Pinnacle West Capital Corp (PNW) 2007 Q4 法說會逐字稿

Good morning. My name is Sylvia and I will be your conference operator today. At this time, I would like to welcome everyone to the 2007 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (OPERATOR INSTRUCTIONS) Thank you.

I would now turn the conference over to Ms. Becky Hickman, Director of Investor Relations. Ms. Hickman, you may begin your conference.

Thank you, Sylvia. I'd like to thank everyone for participating in this conference call to review our earnings, recent developments, and operating performance.

Today, I have with me Bill Post, our Chairman and CEO; Jack Davis, who is our President and Chief Operating Officer and also CEO of Arizona Public Service; and Don Brandt, who is Executive Vice President and CFO of Pinnacle West and also President and CFO of APS.

Before I turn the call over to our speakers, I need to cover a few details with you. First, I encourage you to check the quarterly statistics section of our website. It contains extensive supplemental information on our earnings variances and quarterly operating statistics. Second, please note that all of our references today to per share amounts will be after income taxes and based on diluted shares outstanding.

It's my responsible to advise you that this call will contain forward-looking statements based on current expectations and the company assumes no obligation to update these statements. Because actual results may differ materially from expectations, we caution you not to place undue reliance on these statements.

Please refer to the caption entitled forward-looking statements contained in the MD&A in our third quarter 2007 Form 10-Q and the risk factors in our 2006 Form 10-K, each of which identifies some important factors that could cause actual results to differ materially from those contained in our forward-looking statements.

A replay of this call will be available on our website, www.pinnaclewest.com, for the next 30 days. It will also be available by telephone through February 7th.

Finally, this call and webcast are the property of Pinnacle West Capital Corporation and any copying, transcription, redistribution, retransmission, or rebroadcast of this call in whole or in part without Pinnacle West's written consent is prohibited.

At this point, I'll turn the call over to Bill.

Good morning, everyone. And I thank you for taking time to join us today. Like other years, 2007 was marked by a number of accomplishments and challenges. Don and Jack will discuss our financial results and operations in detail.

But before I turn the call over to them, I would like to address two items. First, growth. Growth in our service territory has slowed from its pace a year ago, a trend also being experienced in other high growth states. However, our growth still remains very strong, compared with national averages.

Arizona's 2.8% population growth is the second fastest in the United States just behind Nevada. That growth is evident throughout our business and continues to dominate our operations and our strategies. Our customer base grew 3.3% in 2007, slowed to 2.6% in the fourth quarter, attracting the trends in population growth. We currently estimate that our customer count will grow at about 2.8% in 2008.

APS has met this rapid growth while maintaining a very strong focus on customer service. J.D. Power and Associates again recognized APS for superior customer satisfaction. APS was ranked number two among western investor on electric utilities by both residential and business customers. We are aggressively focused on the future. Our customers' rapidly growing energy needs and the financial strength we need to meet that growth. With growth in both customers and energy consumption, APS faces a need for new capacity in the 2012 to 2015 time frame.

Earlier this month, we filed several resource alternatives with the ACC. Our goal is to built public understanding of the options and challenges inherent in APS's planning for an acquisition of energy resources. Through this initiative, we will seek broad input from various stakeholders on APS's resource planning issues. These stakeholders include customer groups, market participants, policy advocates, and regulatory authorities. This process will be both transparent and participatory. It will complement the Arizona Corporation Commission's generic integrated resource planning process with a specific focus on APS.

In the short term, we will seek commission approval to expand APS's purchase power in natural gas hedging program to five years from the current three years. Such a change will decrease some of the risk from future price volatility. To facilitate long-term planning, APS will seek stakeholder input and ultimately policy guidance from the commission on the appropriate mix of long-term resources, the regulatory treatment, and the recovery of cost for such projects.

The next step in this resource initiative involves a series of stakeholder meetings. APS will conduct in the first half of 2008. First of these meetings is scheduled to be held on February 15th and in the future we will report progress as appropriate.

The second item I'd like to talk about is earnings guidance, the earnings guidance that we issued this morning. In short, we estimate that our consolidated earnings per share will be within a reasonable range around $2.50 per share. Earnings at APS will be basically flat to 2007, excluding the effects of abnormal weather and out-of-period income tax adjustments. These estimates include the results of the cost and efficiency review we discussed with you in our last call. Don will describe the detailed results of these reductions.

In total, they offset the 2008 cost increases at APS due to growth and inflationary impacts. However, today we are not recovering the cost incurred to meet customer growth since our last rate case, which include approximately $1.7 billion of capital expenditures for reliability and the expansion of our electric system.

As I explained in our last call, we expected to be dealing with the commission on the line extension issue into early 2008, and then incorporate their decision into our future rate planning. That remains our plan. However, it may be necessary to file a retail rate request within the next few months depending upon the disposition of that issue. Our guidance does not include results from either the line extension proceeding or our planned 2008 rate filing.

Jack will update you on these and other regulatory developments as well as our recent operating performance. Now, I'd like to turn the call over to Don.

