You can also listen to an online replay of the call via the website that I just mentioned.

We will archive the call on CenterPoint Energy's website for at least one year. and with that, I would like to turn it over to David McClanahan.

Thank you, Marianne.

Good morning, ladies and gentlemen.

Thank you for joining us today and thank you for your interest in CenterPoint Energy.

This morning I'll review our third quarter results and summarize the performance of each of our operating units.

Overall, our business performed well in the quarter, despite the challenges we faced with back-to-back hurricanes along our Gulf Coast service territories.

I'll also update you on the status and recovery of our stranded cost true up balance and finally I will review our recent dividend actions.

Following me, our Chief Financial Officer, Gary Whitlock, will have some additional comments.

Let me first describe the impact from the recent hurricanes.

Never in our 130-year history have we had to endure two significant hurricanes striking our service territories in the same season.

I'm very proud of our employees and their response to these natural disasters and the prompt and safe manner in which they performed restoration duties.

In late August, our Mississippi and Louisiana natural gas service areas were in the direct path of Hurricane Katrina.

We suffered minimal impact to our infrastructure since most of our natural gas delivery system is underground.

However, over 10,000 of our customers' homes and businesses suffered significant damage and will not be taking service from us for some time.

Since our electric system was not affected, we were able to send our electric crews to Florida, Mississippi and Louisiana to assist other utilities who requested our help.

In Houston many employees played key roles in opening and operating a major evacuation center and in finding homes for thousands of Katrina evacuees from New Orleans.

Less than a month, later Hurricane Rita struck our electric and gas service areas in Texas and Louisiana.

The damage to our natural gas facilities was minimal.

We had very minor damage to our electric transmission and substation infrastructure.

Most of the damage was to our electric distribution systems, and was caused by downed trees and line contact with wind-blown branches.

Over 700,000 customers lost power at the height of the storm as 70% of the company's electric service territory experienced hurricane or tropical-storm force winds.

We restored power to half million customers within 36 hours.

Everyone's power was restored in less than five days.

While we were in the midst of surveying damage and restoring power to our system, we also provided restoration assistance to neighboring utilities, including Entergy, which took the brunt of the hurricane and suffered extensive damage to its transmission system.

Through an emergency interconnect, we energized a number of substations and related transmission lines.

This was the first time this interconnect had been used since it was installed in the late 1950's and accomplished what it was designed to do in an emergency, and that is to get power back on quicker.

I'm extremely proud of the significant efforts of our employees, who quickly and safely restored service, not only to our gas and electric customers, but in assisting other utilities impacted by the two devastating storms.

I think, we'll all breathe a sigh of relief when hurricane season is over at the end of this month.

I know I will.

Now, let me provide you with an overview of our third quarter results.

This morning we've reported net income of $50 million or $0.15 per diluted share.

This compares to a net loss of $1.1 billion last year on 3.66 --- $3.66 per diluted share.

Last year's earnings included an $894 million extraordinary charge to earnings related to our stranded cost true-up proceeding and $250 million net loss related to the sale of our interest in Texas Genco.

Income from continuing operations from the third quarter of 2005 was also $50 million.

Or $0.15 per diluted share.

Compared to $17 million, or $0.05 per diluted share for the third quarter of last year.

The third quarter of 2005 includes after-tax income of $23 million related to interest on our true-up balance.

While we are entitled to interest of 11.075% until our true-up balance is fully recovered, generally accepted accounting principles only permit us to currently recognize the interest at an annual rate of approximately 6%.

We will recognize the rest of the interest in earnings as we recover it in the future.

Now, let me give you some details about the performance of each of our business segments.

Despite the impact of Hurricane Rita, Houston Electric performed well this quarter.

Excluding the transition bond company, the TDU reported operating income of 174 million compared to 169 million in the third quarter of last year.

Houston Electric continues to enjoy solid customer growth adding nearly 53,000 metered customers since September of last year.

We also experienced higher revenues resulting from favorable weather and implementation of the CTC to recover a portion of our true-up balance, which I'll talk more about in a moment.

This quarter the increased revenues that we received from transmission cost recovery were more than offset by the increase transmission costs billed to us from other electric utilities.

On the expense side the increase in operation and maintenance expenses was primarily driven by the higher transmission costs and the absence of games from a land sale that we recorded last year.

And coincident with the implementation of the CTC, we began amortizing the related regulatory assets and rate expenses increasing our depreciation and amortization expense.

Our natural gas distribution segment reported an operating loss of $12 million compared to a $2 million loss last year.

This is a seasonal business and the second and third quarters are typically the lowest earnings periods of the year.

