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WGL Holdings, Inc. (NYSE: WGL ) Q2 2016 Earnings Conference Call May 5, 2016 10:30 ET Executives Doug Bonawitz – Investor Relations Terry McCallister – Chairman and Chief Executive Officer Vince Ammann – Senior Vice President and Chief Financial Officer Adrian Chapman – President and Chief Operating Officer Gautam Chandra – Senior Vice President, Strategy, Business Development and Nonutility Operations Analysts Mark Levin – BB&T Sarah Akers – Wells Fargo Operator Good morning and welcome to the WGL Holdings’ Second Quarter Fiscal Year 2016 Earnings Conference Call. At this time, I would like to inform you that this conference is being recorded and that all participants are in a listen-only-mode. [Operator Instructions] The call will be available for rebroadcast today at 1:00 p.m. Eastern Time running through May 12, 2016. You may access the replay by dialing 1-855-859-2056 and entering PIN number 97338125. I will now turn the conference over to Doug Bonawitz. Please go ahead. Doug Bonawitz Good morning, everyone and thank you for joining our call. Before we begin, I would like to point out that this conference call will include forward-looking statements under the federal securities laws. Forward-looking statements inherently involve risks and uncertainties that could cause our actual results to differ materially from those predicted in such forward-looking statements. Statements made on this conference call should be considered together with cautionary statements and other information contained in our most recent annual report on Form 10-K and other documents we have filed with or furnished to the SEC. Forward-looking statements speak only as of today and we assume no duty to update them. This morning’s comments will reference a slide presentation. Our earnings release and earnings presentation are available on our website. To access these materials, please visit wglholdings.com. The slide presentation highlights the results for our second quarter of fiscal year 2016 and the drivers of those results. On today’s call, we will make reference to certain non-GAAP financial measures, including operating earnings of WGL Holdings on a consolidated basis and adjusted EBIT of our operating segments. A reconciliation of these financial measures to the nearest comparable measures reported in accordance with Generally Accepted Accounting Principles, or GAAP, is provided as an attachment to our press release and is available in the quarterly results section of our website. This morning, Terry McCallister, our Chairman and Chief Executive Officer will provide some opening comments. Following that, Vince Ammann, Senior Vice President and Chief Financial Officer will review the second quarter results. Adrian Chapman, President and Chief Operating Officer will discuss key issues affecting our business and the status of some of our principal initiatives. And in addition, Gautam Chandra, Senior Vice President, Strategy, Business Development and Nonutility Operations is also with us this morning to answer your questions. And with that, I would like to turn the call over to Terry McCallister. Terry McCallister Thank you, Doug and good morning everyone. Our non-GAAP operating earnings for the second quarter is shown on Slide 3 in our presentation were $89.5 million or $1.78 per share compared to $101 million or $2.02 per share in the second quarter of 2015. On a non-GAAP basis, consolidated operating earnings for the first six months were $148.7 million or $2.96 per share. This compares to $159 million in the prior year or $3.18 per share. The decrease in operating earnings in the second quarter primarily driven by lower results on retail energy marketing and midstream operating segments partially offset by higher results at our regulated utility and commercial energy systems operating segments. At the utility, earnings were higher year-over-year primarily due to strong customer growth and rate recovery related to our accelerated pipeline replacement program. We added approximately 11,300 active average utility customer meters year-over-year, which represent an annual growth rate of approximately 1%. We also remain on track to equal last year’s record spend on accelerated replacement program of $113 million. These investments immediately impact earnings and have been a driver of improved results in the utility since the start of these programs in 2011. On the utility regulatory front, Washington Gas filed an application with Public Service Commission of the District of Columbia in February to increase base rates. Filing addresses rate relief necessary for the utility to recover its cost and earn its allowed rate of return. We also continue to anticipate the filing of a rate case in Virginia in the near future and Adrian will talk more about these developments shortly. On the non-utility side of business, as previously mentioned, our commercial energy systems business delivered improved results. We continue to seek earnings growth driven by the distributed generation assets that we own across the country. We remain on track to invest a record $200 million in this area in fiscal 2016. We have also seen more activity locally in our energy efficiency contracting business. Retail energy marketing segment delivered lower results compared to second quarter of 2015. This was expected given the unusually high asset optimization results in 2015 and our expectation of more normal