Thank you, Bill. As Bill said, our consolidated earnings guidance for 2008 is a reasonable range around $2.50 per share. We expect 2008 APS earnings to be relatively flat compared to 2007 after excluding the effect of 2007's abnormally hot weather and prior year's tax benefits. We expect to be able to hold APS earnings flat, primarily as a result of efficiency gains and cost reductions that I will discuss in more detail in just a few minutes. SunCor's earnings are expected to be $20 million in 2008.

Our guidance assumes the transmission rate increases at the wholesale and retail levels go into effect on March 1st of this year. But it does not include any potential earnings effect from amendments to APS's line extension schedule pending before the ACC. The partial year effect of the transmission rate increases assumed in our guidance is approximately $25 million pretax or $0.15 per share.

Turning to the fourth quarter results. For the fourth quarter of 2007, our earnings were down $0.15 per share versus the 2006 fourth quarter. We reported consolidated net income of $3 million or $0.03 per share compared with $18 million or $0.18 per share in the prior year quarter. In summary, higher O&M increased depreciation and lower results from real estate operations substantially offset earnings contribution from increased retail sales.

Now, allow me to provide you with additional detail on these variances. First, increased retail sales volumes related to customer growth added $0.05 per share. Next impacts from last summer's retail rate increase improved earnings $0.03 per share. And lower property taxes added $0.03 per share. These positive variances were more than offset by the following negative factors. Higher O&M cost decreased earnings $0.17 per share.

The cost increase in the fourth quarter was consistent with our expectations and was primarily due to planned generation maintenance and overhaul expenses including the Palo Verde performance improvement program, as well as customer service costs to serve growth. Increased depreciation primarily related to APS electric infrastructure additions reduced earnings by $0.03 per share. The absence of prior year tax benefits that were recorded in the fourth quarter of 2006 reduced earnings by $0.04 per share and SunCor's earnings were down $0.03 per share, mainly related to lower sales of residential property.

Now, allow me to update you on APS's PSA deferral balances and fuel hedge positions. As of December 31st, APS had $111 million of accumulated PSA deferrals. With last summer's ACC enhancement to our PSA, we're in a much better position with respect to fuel cost this year than in the past few years. As a result, we expect to recover this deferral balance through annual PSA adjustors and surcharges by the end of 2008. Details of the changes in deferral balances are included in the quarterly statistics section of our website.

As you know, our hedging program substantially mitigates natural gas and purchase power price volatility for our customers. As of today, we have hedged about 85% of our 2008 exposure to purchase power and natural gas price risk. Similarly, we have hedged about 60% of our 2009 price risk and 40% of our 2010 price risk. These hedge positions are at prices generally in line with current forward market prices.

Finally, turning to our reviews of operation and maintenance expenses and capital costs. During the second half of 2007, we took a thorough look at our company's organizational structure and reviewed our operating and capital cost to identify opportunities for streamlining and gaining efficiencies. We want to make sure that we are as customer-focused and cost effective as possible without sacrificing service, reliability, or safety.

First, I'll frame some of the relevant issues that affect our cost situation, particularly our capital expenditures. Consistent with the slowing economy, our day-to-day construction activities have declined somewhat from their peak levels of the last few years. We added 34,000 new customers in 2007, but we expect to add fewer customers in 2008. Albeit slower, we still expect growth at a rate well-above the national average.

Also, we, like most utilities, have experienced sharp increases in the cost of materials, equipment, and land used for construction. These increases have been driven by dramatic increases in the price of basic commodities such as copper, aluminum and steel, the impact of a weak U.S. dollar and an apparent insatiable worldwide demand for these type of products and materials. Just as an example, a 500 to 230 kV three-phase transformer that would have cost APS just under $2 million in 2004, now costs more than $5.6 million, an increase of 180% over that relatively short period of time.

Looking at our capital expenditures, we eliminated more than $200 million of capital cost over the next five years. First, as a result of slower projected customer growth, we decreased our expected expenditures $130 million for the five-year time frame. Second, we were able to reduce capital forecasts more than $60 million through improved planning, logistics and scheduling, principally in our delivery business. And third, deferring certain system upgrades and projects that would not adversely affect reliability reduced our projected capital spending almost $20 million.

On last quarter's call, I talked briefly about our organizational realignment. These changes were made with the intention of enhancing the speed and effectiveness of decision-making and improving efficiencies. The new organization enhances our focus on customers, and sharpens roles and responsibilities to improve accountability and overall performance. During this process, our executive team identified 300 staff positions that will be reduced in the first quarter of 2008. These reductions should generate $7 million pretax of annual O&M savings.

In addition to the staffing reductions, we identified some $7 million pretax of other annual O&M savings. A majority of these savings relate to process efficiencies and reducing projects in various parts of the organization. The rest largely relate to reductions in employee benefits, communications, and advertising cost.

Our capital expenditures in 2007 were some $900 million. We expect such expenditures to exceed $1 billion a year for the next five years to support the growth and reliability in our electric system. Further, climate change or other environmental legislation could increase our capital spending requirements. We expect to finance these expenditures with a mix of internally generated cash and external financings, both debt and equity. Additionally, cost related to capital spending such as depreciation, interest and property taxes, will continue to increase.