Revenues increases from rate changes and customer growth were more than offset by increases in our allowance for bad debts, hard labor and benefits related to expenses and increased depreciation expense.

Increased margins in our non-rate regulated gas sales business were substantially offset by the effects of mark to market accounting related to financial derivatives used to lock in the economic margins of certain forward gas sales.

Gary will discuss this in more detail in a few minutes.

Finally, our Pipeline and Gathering group had another outstanding quarter, achieving operating income of $52 million, an increase of $17 million compared to 2004.

Our Intrastate Pipelines achieved increased transportation services due in large part to higher basis spreads.

Our Gas Gathering business also benefited from increased through put and enhanced services.

New well connects, increased gas processing and increased sales of data monitoring services continued at rates above historical levels.

While no one can predict how long the current dynamics in the natural gas markets will last, I'm pleased that we have positioned ourselves to provide the services and products our customers need in this environment.

In summary, I'm pleased with our performance this quarter.

I believe we're making the operational improvements and enhancements throughout the Company, necessary to position us for the future and achieve long-term profitability and growth.

Let me briefly touch on several rate developments that occurred since last quarter.

On the electric side, the Texas PC staff concluded that continuation of our existing rates could result in excess revenues in as much as $105 million annually.

Their analysis was based on 9.6 return on equity, 40% equity level, and the elimination of the interest associated with $1.31 billion term loan, which matures later this month.

The commission ordered the staff to initiate a rate take on December 1st, if the companies and various parties have not reached a settlement.

If a settlement is not reached the Company has a 120 days to prepare a rate filing.

We are currently preparing updated analysis of our earnings, using more representative levels of revenues and expenses, in what we believe is the appropriate capital structure, as well as return on equity.

We believe we expect to have discussions with the other parties and hopefully avoid a costly and extended rate proceeding.

They have also had several developments in the natural gas distribution segment.

Yesterday, we filed $41 million rate request with the Minnesota Public Service Commission.

Our request is driven by higher bad debt expenses, increased carrying costs associated with natural gas storage, significant new capital investments and reduced natural gas usage per customer.

A decision on this request is expected in the third quarter of next year.

We were disappointed by the decision of the Arkansas Public Service Commission to lower our rates by $13 million effective the end of September.

Since almost 10 million of the decrease is due to reduced appreciation, the impact on operating income will be just over $1 million.

We believe these rates do not provide us with an adequate rate of return on our investment.

This is a significant set back in a state where we have made considerable capital investments over the last several years.

Now, I'd like to turn to a major milestone for the Company.

The recovery of our true-up balance.

As most of you know, in December of last year the Texas Public Utility Commission issued a final order allowing us to recover approximately $2.3 billion, including interest, through August.

And we are continuing to accrue interest until we recover our authorized balance.

The two ways we recover our true-up balance are through implementation of a competition transition charge, or CPC, or by issuing transition bonds.

I'm very pleased that we have now begun to recover a portion of our true-up balance with the implementation of the CTC in mid-September.

Through the CTC, we will recover about $600 million plus interest over 14 years.

We will also recover $24 million in rate case expenses over three years, but without interest.

I'm also pleased that we are moving forward on issuing transition bonds for the remaining portion of our true-up balance of $1.85 billion.

Gary will update you on the status of this process in his remarks.

While we're pleased to begin recovering a portion of the authorized true-up balance, we filed our appeal in January with the Travis County District Court seeking reversal of about 1.3 billion of dis allowances.

In August, the District Court issued its ruling, affirming most aspects of the PC order but reversed two of the commission rulings, which would have effect of restoring about $620 million plus interest to our request.

We have other -- we and other parties, subsequently, filed notices of appeal with the third court of appeals.

We anticipate that the appeals process, if ultimately taken to the Supreme Court, may take up to two years.

As I stated in the past, our primary focus is to enhance and grow our energy deliver businesses.

Last week we announced a significant addition to our Intrastate Pipelines.

We will construct a new 168-mile pipeline between Carthage, Texas and our Perryville hub in northeast Louisiana, which will have an initial design capacity of about a billion cubic feet per day.

The announcement was concurrent with the signing of a ten-year contract with XTO Energy, as anchor shipper, for the transport of about 600 million cubic feet per day of their natural gas production.

We are currently holding an open season to solicit interest in the remaining 40% of the capacity of the new pipeline.

The pipeline will cost approximately $375 million and with timely receipt of permits it could be in service as early as next winter.

We believe this is an excellent project in a capacity constrained area and is expected to provide attractive returns to the Company.

Last quarter I indicated that we were going to assess our possible participation in the retail electric business in Texas.