levels in 2016. Midstream energy services also realized lower earnings in 2015 partially due to the effects of warmer weather on current market prices. Given our results in the first six months and our earnings outlook for the remainder of the year, we are affirming our consolidated non-GAAP earnings guidance in the range of $3 to $3.20 per share for fiscal year 2016. I am now going to turn the call over to Vince who will review our second quarter results by segments. Vince Ammann Thank you, Terry. Turning first to our Utility segment, adjusted EBIT for the second quarter of fiscal year 2016 was $153.9 million, an increase of $1.5 million compared to the same period last year. The drivers of this change are detailed on Slide 5. We continued to add new meters. The addition of 11,300 average active customer meters improved adjusted EBIT by $2.3 million. Higher revenues from our accelerated pipe replacement programs also added $3.1 million in adjusted EBIT. Lower operations and maintenance expense improved adjusted EBIT by $4.4 million. Offsetting these items, lower margins associated with our asset optimization program reduced adjusted EBIT by $2.7 million. The unfavorable effect of changes in natural gas consumption patterns in the District of Columbia reduced adjusted EBIT by $2.6 million. Reduced revenues related to the recovery of gas inventory carrying costs due to lower gas prices decreasing the value of our storage gas balances reduced adjusted EBIT by $600,000. Other miscellaneous items reduced adjusted EBIT by $2.4 million. Turning to the retail energy marketing segment, adjusted EBIT for the second quarter of fiscal year 2016 was $8.4 million, a decrease of $18.7 million compared to the same period last year. On Slide 6, you will see the primary driver of the decrease was lower natural gas gross margins. In the natural gas business, gross margins were $15.7 million lower driven by a decrease in portfolio optimization activity that returned to more historical levels during the quarter. The same quarter in the prior fiscal year showed outsized gains in this area that were not expected to recur in the current year. Electric margins decreased $1.1 million driven by higher capacity charges from the regional power grid operator, PJM that impacted the timing of margin recognition. These costs will decline in the latter half of the year. As stated previously, our retail energy marketing business has increased its focus on large commercial and government account relationships in both the electric and natural gas markets. As a result, the overall number of electric and natural gas accounts both declined this quarter 10% and 7% respectively compared to the prior year. However, indicative of our revised focus, electric volumes increased 7% versus the prior year and natural gas volumes were slightly higher versus the prior year. The increase in commercial load in both electric and natural gas continues to help offset the decline in mass-market customers on a volumetric basis. Operating expenses increased by $1.9 million primarily due to higher commercial broker fees. Next, I will move to the commercial energy systems segment. Adjusted EBIT for the second quarter of fiscal year 2016 was $2.3 million, an increase of $700,000 compared to the same period last year. The increase reflects growth in distributed generation assets in service, including higher income from state rebate programs and solar renewable energy credit sales as well as improved margins from the energy efficiency contracting business. We also saw improved results in our investment in solar businesses related to changes in the recognition of earnings from our solar partnership. These improvements were partially offset by higher operating and depreciation expenses due to additional in-service distributed generation assets and a $3 million impairment related to our investment in thermal solar project recorded during the three-month period. During the second quarter, our commercial distributed generation assets generated over 43,500 megawatt hours of electricity, which is sold to customers through power purchase agreements. This represents a 57% increase in megawatt hours compared to the second quarter of last year. As of March 31, the commercial energy systems segment has invested $449 million in distributed generation assets. Our alternative energy investments, which include ASP, Nextility, and SunEdison represent an additional $128 million of capital investments since inception. We now have approximately $577 million invested in total in this segment. Next, I will move to the midstream energy services segment. Results for the second quarter of fiscal year 2016 reflect an adjusted EBIT loss of $8.4 million compared to a loss of $3.1 million for the same quarter of the prior fiscal year. The decrease is primarily related to the recognition of losses associated with current market pricing. We anticipate these losses will reverse by fiscal year end as we realized the value of economic hedging transactions to be executed during the first two quarters and as certain contractual procedures approach resolution. Results for our other non-utility activities reflect an adjusted EBIT loss of $1.5 million compared to a loss of $800,000 for the same period for the prior fiscal year. Interest expense, primarily driven by long-term debt, was essentially unchanged at $13 million during the second quarter compared to $13.3 million in the prior period. As Terry stated