Although these specific costs and organizational reviews have been completed, the effort to identify and implement cost reductions throughout our organization will be ongoing. We will continue to maintain strict discipline in managing our cost.

Now, I'll turn the call over to Jack.

Thank you, Don. And good morning, everyone. I will start by summarizing regulatory issues. As Bill mentioned, we have been working on regulatory issues related to growth in our state.

The ACC commissioners have expressed concerns about how to support the vitality of our state and its considerable growth. They have also expressed concerns about who should pay for growth and how. We share these concerns. Paying for growth require innovative rate setting policy. In a decision on APS's retail rate case last summer, the commission have required APS to file a revised line extension schedule for ACC approval. The required revision will eliminate certain allowances for new or expanded services which would permit APS to collect costs related to the line extensions on a current basis, thereby reducing the amount in effect of future rate increases on APS's customer base as a whole. These costs averaged $3,500 to $5,000 per new meter set.

In October, APS filed proposed amendments to its line extension schedule. The proposal would eliminate the construction allowances and treat payments received as nonrefundable revenues. It also includes provisions to grandfather existing line extension agreements. If the ACC were to improve -- were to approve APS's proposal by the end of the first quarter of this year, we estimate that the changes would increase APS's pretax revenues by approximately $35 million in 2008.

Late yesterday, we received the ACC staff report on this issue. Among other things, the staff continues to support our amendment to collect line extensions. However, they recommend that payments received by APS be accounted for as contributions in aid of construction, not miscellaneous revenues as we had proposed. We are evaluating the staff report and recommendations and will respond appropriately. We expect the commissioners to consider the staff report as well as our proposal at a future open meeting that has not been scheduled as yet.

Our transmission rate case is pending before the Federal Energy Regulatory Commission. As a reminder, the filing asks for $37 million increase in annual transmission revenues and includes a proposal for the FERC to approve a [formula setting] methodology to allow APS to adjust wholesale transmission rates on June 1st of each year.

In September, the FERC issued an order allowing APS's proposed transmission rates to become effective March 1st of this year, subject to refund. Several settlement meetings have been held and we believe progress is being made. However, at this point, we don't know whether the case ultimately will be settled or go to a hearing. It's important to understand there are approximately $30 million of the transmission rate increase related to transmission to serve - relates the transmission to serve APS's retail customers.

In December, APS filed an application with the ACC to increase retail rates effective March 1st through the transmission cost adjuster or TCA that the ACC approved in the 2005 rate decision. The TCA was intended to provide a mechanism through which changes in retail transmission charges can be reflected in APS's retail rates in a timely manner. On Monday, the ACC staff issued its recommendation on the TC adjuster be approved as proposed by APS, subject to adjustment based on the final outcome at the FERC.

Now, I'll review the various adjustors and surcharges under the power supply adjuster for PSA. First, the four mills per kilowatt hour PSA adjustment that took place on February 1st, 2007 remain in effect as long as necessary to collect an additional $46 million of 2007 cost referred as a result of the mid-2007 implementation of the new base fuel rate. We estimate this adjustment will remain in effect through mid this year.

Second, July 1st -- second, since July 1st, APS has been collecting approximately $34 million including interest through the PSA surcharge. This amount represents PSA cost deferrals related to the 2005 replacement power cost totally incurred for Palo Verde outages. This temporary surcharge will be effective through June 30th of this year.

And third, the process is under way to set the 2008 annual PSA adjuster rate. Based on calculations we filed with the ACC in December, the rate will be four mills per kilowatt hour for 12 months beginning February 1st of this year.

Now, I'll provide some highlights regarding growth in our market. As Bill discussed, our service territory continues to grow. Our retail sales increased 10.4% for the year. On a weather-normalized basis, retail sales grew 2% reflecting a 2.8% increase for residential customers and a 1.5% increase for business customers.

Our customers and sales growth also translate into peak load growth. Our 2007 peak was 7,545 megawatts. While this was not an all-time record on a weather-normalized basis, our peak did grow 3% compared to previous year, which was consistent with our expectations. During the past five years, our peak has grown at an average annual rate of 5.4%. So in spite of the economic slowdown throughout the country including its impact on the housing market, we continue to experience growth at a rate much higher than the national average and we expect the growth to continue for years to come.

Now, let me turn to operating performance. Looking at our nuclear plant performance, the combined capacity factor for Palo Verde for the full year 2007 was 79%, up from 71% in 2006. For the fourth quarter of 2007, the site average capacity factor was 57% compared with 75% in the comparable quarter a year ago.

The capacity factors in both fourth quarter were affected primarily by plant refueling outages, unit three in 2007 and unit two in 2006. Of note, 2007 refueling outages at Palo Verde unit three included the planned replacement of steam generators, low pressure turbines, and core protection calculators, which require a longer-than-normal outage. Similar work was completed for unit two in 2003 and unit one in 2005. With the completion of replacement in unit three, the production capacity for each of the three units has been increased by 5%.

Palo Verde has two refueling outages each year. During 2008, unit one is scheduled for an outage in the spring and unit one is scheduled for an outage in the fall. We expect these outages to last 40 to 50 days.