We have completed our evaluation and concluded that we will not pursue this business at this time.

The shrinking profit margins together with volatile and elevated commodity prices does not offer attractive enough returns for the risk.

Before I turn the call over to Gary, I would like to remind you of the recent dividend action by our Board of Directors.

On October 24th, the Board declared $0.06 per share dividend payable on December 9th, to shareholders of record on November 16th.

This brings our total dividends for the year to $0.40 per share consistent with the level we had paid over the last two years.

The new energy bill signed into law in August repeals the Public Utility Holding Company Act effective in early February.

This means that from a practical standpoint the restrictions on our dividend payments won't impact our dividend decisions next year.

We believe that the dividends actions that we've taken this year demonstrate our strong commitment to our dividend.

We understand that our shareholders expect a competitive dividend.

As we have previously stated, our long-term objective is to pay a dividend of between 50 and 75% of sustainable earnings, and we plan to be in a position to begin increasing the dividends in 2006.

Let me close by saying that we are making progress in implementing our strategy.

We are executing on the plans that we developed and communicated to you prior to the formation of CenterPoint Energy.

Our businesses are performing well and continue to improve their financial and operating results.

We are focusing our attention on value enhancing opportunities consistent with our strategy.

Now, I'll turn the call over go Gary.

Thank you, David and good morning to everyone.

I'd like to discuss a number of items with you this morning.

Let me begin with an update on the transition bonds and our plans to meet the upcoming maturity of CenterPoint Energy, Houston Electric, $1.31 billion term loan.

As David mentioned, we're moving forward on issuing the transition bond.

We've been diligently working with the commission through its financial advisor on the steps necessary to issue approximately $1.85 billion in bonds by year end.

Therefore, based on this expected timing, to repay the $1.31 billion term loan at CEHE which is due on November 14th, we will draw our back stock credit facility which we put in place specifically for this purpose.

The interest costs under the new facility of LIBOR plus 75 basis points is substantially below the interests costs on the maturing term loan.

When we received the proceeds from the sale of the transition bonds, we will use a portion to repay in full the borrowings under the back stop facilities.

Subsequent to the repayment of the back stop facility, we will then recapitalize CenterPoint Energy Houston Electric to achieve a capital structure more typical of the regulated electric utility.

Now, let me give you an update on the exchange offer for our 3.75% contingently convertible senior note that was settled on August 23rd.

We accepted for exchange approximately $572 million or 99% of the old notes.

The new notes are essentially identical to the old notes with exception that upon couldn't version, the Company will have the right to settle the principle portion of the new notes and cash rather than stock.

This modification will allow the Company on a perspective basis, to decrease the diluted effect of these securities resulting from EITF 04-8.

For the third quarter we reported a diluted impact of $0.01 per share for two contingently convertible securities.

Next, I'd like to comment on Standard & Poor's positive credit ratings action.

S&P recently revised its outlook to stable from negative on CenterPoint Energy Inc.

And on CERC, our natural gas distribution and pipeline subsidiary.

And CEHE, our electric subsidiary.

S&P also affirmed it investment grade rating on the 3 Companies.

We are very pleased that S&P's outlook is now stable on all three entities.

We believe we have taken consistent and significant steps to improve the credit metrics and risk profile of both the parent company and our utility subsidiaries, which we think S&P recognized in taking positive ratings action.

We will continue to take the steps necessary to enhance the credit ratings of the operating companies and the parent company.

I'd also like to discuss the impact of sustained high natural gas prices on the Company's earnings and liquidity.

In terms of impact to earnings, we are experienced both positives and negatives.

As we indicated in our press release this morning, the Pipeline business is benefiting from increased demand for transportation and our Gas Gathering operation is benefiting from increased throughput and demand for its services.

While our Natural Gas distribution businesses have favorable adjustment clauses, we are beginning to see the effects of higher natural gas costs on our customers' ability to pay.

In response, the Company continues to manage its business to mitigate these impacts.

For example, as part of the Minnesota filing, we have requested a bad debt tracker.

Furthermore, we have gas hedging programs in place for most jurisdictions and we continue to communicate with our customers and add innovative programs to help them manage their gas heating bills and natural gas usage.

Finally, we seek assistance for our customers through [Indiscernible] and other low-income assistance programs.

In terms of the impact to our liquidity, we have stress tested our liquidity requirements at various gas prices and are comfortable that we have adequate credit facilities in place at the parent company in each of our utility subsidiaries.

Now, as David referred to in his remarks, I'd like to review with you the specifics for the accounting of derivatives and impact to our third quarter results.