earlier, we are affirming our consolidated non-GAAP operating earnings guidance in the range of $3 to $3.20 per share. This guidance does not include any potential impacts related to the decision in April by the New York Department of Environmental Conservation to deny the Section 401 certification for the Constitution Pipeline, except for the reduction in forecasted AFUDC related to the project. Our expectations for the regulated utility are modestly lower driven by higher O&M costs for system integration work and project expenses related to a new customer service system. On the non-utility side, we anticipate better than expected results in the midstream segment related to the impact of favorable spreads on storage earnings. These will be somewhat offset by lower results in the energy marketing segment as customer growth is expected to be lower than planned for the year. Please note that this earnings guidance includes dilution from the planned issuance of equity in fiscal year 2016. In November, WGL filed a registration statement and launched a program to sell common stock with aggregate proceeds of up to $150 million through an at-the-market or ATM program. WGL first sold shares under this program in February. During the second quarter, WGL issued approximately 466,000 shares of common stock under this ATM program for net proceeds of $31.5 million. I will now turn the call over to Adrian for his comments. Adrian Chapman Thank you, Vince and good morning everyone. I am pleased to provide you with an update on our utility operations and regulatory initiatives. In the District of Columbia, Washington Gas filed an application on February 26 with the Public Service Commission to increase its base rates for natural gas service, which would generate $17.4 million in additional annual revenue. The revenue increase includes $4.5 million associated with accelerated pipeline replacements previously approved by the commission and currently paid by customers through monthly surcharges. On April 27, the commission issued an order approving Washington Gas special contract with the U.S. Architect of the Capitol. This contract for natural gas service will generate annual firm revenues of $2.6 million and results in a reduction of the revenue deficiency in the pending rate case from $17.4 million to $14.8 million. As part of this rate case filing, we requested approval of the revenue normalization adjustment, or RNA. The District of Columbia is currently the only jurisdiction where we do not have revenue decoupling in place. In addition, the filing includes a new combined heat and power rate schedule, which sets forth the framework for the delivery of natural gas for CHP systems to provide flexibility for negotiated rates to better meet customer needs. Finally, in line with our initiatives in other jurisdictions, the filing also proposes new multifamily development incentives to help bring the benefits of natural gas to more residents in the District of Columbia. The application request authority to earn an 8.23% overall rate of return, including a return on equity of 10.25%. A procedural schedule was issued on April 26 by the PSC. Hearings are currently scheduled for October 2016 with the projected issuance of the commission final order in March 2017, which is consistent with their goal of issuing an order 90 days after the close of the evidentiary record. As a reminder, the last rate increase in the District of Columbia was approved in May 2013. In Virginia, we planned to file a new rate case with the Virginia State Corporation Commission on or before July 31. The filing seeks to allow us to rebalance our revenues, expenses and utility investment in the Commonwealth of Virginia and include in base rates the accelerated pipe replacement expenditures whose plant-related costs are currently being recovered in a surcharge. The anticipated filing would transfer approximately $19 million in accelerated pipeline replacement revenues from our current surcharge into base rates. Virginia has a 150-day suspension period, therefore placing new rates into effect for the winter of 2016-2017 subject to refund. Our last rate increase in Virginia was affected in October 2011. Also in Virginia, Virginia allows local distribution companies to recover a return of and return on investments in physical gas reserves that benefit customers by reducing cost, price volatility, or supply risk. Washington Gas entered into an agreement with the producer in May of last year to acquire natural gas reserves in Pennsylvania. However, the SCC of Virginia issued an order denying our gas reserve application. We are continuing our pursuit of a long-term reserve investment opportunity that will benefit our customers and address the issues that were raised by the SCC of Virginia in our previous filing. Once Washington Gas finalizes a new agreement with the producer, we will file a new application with the SCC of Virginia. I would like to now turn the call back to Terry for his closing comments. Terry McCallister Thanks, Adrian. I would now like to highlight a few recent developments and provide an update on the status of our midstream and our distributed generation investments. First, an update on WGL’s investment in the Constitution Pipeline project. On April 22, the New York State Department of Environmental Conservation denied the necessary water quality certification for the New York portion of the Constitution Pipeline. While we are disappointed, the