The Nuclear Regulatory Commission conducted a rigorous comprehensive inspection in October at Palo Verde. During the four-week inspection, the NRC looked in detail at all the areas of the plants' operations. We expect to receive a formal inspection report late this month or early next month. As I stated earlier about the inspections, you are aware we are in the midst of the NRC's 95003 process. This is a process I just described. During the process, we are taking a conservative approach to the operation of Palo Verde. In doing so, issues have and will continue to arise that may impact the operability of the Palo Verde units. We continue to work closely with the NRC to address these issues.

Turning now to our coal plants. Our coal fire plants continue to operate superbly. During 2007, the coal plants posted an 87.5% capacity factor, a new all-time fleet record, slightly ahead of the record set a year ago and well ahead of the latest available industry average of 71%. This achievement was led by our four corners and Cholla plants. Four corners posted a capacity factor of 86% while Cholla units reported a capacity factor of 90%.

That concludes my prepared remarks and I'll turn the call back over to Bill.

Thanks, Jack. In October, Jack announced his plan to retire March 1st, completing a very successful 35-year career with our company. Throughout his career, Jack has provided leadership and focused and excellence in every aspect of our business . This will be Jack's last earnings conference call.

And I'd like to take this opportunity to say publicly. Jack, on behalf of myself and the 7,000 men and women of our company, thank you for all your contributions. You will be

I appreciate these comments, Bill.

Thanks, Jack. As you know and as previously announced, Don Brandt will take the helm as CEO of APS upon Jack's retirement.

That concludes our prepared remarks. And we would be happy to answer all your questions now.

Thank you. (OPERATOR INSTRUCTIONS) We'll pause for a moment to compile the Q&A roster. Please hold for your first question.

Your first question comes from the line of Paul Ridzon from KeyBanc.

Hello, Paul.

Just a quick question with regards to '07 actual versus kind of the guidance you gave most recently. Could you kind of walk through some of the big [datas] and drivers there?

Sure, Paul. This is Don Brandt. We continue to see revenue -- additional revenue from growth but it's more than offset. Just the single largest item or combination of items is I called it capital-related expenses, depreciation, financing and property cost, taxes just related to the assets, we've put in service. As Bill mentioned to you in his comments, we have invested -- put in service $1.7 billion of capital expenditures since the amount of capital expenditures reflected in the last test year. So those are -- I mean, there's a number of smaller ones, but that far outweighs any other cost, positive or negative.

I'm sorry. I should've been more clear in my question.

Okay.

Could you contrast '07 actual with your last '07 guidance?

Okay. Okay, 295 versus our actual. We had some -- about $0.08 worth of positive on the mark-to-market on the trading side. SunCor was actually $0.03, came in $0.03 better, some capital-related savings from our forecast of about $0.03 and then we get into a variety of smaller items that impacted actual '07.

When you give guidance, you assume mark-to-market is zero or how do you do that?

Yes. We do assume zero.

So, higher gas prices were a benefit for you?

Yes.

Thank you very much.

Okay.

Your next question comes from the line of Dan Eggers from Credit Suisse.

Good morning, Dan.

First question, I guess, can you walk us through a little bit of the decision tree? When you decide to file this retail rate case, how the line extension conversation layers into that? And if it is not a revenue treatment but as a construction and aid, does that accelerate the need to file the rate case?

Sure, let me take a shot at that and then Jack can add his thoughts. As you know, in fact I think as you and I talked in our last conference call, we've been working with the commission to deal with the growth issue and particularly schedule three on a schedule that started really with their request last summer and that has been something that obviously has an effect impact on our future rate planning in large part because of the way it's accounted for.

Literally, since that time, there hasn't really been any disagreement in terms of the issue of charging a connect fee in the regulatory filings and proceedings. It's been really focused to a great extent on the accounting treatment. And obviously the reason I mentioned that is the accounting treatment has a very significant effect upon our overall earnings level. And it has been our hope that this was an issue that we could resolve. We've been working as aggressively as we know how with the commission at their request. And as Jack pointed out, literally last night, they filed or the staff, I should say, filed their report, which proposes contribution and aid of construction treatment rather than revenue recognition treatment.

That has an impact and what it would do, what contribution an aid of construction treatment does compared to revenue recognition treatment is it pushes the need for a rate increase even quicker and depending upon the disposition of that and the timing of that issue as the commission deals with this, that's how we would be dealing with the potential filing for base rates. It's something that from our standpoint is critical, dealing with this issue of growth. Not only from the standpoint of in effect recovery for the incremental capital expenditures that Don talked about, but also the issue that growth has on our company in terms of the attrition issue. And they're really -- although sometimes described as the same issue, they're really two different ones. And so from our perspective, it's both dealing with the attrition and the capital requirement.

We will take into account the consideration of the commission in terms of the process and the schedule and certainly their decision as they deal with this. But it's also important that we deal with the $1.7 billion of additional expenditures that we have made. And as I mentioned in my comments, we may find ourselves in a situation where we would be dealing with these things in parallel after we file a rate case sometime in the next couple of months. It really comes down to how this issue is going to be dealt with at the commission and then whether or not we can do it sequentially or in parallel.