As you know, the Company offers variable and fixed priced, physical and natural gas supplies to commercial and industrial customers and natural gas distributors through CenterPoint Energy services business.

As a result, we're exposed to various market risks for which we use derivative instrument s such as basis swap to lock in economic margins on certain transactions to buy, transport and sell gas at different locations.

Swaps are treated differently than the physical transactions for accounting purposes.

Swaps are mark to market, while physical sales are accounted for on an accrual basis, which may cause earnings to be recognized in different periods over the lives of the contract.

However, upon settlement of both the intended economic margin is realized.

This quarter, the wider spread and basis differentials resulted in larger earnings impact than we experienced in prior quarters.

As a result, earnings were negatively impacted by approximately $8 million due to the mark to market accounting requirements.

Therefore, earnings in this business may continue to fluctuate dependent upon future changes in natural gas prices and basis differentials.

However, it is important to remember that over time we will ultimately realize $2.3 million economic margin we have locked in during this quarter by using these instruments.

Now, I'd like to comment on our income tax rate.

Our effective tax rate for the third quarter was 45.2% compared to a normalized tax rate of approximately 35%.

The most significant item affecting the increase in our tax rate is an issue related to zero premium exchangeable subordinated note or ZIM.

The IRS is proposing to disallow all deductions for interest and OID relating to the ZIN.

The contention of the IRS is that the OID and the interest actually paid on these securities is not currently deductible, but instead must be added to the basis in the Time Warner stock that we own. .

This would have the effect of recharacterizing ordinary interest deductions to capital losses or reduce capital gains.

Currently the company does not expect to have adequate capital gains to offset the projected capital losses.

Therefore, we are required under the accounting rules to reserve for this item.

The Company disagreed with the IRS and is contesting this issue.

The total tax reserve after the end of September was $111 million of which $10 million was reserved in the third quarter.

Until this issue is ultimately resolved, we expect to add approximately 10 to $15 million to the tax reserve each quarter.

However, the actual amount added to the reserve will be affected by the market price of the Time Warner stock, the amount of ZIN and OID which increases quarterly and the assessment of any capital gain.

Let me thank you for the interest in the Company and I will turn the call back to Marianne. .

Thank you very much Gary.

It is now time for questions, so Crystal would you please give the instructions on how to ask the questions.

[OPERATOR INSTRUCTIONS] Your first question comes from has Lasan Johong.

Good morning.

Good afternoon.

On the 105 million rate case pending, is it my understanding, correct me that -- if CenterPoint reaches agreement with the PUC on what rate -- implied rate should be, that is the TDU, then this thing all goes away?

Right, if we can reach a settlement as to what the appropriate rate level would be, we wouldn't have to hold a rate case, we would go ahead and implement whatever the settlement would be.

Can you describe kind of -- give us color as to around what numbers you're talking or discussing ask?

You know, we haven't -- we haven't began discussing any numbers.

What we have done, and this just happened last Friday.

We are preparing internally our analysis of what the appropriate revenues and expenses are, on which rates should be based, as well as, looking at our capital structure and what is the appropriate return.

So we haven't started talking to the parties about a specific number that will probably not occur for a few days.

Then let me ask you this way.

Based on internal analysis, how how much, of the $105 million, how much would go away?

We're not ready to tell you how much would go away.

We think that number is too high but it depends on what you assume as to your capital structure ROE.

We have a number of expenses that have gone up that we don't think are reflected in the analysis.

The easiest one is a new city of Houston franchise agreement that we signed earlier this year that increases our franchise fee about $18 million, or so.

And obviously, that hadn't occurred in 2004.

The staff used the results of 2004 to base this analysis.

So you just have to bring all your expenses, as well as revenues up to date before you can reach any conclusions.

We do believe the 105 is too high.

Okay.

You had mentioned in your prepared remarks there was an impact from the hurricanes of about 10,000 homes and businesses discontinuing gas services for a while.

What kind of overall impact do you foresee in the fourth quarter and going forward in terms of dollar amounts?

You know, we don't see a significant amount.

It is less than a million dollars on an annualized basis that we see from this whole impact.

So we'll see a little impact in the fourth quarter, not a lot.

It's going to take a while for a number of these homes to be rebuilt, because they were, in essence, destroyed, and we expect them to be rebuilt, but that will take some time and it will be over a number of years.

So there's going to be some minor impact, but it's not --- it's not significant revenue standpoint.

That's good to know.

One last question, bad debt expense, how bad do you think it's going to get for the fourth quarter and first quarter of next two quarters?

Well, it's hard to say.

I think our increase in expenses this year has been about 5 or $6 million.