partnership remains absolutely committed to the project and intends to challenge the legality and appropriateness of the New York decision. In light of the denial of the water certification and the anticipated action to challenge the decision, target in-service date has been revised to the second half of 2018, which assumes that the legal challenge is satisfactorily and promptly included. We are still evaluating any potential impacts to our financial forecast. As of March 31, WGL Midstream had an equity investment of approximately $40 million in the Constitution Pipeline project. Next, I will turn to our investment in the Central Penn line. Central Penn line is greenfield pipeline segment of Transco’s Atlantic Sunrise project. This project is on track and development activities are proceeding as expected. Central Penn line has projected in-service date to the second half of calendar 2017. WGL Midstream will invest approximately $411 million in the project. And as of March 31, WGL Midstream has invested approximately $51 million. Our third pipeline investment involves Mountain Valley pipeline project. The Mountain Valley pipeline is a proposed 300-mile transmission line through West Virginia and Virginia is designed to help meet the increasing demand for natural gas in the Mid-Atlantic and Southeast markets. Project is on track and development activities are proceeding as expected. Projected in-service date is December 2018. WGL Midstream plans to invest $228 million in the project. And as of March 31, WGL Midstream has invested approximately $13 million. In February of this year, WGL Midstream exercised an option for an $89 million equity investment in the Stonewall Gas Gathering system, representing a 35% ownership stake. WGL Midstream’s ownership interest is expected to decrease to 30% during fiscal year 2016, as certain other participants are expected to exercise the rights to invest in the project. The Stonewall system connects with Columbia Gas Transmission, an extensive interstate transmission line that reaches markets across the Mid Atlantic region. M3 Midstream serves as the majority owner and operates the Stonewall Gas Gathering system. The system initiated operations in November of 2015 and is currently gathering 1 billion cubic feet of natural gas daily from the Marcellus production region in West Virginia. Turning to our commercial energy systems business, our portfolio of distributed generation assets continued to grow this quarter. And as of March 31, we had over 134 megawatts of capacity in-service with an additional 63-megawatt contracted or under construction. WGL Energy recently received approval to build and operate over 15 megawatts of community solar gardens in Minnesota as part of the utility program mandates in that space. WGL Energy has secured subscribers for all of these community solar gardens under a – that are under contract and the target operational date is later in the fall of this year. This investment highlights WGL Energy’s continued strategy of growing its distributed generation assets portfolio by taking advantage of favorable legislation in states like Minnesota. Finally, we look forward to seeing many of you at the AGA Financial Forum in a couple weeks. And that concludes our prepared remarks and we will now be happy to answer your questions. Question-and-Answer Session Operator Thank you. The question-and-answer session will begin now. [Operator Instructions] We will take our first question from Mark Levin, BB&T. Please go ahead. Mark Levin Thank you, gentlemen. First question, as it relates to Constitution and maybe how to think about it, as it relates to your long-term guidance and what’s embedded in it, I realize you guys don’t want to quantify it quite yet, but maybe giving us some of the parameters at least to think about? Vince Ammann Yes. Mark, this is Vince. As it relates to our long-term guidance, we – at this point, wouldn’t expect to change that because we think the project is good and it’s worth going forward. So that’s the way we view it from a long-term perspective. What we have done in the short-term is, we have suspended the accrual of AFUDC and that’s just a prudent thing to do, as we are waiting to get this issue resolved. Mark Levin Got it, fair enough. And in your options with regard or the options with regard to Constitution and maybe the timeline as to how to think about how that would proceed? Terry McCallister Yes. This is Terry. I think it’s probably a little premature for us to know that. I think all the partners are looking at that and saying, what are the options, how would we go forward on that. And so I think we are probably just a little – you are probably just a little ahead of the curve for us to know exactly what that looks like, yes. Mark Levin Got it, fair enough. And then finally, just with regard to the gas reserve opportunity, is it reasonable to assume that you guys would be able to strike an agreement sometime this fiscal year. And then the second part to that would be, maybe some of the lessons that you learned from the first attempt? Adrian Chapman Mark, this is Adrian. I think as we have mentioned last quarter, where our target is still to get a filing out before the end of our third fiscal quarter. So I think we are still working towards that as an end result. And I think certainly the commission’s focus was looking at probably the length of the term of the reserve agreement. The 20-year term was a concern of theirs and