As we think about following this rate case and kind of the transition of three commissioners at year-end '08, what are you thinking about as far as timing and implementation of rates? It seems like we could potentially see this pushed toward a year-end '09 type of resolution, given the expediency that we tend to see in Arizona.

Well, certainly if you looked at the past in terms of dealing with rate cases, they have been in that range of 18 to 24 months. You know, I think if you look at the last couple of years and some of the things that we have dealt with and I say we, meaning both the commission and the company, those issues have often been dealt with. Certainly, the base rate case was of that kind of a time frame but if you look at their actions in terms of the fuel cost for example, we were able to get fairly quick action.

This is an issue that -- as you know, the attrition issue was an issue that was addressed in the last rate case. It's something that will be addressed in our next filing, both in terms of the accounting treatment and in terms of the rate-making treatment that is associated with that, and so our hope would be to be able to get a decision on this earlier than our historical time frame would suggest.

Okay.

I would only add emphasis to Bill's comment. This is Jack. We have no intent just to let this go on and on. We recognize that we can't get a quick resolution to the impact fee issue. We must file a rate case and then address whatever impacts are in the rate case as relates to schedule three.

Okay. Not to take up too much time here, but Don, if you kind of think about the earnings impact and the timing or uncertainty of timing of cash and the fact that ROEs going to look at 7%, plus or minus the utility in '08, what are your conversations right now with the rating agencies and how are you guys thinking about equity for '08 at this point?

I think the conversations have been positive. As I made my remarks as I've said in countless earlier calls, we'll have to rely on the equity markets and the debt markets going forward, given the size of the billion to a billion one a year of capital expenditures and given the relatively modest level of internal cash generation. We're going to be in both markets.

And do you have equity issuance in the 250 guidance for this year?

We are giving consideration to it, Dan.

Okay. Thank you.

Your next question comes from the line of Edward [Heine] from Catapult Capital Management.

Good morning.

Good morning.

Just had a quick question on in regards to what sort of O&M you're assuming in your 2008 guidance, and does it include the $7 million of head reduction and $7 million of non-head reduction and also what kind of your view on O&M increases at Palo Verde are?

Yes. Ed, I've got some numbers here. We're looking at -- yes, we've included the $7 million of savings, actually [14/ 7] of staff reduction and seven of others. But in spite of that, we're looking at Palo Verde actually relatively flat from '07 actual to our forecast for '08. But if you give me a moment to back -- we're looking at around a net of about $40 million increase in O&M. That's a pretax number overall.

Okay. And on a percentage basis, that's around like 5% or so, 5 or 6%?

[40] over about a base of around 7.

700.

[700], 710.

Okay. But the Palo Verde is relatively flat and can you just walk through why that is? That's just because you don't have a steam generator replacement this year?

That's partially it. Our improvement program was up and running a good part of '07 and we don't see substantial increases going into '08. When I say relatively flat, our '07 actual was 120 and we're looking at 122, to be precise next year, so.

Okay. Great. And then just a quick question on -- you touched a little bit on this with Dan's question, but have you gotten any indication whether on the free footage extension issue whether the commissioners are going to call for a -- I think commissioner asked for an extended or potentially an extended hearing to look at this issue or whether it will be addressed in kind of the next open -- one of the next open meetings.

I think Commissioner Mayes did mention a hearing. I do not believe she used the word extended and I don't think that would be her intent. I'll go back, since I was the one on the witness stand, and Commissioner Mayes and other commissioners asked me about this subject, I'll call it growth paying for itself and asked us to think outside the box and we gave a lot of thought to it and late last summer, early fall, had a number of discussions at some of the discussion sessions at the commission workshops and which many of the commissioners, including commissioner Mayes and virtually all the others participated in or sat through and I think they were impressed by what we set forth.

Now, the staff recommendation is for kayak. That's sort of the traditional view and that in most places you would treat these as kayak. APS, with our growth almost three times the national average is a different situation. The commissioners asked me to -- all of us to think outside the box. We did. I think they'll look at our proposal and give it a serious thought. It's something outside the box and maybe something that is warranted in the unusual situation, a growth situation like APS presents. So, I take them at their word that -- and I don't think they're looking for an extended process.

You know, if I could add something to that, Ed. If you look at contribution and aid of construction accounting, that's not new. What makes this new is that we're dealing with a very high growth impact in terms of our earnings and our capital expenditures. So what we're trying to do is take in effect an accounting concept that was used to deal with almost one-off type of extensions where you had large investments for individual customers and apply that kind of accounting treatment, which made sense if you're doing it one customer here, one customer there, to minimize the overall effect of socializing those costs for one customer. But now we're dealing with a concept of growth which is affecting the entire company and the entire state and all of our customers and so you've got really a different issue you're dealing with here in terms of growth and I think the letter that was sent by Commissioner Mayes, as well as the dialogue that's taken place in some of the workshops with other commissioners, recognizes that this is a different issue and that is one of the things that I believe they've been trying to take a look at, one of the reasons that they asked for more analysis by the staff report which was provided literally yesterday, and I think their intent here is really to incorporate the more specific issues that we have, rather than generic ones that may apply to accounting processes throughout the country.