We haven't actually got into the winter months, yet.

So it could be significant.

Now, we work with our customers, especially, low-income, fixed income customers, we work out payment arrangements.

We try to do everything to make it easier for them and to keep from -- keep them from becoming delinquent, which causes the real bad debt problem.

So we're going to work real hard at it.

We aggressively seek assistance for our customers, but I would expect that we're going to see some increase certainly over last year.

Whether it's, or so, I'm not sure how to gauge that, yet.

Thank you.

Your next question comes from John Keane.

Hello.

Hello.

Hi.

If you do end up going through a full-blown rate case because no settlement is actually reached, do you think that would delay your decision on dividend increases a little bit in '06?

John, I think we're going to look at that in the first quarter.

We'll obviously have to make some assessment on what that impact would be, but I expect that the board is going to want to look at our dividend level in the first quarter.

We'll just have to make our best judgment as to where the rate case will come out.

If it is not settled.

Great.

Thanks, that's helpful.

Your next question comes from Charlie Ventor.

Hello, this is from Pete at Prudential.

Can you hear me okay?

Yes, go ahead.

Yeah.

Couple of questions.

One looks like industrial deliveries on the electric side fell, about half million megawatt hours versus last year.

We were wondering what is contributing to that?

And how much of that was from the storm related effects and how much is from high gas prices causing demand destruction.

We're having a little trouble hearing you.

I'll say, though, based on your question, that we believe that probably more than half was related to the hurricane.

Clearly, I think there is some impact from higher cost of fee stock, but it's primarily hurricane-driven.

Okay.

Okay.

And on that--on the same--can you hear me better now, by the way?

Much better.

Okay.

On that same note, is there a good chance for hardening of the infrastructure and some spending for that?

If the premise that the storm activity, you know, it may be in for several years of higher than normal storm activity?

Well, as you may have read, you know, we would like to strengthen, harden our system with any excess revenues that we may be earning to apply them to harden the system, because we do believe that we've seen so much more hurricane activity and while you can't stop all of the outages, hardening the system in select areas could certainly help with that.

So that is a topic we want to talk to the parties about, are there some things that we need to do instead of reducing rates, take some of these dollars and harden the system.

That is certainly one thing we would like to talk about.

The premise thing is hardening there now would be a lot cheaper than having to fix a bunch of stuff later.

Is that --

That is one thing.

The inconvenience, when you lose electricity, that is really inconvenient, whether you're a--a residential customer or industrial customer, and so plus it does cost money to fix the infrastructure when it's damaged.

So both of those are important considerations when we decide and the other parties decide what we want to be doing.

Okay.

Thank you, guys.

Your next question comes from Nathan Judge.

Hi, just a couple -- could you remind us why you own the ZIN, again?

Why what?

Why you own the ZIN Securities, the Time Warner stock?

This goes back to the 1990 -- we at one time owned a cable television company and we were in the -- we were a partner with Time Warner.

When we sold that business, we sold it to Time Warner.

And in part of the consideration for the sale, was Time Warner stock and some preferred stock that Time Warner issued to us, that was convertible in Time Warner common shares.

And so the ZIN are related to the Time Warner shares we own, and thats the reason.

The ZINs were done in connection with the financing using the Time Warner shares as a not collateral, but it's related to the value to the Time Warner shares.

Sure.

Is there a reason you're continuing to hold on, and is there any reasons why you can't undo that transaction or get out of that transaction?

Well, the -- no, there is no reason other than you have to tender for them.

I don't think you can call them.

Mark, I'm going to look to you.

It would be--you know, to get them in, you have to go in open market and buy them.

And but there is no reason you couldn't do that if we decided to do it.

Nathan, this is Gary, I think another point there, and is that absence this tax issue, this is a low-cost borrowing in our capital structure, so certainly again as I said, we have merit in it, significant merit in our defenses.

We need to let this play out a bit further.

It is in the appeals process with the Internal Revenue Service.

We have a strong case and again, absent this issue, certainly it is a -- an element of our capital structure that can make some sense.

Having said that, certainly, if we are unable to resolve this to our benefit then we will look at all options that would be in the best interest of our Company at that point.

Can you give us some type of time line or expectation of how long this will take to resolve and what milestones we can look for?

You know, I'm hesitant to give you an exact time line for all the obvious reasons.

Let me just share with you that this came up in a normal -- I won't call it routine -- but the normal examination process.

It was not a special look at the ZIN.

It came up in the normal audit process.

And then there is a protocol you follow which is the next step appeals to more senior level to Internal Revenue Service.

That will take a potentially a number of months but it could be sooner or later than that.

So we really can't commit to a time.