just uncertainty about pricing in the future. They were – expressed some concern about the different perspectives on the reserves and the volumes in the reserves and what the depletion rates were. So there was some differences of opinion in the hearings about that and I think we just need to be able to give them some greater certainty as to what deliverability would look like, because for a given fixed investment, lower volumes would mean a higher price per dekatherm. So that was the primary concern that they had. So we are working to try to fill those issues, fill those gaps and give the commission comfort with some greater balance of risk associated with an investment. Mark Levin Got it, great. Thanks guys. I appreciate it. Operator And your next question comes from the line of Sarah Akers with Wells Fargo. Your line is open. Sarah Akers Thanks. Good morning. Terry McCallister Hi Sarah. Sarah Akers Can you go over again the reasons for the lower utility outlook this year and any sense of the magnitude of the change in expectations there? Vince Ammann I will take a stab at that Sarah, this is Vince. We haven’t – traditionally, throughout the quarter, we haven’t provided specific guidance for the operating segments by – as we go from quarter-to-quarter, just started giving out, as you know consolidated guidance. But the only issue that we are addressing here on the – and what we have discussed is a couple of factors. We continued to see some higher operating expenses in the field as it relates to just leak repairs and system integrity type works that we have been doing that was a little ahead of what we have planned for the current year. We also have seen some higher project expenses. We launched a new e-service portal this year and that’s sort of in advance of going live with our new billing system next year and we had some difficulties when we first launched that and we have spent some dollars to bring that system back to good working condition. So, those are some of the issues that we see that were pretty temporary just for this quarter. And as it relates to the initial guidance and where we saw things last quarter. So, those particular items shouldn’t continue significantly for the rest of the balance of the year. So it’s pretty much a second quarter phenomena that then just caused us to re-think where we were going to be for the rest of the year. So those are the items on the utility side. That’s all I can think of Adrian that is of significance. If you have anything else you want to add, I think. Adrian Chapman No, I think you covered it. Sarah Akers Great. Thank you. And then just one on the midstream, so it sounds like there is some unexpected strength there, do you view that more as one-time opportunistic margins or should that uplift sustain into future years? Gautam Chandra Sarah, this is Gautam. I would say that the up-tick that we saw in midstream is based on the market conditions that we saw in midstream this year that we were able to capitalize on. Now as we have mentioned before, our storage portfolio is a low cost portfolio. So we expected to have good returns in the long-term, but there are some up-ticks and downticks depending on the exact storage spreads in any given year. Vince Ammann Yes. I would only add Sarah, that as we have said – we saw in recent years, we certainly know we can make money on that storage portfolio when the weather is extremely cold and we have the opportunity to pull gas out of storage at real high margins. But what we saw this year is confirming our expectation, which is when the weather is warmer than normal. There is also opportunities to see the seasonal spreads get very significant. So we came out of this winter heating season with a significant amount of gas. As an industry, it’s still in storage and the production levels were still high. So essentially, we saw the front end of the curve come down quite substantially and then yet the pricing for next winter stayed pretty firm. So we saw some good spread opportunities, which is what we would expect when you have warmer than normal sort of winter. So yes, I think as the supply balances out with our country storage, we do see that this is a – the storage play continues to be a low-risk opportunity to create some margins from the value added by storage. Adrian Chapman Sarah, this Adrian. We also hedge forward to some level. When we see that opportunity, we will hedge forward. It’s kind of how big the opportunity, but a lot of it or some of it just lock in a fair amount of value and so when prices fell this last quarter and the forward value didn’t fall, we locked in some of that value. So that’s why we are projecting that pick up during the second half. Sarah Akers Okay, great. Thank you. Operator Again, I would like to remind everyone that you can listen to a rebroadcast of this conference call at 1 p.m. Eastern Time today running through May 12, 2016. You may access the replay by dialing 1-855-859-2056 and entering PIN number 97338125. There are no further questions at this time. And I will turn the call back to Mr. Bonawitz for any additional or closing remarks. Doug Bonawitz Well, thank you all for joining us this morning. And if you do have further questions, please don’t hesitate to call me at 202-624-6129. Thanks and have a great day. Operator This concludes our conference call for today. Thank you for participating. All parties may disconnect now. 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