Understood. Thanks a lot, guys.

Thanks, Ed.

Your next question comes from the line of Bill [Atesali] from [Citi] Investment.

Hi, good morning.

Good morning.

I think most of my questions have been asked but I guess you just -- you said that the hook-up fee were to be treated as you guys have requested you believe that would add $35 million to the '08, is that correct?

That's correct. In the hypothetical, if it was put in place by the end of the first quarter of 2008, and with the I'll call it phase-in of the contracts that are in place, would add about $35 million pretax to revenue.

Okay. And then just regarding the transmission rate increases, so you're basically assuming that the next open meeting given that the staffs come out in support of your position, the TCAs approved and in your guidance you're assuming the 7 million a piece and the 30 million a piece go into effect March 1?

Correct.

All right. And then, within that guidance, you have assumed $25 million?

That's correct.

Is in back flow through '08? Okay.

Correct.

That's weighted given the amount of time that's already elapsed this year and how the transmission revenues come in?

Correct.

All right. Thank you.

Okay.

At this time, I would like to remind everyone. (OPERATOR INSTRUCTIONS) Your next question comes from the line of Andrew Levi from Brencourt.

Hi, guys.

Good morning.

Good morning.

Just have two questions. The first question is just for the 2008 guidance, what are you assuming as far as sales and customer growth?

Customer growth is 2.8%.

Okay. And you had 2% in 2007, is that correct?

2% sales.

Sales growth.

I'm sorry. Okay. And what did you have in 2007 customer growth?

3.3%.

Okay. So, this is lower but still high. Okay. And then, this is just kind of a longer kind of thought question. I don't know if you can answer it. But obviously, the commission hasn't been very favorable to you, guys. I don't think you deserve the treatment you're getting but it is what it is. And obviously, the guidance you gave this year is in the 250 range and I guess the question in my head is if the commission continues to go down the path of underfunding you, whether it's right or wrong, I think it's wrong, but that's a whole another thing. Does the dividend become a question at some point, 205 dividend and the continued -- if the commission continues to kind of deteriorate your earnings?

Well, I guess the way I would look at that is to look at the last few years in terms of the issues that this commission addressed. If you look at the -- kind of the process that we have had in place here, what we've dealt with in the last two years have been legacy issues that have remained from movement towards competition and then back to a fully-vertically integrated electric utility, compounded by very significant increases in fuel costs that we all know about.

So when you take into consideration, for example, the creation, the construction, and the enhancement of the fuel clause, if you take a look at the issues associated with establishing a process to deal with new resource planning, if you look at the issues that we dealt with in terms of putting forward literally a new regulatory structure, we've dealt with many substantive issues over this time frame. So if you look on a below the numbers, there has been a significant amount of substance in dealing with many of the issues. Obviously, when you take a look at the customer impact, we've had a large impact in terms of our customers over this period and that's something that we all give consideration to, certainly they do and we do as well.

So in our next case, we're going to focus even more aggressively on the issues that we talked about here related to growth. In particular, the issue associated with attrition and also the issue associated with advances. And depending upon, as I said, the disposition of this issue, it would be incorporated into that filing or we'll deal with that if parallel. In either case, we will be dealing with it in terms of the overall structure in this next case on both paths.

And when I say both paths, let me explain what that means. The first one is to ameliorate the in effect socialization of extraordinary charges that come about because of high extension fees to individual customers. That fits with the dialogue that exists across the country in providing customer advances in dealing with customer advances in a way that deals with the whole customer base. The second way we'll be dealing with, this is the issue of attrition and the impact that has generally on our company, our state, our customers and the way that we need to pay for the costs of growth. So I'd ask you to think about it from really both of those perspectives and they often get kind of put together. They're really quite different.

And so from my standpoint, I think it's going to be very important that we deal with that issue and find a mechanism to deal with the historical test year challenge that we have in our state. The historical test year here, when you take a look at the fact that we're the -- depending upon the year, the highest or the second highest growth in the country in terms of customer growth is not a model that accommodates the reality that growth has. We have obviously constitutional issues in dealing with a historical test year but I think it's going to be absolutely critical that we focus aggressively on the issue of incremental growth and its impact on our state and our customers. So, that's a long answer to what you described as kind of a theoretical broad question and unfortunately have to give you a theoretical, broad answer to it. But I'm not sure I would just take the last few years and extrapolate them in, in terms of making a determination of their intent for our future recovery.

Definitely not doing that. I just want to understand that, you know, I guess you definitely need better treatment than in the past two years to kind of continue to keep your financial ratios and everything like that where they are. I guess that's kind of where you're at. Is that fair?

That's what we're aggressively working on. You're right.

Okay. I hope that all worked out for you because clearly the commission's listening. They deserve some money, guys. Thanks.

Let me just add to that. Attrition continues to be an issue and as Bill said we'll deal with that. But my prepared remarks were relative to the PSA. I just want to underscore that. We have a balance of 111 million. We'll essentially collect all of that through the existing adjustors and surcharges. When you look back just two years ago, we were faced with a balance growing toward $300 million.