What I will say, Nathan, is that with an important issue for us and we're absolutely focussed on it, but we can't commit to a timing to resolve it.

Okay.

I guess -- is it pertains to the rate case at Houston Electric, is this like the corporate level, this is not at Houston Electric level.

Is that correct?

It is at the Houston Electric level.

Not at the CenterPoint Energy level but -- but the CenterPoint Energy Houston Electric level.

The reserve you're taking on this tax allowance is that involved in the rate case at all?

I'm sorry, I'm sorry, Nathan.

I messed up there.

I misunderstood your question.

The reserve for the ZIN taxes is at the CenterPoint Energy corporate level.

Is that your question?

Yes, it was.

So the reserve has nothing to do with level of costs or anything.

Oh, that's right.

Absolutely.

This is actually or David, one of maybe -- can you just talk about perhaps in broad perspective, what is the right perhaps return on equity level that you think is appropriate at these interest rates?

And perhaps what is the correct equity or capital structure for a Company of your risk and size going forward over the next five years?

First, let's talk about the capital structure.

We both -- the capital structure that was set in 2001, was set on a generic basis for all companies -- delivery companies in Texas.

It was set at the 40% level.

There were no specific unique items that were considered by company.

We believe that the appropriate capital structure is certainly a lot closer to 50% than it is 40%.

So we think that especially along the gulf coast and the variations and potential impacts you see from storms and other natural disasters, you need to have a very strong healthy utility.

We believe of a capital structure of around 50% is much more appropriate.

I would say that in terms of ROE, we've done a fair amount of work in our other gas jurisdictions and we continue to believe that an ROE of 11.25 or so is in fact the right return and that is what we will argue.

Certainly, at the Railroad Commission when we did our cash on the environments, they accepted that argument and they set a return on equity of 11.25.

And that was just done earlier this year.

If you look around at other jurisdictions in the country for electric utilities, I think you're going to see them vary from 10.5 to somewhere in the 11.

So, you know, we think 9.6 is clearly too low.

We'll just -- that's something I'm sure that's going to be a topic of considerable discussion, but we think -- we think it should be closer to our present allowed ROE of 11.25.

Sure.

Thank you very much for that color.

Lastly on that bad debt expense.

Can you give us where you are with regard to bad debt expenses in the third quarter and how is that relative to history?

And also, if I understand correctly, shareholders are the ones that take on the responsibility or the risk of bad debt expense and that's not recoverable in the future?

Do I understand that correctly?

That's right.

We do not have any bad debt trackers, Nathan.

So to the extent that we incur bad debt, that is in excess of what we haven't raised.

It obviously goes to our return.

In terms of the third quarter, we incurred $5 million of increased bad debt over the same quarter of last year, through the first nine months of this year, we're running about $7 million ahead of last year.

Thank you very much.

Your next question comes from Faisel Khan.

Morning.

Good morning.

On the mark to market loss of $8 million, was that a pre-tax or after-tax number, the quarter.

That is pretax.

Okay.

And in terms of looking at some of the press releases that have been out and their plan to spend or they're trying to encourage $2.8 billion in spending to upgrade the transmission system over the next 6 years.

How does that figure into the current CapEx plans you guys laid out reported in your 10K last time?

We will see some increases in transportation costs, I think, in '06 and '07.

We've identified a couple of projects that also agreed that need to be done and if I'm not mistaken, over a couple of year period that will add 75 to $100 million in capital expenditures.

Is that right, Tom?

Yes, so that will begin to occur in next year and then again in '07.

We always weigh in to our forecast a given level of transmission upgrades, but we're seeing over the next couple of years that level being higher than our normal run rate, probably $100 million or so.

Okay.

On the -- in terms of customer conservation at both the electric utility and gas utilities, have you guys done any analysis in terms of what the weather normalized consumption levels on your residential customers have done year-over-year?

Well, we don't have a lot of, I think, specific analysis we can share with you.

I will say this, though: In our northern service territories, primarily Minnesota, it is clear we have seen some reduced consumption on the part of our residential customers.

Part of this is just tighter building in home envelopes, as opposed to conservation.

But there is clearly some conservation going on there, and it's pretty identifiable in the data.

In the south, especially Houston, in our gas distribution system, we don't see that kind of phenomenon, primarily because gas is not a major part of their budget.

On the other hand, we see that effect on the electric side.

We believe we're starting to see this year the last three or four months the impact of higher electric prices in the consumption pattern.

We don't know exactly how much it is, and we haven't seen it long enough to believe it's a trend, but we do believe that there is conservation that is occurring.