The commission addressed that very proactively with the forward-looking PSA in combination with our hedging program. We essentially take fuel risk and fuel under recovery off the table for us and our shareholders and we add a tremendous amount of stability in fuel prices for our customers on a going-forward basis. So that was a huge problem. They responded to it in a very timely fashion. Now, we've got other issues and we'll address those in the coming months.

Your next question comes from the line of Danielle Seitz from Dahlman Rose.

Thanks. And actually I was wondering if you are looking longer term, when do you anticipate that the Palo Verde units will be back to their normal status and normal capacity factor, et cetera? Is there some sort of a date that you are looking at where you feel you will have accomplished all the upgrade you wanted to do?

This is Jack. As I said in my prepared remarks, unit three overhaul is done. We've put in new steam generators, new core protection calculators, new low pressure turbines which completes it for all three units. All three units are up and running today at 100% output. And as I mentioned, what we look for in '08 is would do have as in a normal year two refueling outages, one for unit one and one for unit two.

Okay. So, essentially, if you get to '09 you should be completely operating at a normal capacity factor with all of the upgrades and efficiencies that you put in the system?

Well, actually, barring unforeseen circumstances, so I can't sit here and predict any unforeseen circumstances which is always a possibility and also the fact, as I mentioned in my prepared remarks, we're in a 95003 NRC process which requires more scrutiny.

Right.

With those qualifiers, what I can say in 2008 we would hope to approach a more normal year. In fact, we only plan for two normal refueling outages.

Right. And I was wondering also in terms of costs, do you see cost sort of tapering off or do you think that this is pretty much the excluding refueling. This is pretty much the level you will be at.

Are you referring to -- ?

In terms of O&M, yes.

Don Brandt here. As I mentioned, we see Palo Verde costs relatively flat within a couple million dollars between '07 and '08. I think going forward, other than unforeseen events, that being an adequate level. Obviously with some --

Great. I was wondering if you were really still going through extraordinary measures and that the curve was basically either tapering off a little or just staying flat. So, your anticipation is that you probably will stay at the same level?

Yes.

Great. Thanks.

Your next question comes from the line of Reza Hatefi from Polygon Investment.

Thank you. Good morning.

Good morning.

Just had a quick follow-up on the last question. So I guess the O&M at Palo Verde is supposed to or I guess you guys are saying $120 million in 2007, $122 million in 2008, so very flat. Was the issues that Palo Verde has gone through during the last couple years were the expenses or costs associated with that, were they all capitalized, and that's why here not seeing a decrease in O&M?

No, no. They were not all capitalized. The bulk of the expenditures at Palo Verde are expensed. The comparison that you're looking at comparing 2007 and 2008, in 2007 we had additional expenses as a result of 95003 and the efforts that we had under way there to build our performance improvement plan and as we shift from 2007, where our focus has been building a plan to take us back to the level of excellence that we've had in the past, our focus in 2008 is more in execution. So, what you're seeing is a shift from in effect development costs in 2007 to build that plan, to 2008 in executing that plan and that's how they end up about the same, but they're for different things.

So is there an opportunity to reduce O&M as we move to 2009 and '10 from the Palo Verde perspective as you accomplish your plans and your execution plans?

Well, let me just kind of address that philosophically. We're not providing projections beyond 2008, but if you look at it philosophically, as I mentioned to you, our focus is to bring Palo Verde back to excellence over the long-term. And it's not just to deal with some of the current issues, it's basically to perform at the highest level on an ongoing basis over the long term.

And if you look over the long term, the issues associated with the 95003, the issues that we had a year before last as we dealt with the vibration issue on unit one, the issues that Jack talked you about in terms of the steam generator for each of the three units, have an opportunity as we go forward to provide efficiency savings and certainly that's a part of our plan in achieving excellence. But that is a long-term plan.

Our focus right now as Jack mentioned to you is to be very conservative in our operation of Palo Verde and to focus on everything that we do in dealing with the NRC to ensure that that operation is as safe as it can possibly be. That has been our focus and will continue to be our focus until some point in time -- some time in the future when we can start thinking about efficiencies. But today, that is not our focus. Today, our focus is really on safety and working with the NRC and as he mentioned to you in a mode of operation that's very conservative.

Great. Thank you very much.

Your next question comes from the line of Paul Ridzon from KeyBanc.

You mentioned you question the constitutionality of a historical test year. How owners would things have to get before you would play that card and what form would you play it in?

If you got the impression I was questioning the constitutionality of that, in no way am I questioning the constitutionality of that. My reference was it is constitutional. In Arizona, because our commission has basically constitutional authority. The historical test year is constructed underneath the state constitution. So my reference was to the way it's structured in our state, not that it's somehow illegal or inappropriate from a legal standpoint.

I misunderstood your comments. And then just could you just kind of summarize the staff position that they filed last night? The revenue treatment just seems like a great opportunity to keep you out of rate cases and a way of ameliorating a lot of the pressures customers are seeing. If you could help us understand thinking.

Sure. Well, Paul, as I mentioned in my prepared remark, we just got it late last night. So, I must admit in front, none of us here have done it -- analyzed it in depth. In general, they took the traditional approach as Bill mentioned in answer to a question earlier. The staff took a traditional approach that the best way to handle this issue is with a contribution aid to construction and that's -- I guess they didn't want to vary away from what they've always done.