And it is probably related to demand and elasticity in these high electric prices driven by high natural gas prices.

On the tax -- on the tax issue, going back to that for a second, $10 million a quarter, is there -- is there -- at what point would you say you would take a charge, the whole tax charge?

Would that be some sort of settlement on case with the IRS? $10 million a quarter kind of makes it a recurring item every year which would lower your earnings in the long run.

Trying to think of how to treat that in over a long period of time?.

Well, Gary, [Indiscernible] what I laid out is that this will be resolved with the IRS.

Again, we don't have a specific timing.

For the near term, as I laid out and we'll certainly keep the apprised in our disclosures, that you would have to -- I think you need to consider around this $10 million level, there is variability around that.

I think you need to consider that until you're able to resolve this issue.

Having said that, as I've indicated, we don't want to step out too far here, but we have significant merit in our case or our position, and we're hopeful that we can reach a settlement sooner rather than later.

But in the near term until we can let you know otherwise, I think you need to look at that number and it range 10 to $15 million.

Fair enough.

Thank you.

Your next question comes from Debra Bromberg.

Good morning.

Good morning.

When you guys recapitalize, what do you guys see as the appropriate size at Houston Electric relative to the $5 billion of total capital in 2004?

Do you see it being fairly level or increasing?

The capital structure itself or the total capitalization?

Total capitalization dollarwise.

You know, when we repay the high-term loan, the billion-three, we will have a significant amount of equity in the business above and beyond what we need.

We expect that we will take the -- in dividend to the parent to get the Company's CD's capital structure to approximately 50- 50.

I would expect that that would mean 4 or $500 million of less capital -- capitalization at Houston Electric than is there today.

But, you know, we'll take the excess proceeds from the transition bond, and we'll first pay off the high cost loan and then we'll dividend the rest to the parent or dividend as much to the get the capitalization to 50-50 as is necessary.

Okay.

And separately, what has the higher transmission payments that Houston Electric running here to date roughly, versus what you've been recovering through riders?

Yeah, we're in the -- excuse me, in the third quarter I think we incurred about $3 million more in cost buildup than we recovered, and that is more than last year.

So it's -- we are incurring a little bit more because there's been some transmission costs that have gone up around the state.

We're bearing our fair share of that and we're not recovering all that currently.

I think the net impact in the third quarter was about $3 million on to us.

You know, do you have an idea of what it might be, what the under recovery component might be for the full year and whether you expect that to increase next year?

Debra, off the top of my head, I don't.

It's going to be probably a little less than $10 million, I think.

Hang on, let me see if I can get an answer to that.

And if I can just get in one other quick question.

Okay.

Could you break down the major components of the increase in O&M at the electric company it increased about 19 million?

I'm not looking for a full breakdown, but if there are one or two drivers there.

There are two big drivers.

One is last year we sold some property.

We had a $10 million gain and the way that's recorded is a credit to the expense.

Okay.

That's not there this year.

So 10 million of the change is just related to this land sale last year.

And then we had an $8 million increase in tee costs.

So those two are 18 million of the 19.

Everything else kind of washes out.

Okay.

Thank you.

Your next question comes from Reza Hatefi.

From Minnesota gas $41 million rate filing, what was the reason for that, were you under earning or to recover cost overruns you expect next year because I guess Minnesota a forward test year?

Yeah, we do use a forward test year.

There is a few things going on there that are very significant.

One, is that we have seen a decline in usage per customer which directly impacts our bottom line.

We think that is 7 million of the 41.

We made a substantial increase in investment there.

We've got a major replacement project under way today.

Plus we've made other investments since we were in last and that's a fair significant part of it.

Our increase bad debt, plus the impact of higher natural gas prices on our carrying costs because we have a fair amount of gas and inventory, and the related legal of that 12 or $13 million.

So and then we have a--we believe our--rate of return should be a little higher that's embedded in the current rates as well, and we clearly ask for that.

What rate base and equity ratio did you file?

The rate base is--hang on, let's see if we can find that for you.

You know, I can't find the specific number.

Certainly it is between 500 and $550 million, in that range.

And we use a hypothetical capital structure and I think it's on the order of 45% equity 55% debt in that range.

I don't know the specifics.

We can certainly get them for you if you need them.

Sure.

The ROE you filed?

11.25.

And 1 last question on the ZINS, since basically because the OID is not deductible, what is the annual OIT that's then not deductible?

About $100 million a year, probably a little less.

About 100 million a year.

Yeah.

Does this hundred million a year show up in your total interest expense we see on your income statement?

Part of it, not all of it.

Only the actual interest that is paid on the ZIN shows up in interest expense.

But the OID, does it show up anywhere on your--where does it show up on your income statement, I guess, is the better question ask?

Jim, why don't you answer that.

OID is strictly a deduction for income taxes, it is not a book expense.

The expense I believe is 2% interest rate on the base amount of the ZINS.

Oh, okay.

I thought it was one of those where it gets amortized over the life of the bond.

The original issue discount.

Was my general understanding of how normal bonds discounts work but maybe this one is different, I guess.

This has a lot of complications to it.

Okay.

Thank you very much.

Your next question comes from Zack Shriber.

My questions have been asked and answered.

Thanks so much.

Your next question comes from David frank.

Yeah, hi.

David, we can't hear you.

Can you hear me now?

Yes.

On the Houston franchise expense, I was--I was curious if the 3 million you quoted Debra before, was that included as part of that 18 million you had spoke of earlier or is that separate?

No, it--it didn't--the new city franchise started in July and so there were some--some impacts in the quarter, but it certainly wasn't a full 18.

It is three or four million dollars, I think.

It is volume metric based, I think.

It's based on a volume-driven in terms of how it is expensed.

But there is probably 3 or 4 million in the third quarter of that net increase.

I see.

So 18 is for a full and annualized number then?

18 is for the full year and that does change.

It will--it will go up year-to-year based on just the increase in kilowatt hour sales.

That's not a past.

You have no recovery of that, as it is set up today.

You currently absorb that?

That's right.

City franchise is part of our base delivery rate.

Okay.

And then there was some ISO, when you were speaking to Debra, you were talking about some ISO expenses.

Is that different than this volume metric franchise expense?

(Inaudible).

Absolutely.

That is much different.

What is that on an annualized basis.

Total per year?

Yeah, roughly.

Let's see, if we have it anywhere.

Okay.

And then was that in effect from the start of this year or something that is just recently gone into effect, the higher.

No, David , that's been ongoing and the way transmission costs are allocated are based on coincidental peak demand and total cost of transmission throughout the state is basically born by all of the utilities.

So it increases or decreases.

Key cost expense for projected for '05 is about $225 million.

We get revenues of about 210 or something like that.

So we have a net deficit there.

But we've been running a net deficit for some time.

Okay.

I was just trying to figure out what the '05 versus '04 expense that you're directly impacted by?

And the net increase in the amount we're not recovering for just the third quarter was $3 million.

Okay.

Okay.

Thank you.

Okay.

Okay.

We're bumping up against our time.

We'll take one more question.

Your last question comes from Michael Goldenberg.

Good morning, guys.

Good morning.

Had a quick question on capital structure as it relates to potential filing of the rate case.

I guess you've mentioned the 50-50 figure on the call.

Maybe once again talk about the reasoning and if the actual equity of ratio was higher, which I think it may be after the repayment of debt.

Has there been precedent of, you know, reimbursing utilities based off of a 50, 60% equity, do you think that's a possibility?

I think certainly in our gas today, many of the jurisdictions use a 50-50 debt equity ratio.

In the past, we've used anywhere from 45 to up to 50% equity, as I recall, in our filings and we've gotten returns based on that.

So I think 50% is not out of line at all in what we see other jurisdictions are doing and what we do in other gas jurisdictions, to be very honest.

If you get up to 60% would be very unusual, but around that 50% level, I think is reasonable.

I was just seeing that your actual, especially according to the staff filing, actual after the buffered loan was more like 55%.

I was wondering if part of that filing was implying that that's a possibility of getting recovery based on 55%?

Well, I'm--you know, I think that--

Sorry, equity ratio.

The way the staff looked at it was hypothetical basis and not actual basis.

And so we want to capitalize electric appropriate and consistent with the way rates are set.

We think something around 50% is the appropriate level which means that we'll take it down from the 55 or 57% once the high cost loan is paid off.

And just a small comment on the window given to you by the commission.

Overall, do you think in general that's enough time to reach a settlement and how--how far along are the discussions?

Well, I think it is pretty short time.

I mean, these discussions always take time.

I think there is progress being made, perhaps we can get a little bit more time, but I think it is very short.

I think it is aggressive time frame.

We'll work hard to see if we can get something accomplished but it is in--at least if history is any guide, that's not very much time try to strike a settlement.

Are there other discussions fully under way?

We've had discussions, yes.

I mean, we haven't talked detail yet but we have--we've talked to a few parties.

Got it.

Thanks very much.

Okay.

Okay.

Well thank you very much everybody .I just wanted to thank you can for participating in our call today and thanks again for your support and have a great rest of the day.

This concludes today's conference call.

You may all disconnect.