The positive aspect of that is the report -- nowhere in the report says that we shouldn't actually get money upfront for an impact fee or connect fee, whatever term you want to use, and the difference we have with the staff is the revenue treatment versus the staff recommendation. I should mention, this is really -- It is staff recommendations but they hired a -- should I say traditional rate consultant in order to evaluate the analysis.

And I think as Don mentioned in his comments, that this doesn't close the book because the commissioners actually asked us to go out and do something, do something different and we did something that was different and so our hope would be in the context of trying to decide what we're going to do that we would get our should I say face time soon with the commissioners to bring this particular issue to a close.

Let me just add a couple things to that, if I could. First, the commissioners as I think you know are not bound by a staff position. That's one of the things that they'll consider. And in the staff report, the consultant addressed the issue that we had proposed of recording this as miscellaneous revenues and the fact that this provides much earlier benefit to our customers than the traditional utility method that's been used for years throughout the country. And I would just reinforce what I said earlier. I apologize for being redundant here, but I think it's a very important point.

And if what you're looking at is the issue associated with an extraordinary cost for a particular extension, then contribution in aid of construction accounting, which was really built around that theme, makes sense. On the other hand, if what you're thinking about is the fact that customer growth significantly stretches an organization that has a historical test year to be able to deal with the issues of attrition during that period, that then in effect gets socialized through all different kinds of cost categories, not just capital expenditures, but it covers everything from return on equity to the cost of debt to literally the operating expenses that we have every single day. That's a different concept and so that concept is really the one that we provided to the commission that said maybe we've -- because of our unique situation, applying a tool that was used for kind of a one-off impact that was built to solve in effect a national issue through FERC accounting, may not be the most appropriate method.

So that's kind of a long answer to your question, but it really identifies., One, the fact that the commission was the one that said you know, we really need to deal with this in a more creative way. And two, our response to that, which is to give them a different approach than we've had historically. So, it's really in the hands of the commissioners.

Thank you.

Your next question comes from the line of Jeff Coviello from Duquesne Capital.

Good morning, guys. How are you?

Good morning.

I had a question, you were speaking about some of the regulatory issues in Arizona, and I think one of the things that came up was the potential to change the test year from, what i believe, a backward-looking test year to a forward-looking test year. I was wondering in the legal framework of Arizona, as unique as it is, what would have to change, what would have to occur for that change to take place? Is there any process ongoing now for it to take place? And what -- essentially, what are the prospects for it and how could it come about, I guess to ask the question broadly?

Sure. Let me back up. Because I want to make sure everybody has a little foundation for the comment that I made earlier. Our commission has authority under our state constitution. And that state constitution basically prescribes an approach that the commission, in general terms, that the commission uses to establish fair value and then from fair value a determination of fair return. Because of that constitutional structure and because of the history and practice that's existed in Arizona, we have a long-standing record of using that historical test year. That's not true for just APS. That's true for all public utilities in Arizona.

So given that structure, what I was talking about earlier is that do we have a mechanism, other than changing the historical test year, to accommodate the reality that customer growth has an effect not only on our ability to be able to finance it but also the resulting cost as those resulting costs from incremental growth get socialized to all customers. So what I was saying before is that we can develop in effect a surrogate mechanism, a mechanism that fills that gap that exists in the current legal model, to deal with the influence that new customer growth has on our company, our customers and the state. I didn't mean to say, and if people infer that our goal is to change the historical test year structure, that is a goal we would have.

However, that has been looked at in the past and in fact what it takes is a ballot initiative and a vote of the people to change the the state constitution in the way that it deals with fair value. That's actually occurred here in our state in the past, many years ago, and because of complexity of that and many other issues that I could go into, if you want me to, that was a process that failed in terms of a ballot initiative.

So from my standpoint, what I was doing was saying given the premise, given the assumption that we have a historical test year and a rate methodology that allows for making adjustments to that historical test year to normalize that period for known and measurable events of which growth is certainly one, can we come up with a mechanism that's supplemental to and fits inside of the legal structure that exists in dealing with a historical test year. So my comment there assumed that the historical test year remains in place and it is our assumption that it will continue to stay in place as we go forward.

Got it. Got it. And then the surrogate mechanism was the attrition adjustment, am I right about that?

Yes. That's correct.

Okay. All right. Thank you very much.

Your next question comes from the line of Ron [Zimber] from [Zimber Lucas].

I was wondering if you could give us any indication of how much equity issuance is embedded in the 2008 guidance numbers.

No. We haven't made any decision on the amount or timing.

Okay. Thank you very much, then.

At this time, there are no further questions. I will now turn the call over to Ms. Hickman for closing remarks.

Thanks, I'll let Bill say a few closing comments and then I'll close us out.

Well, I'd just say thank you for your time. We know this is a very busy time for you and please feel free to get ahold of Becky on any of the details or other issues that were brought up here in terms of numbers or any of the numbers that we have on our website that you want additional explanation about. And thank you for your time.

And Bill just stole my comment. Basically let me know if you need anything and thank you very much for being with us today.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.