Good morning, welcome to CenterPoint Energy's third quarter 2016 earnings conference call with senior management. During the company's prepared remarks, all participants will be in a listen-only mode. There will be a question and answer session after management's remarks. To ask a question, please press star one on your touchtone keypad. To withdraw your question, press the pound key. I will now turn the call over to David Mordy, Director of Investor Relations. Mr. Mordy?
Thank you, Thea. Good morning, everyone. Welcome to our third quarter 2016 earnings conference call. We recognize this is a busy day for earnings calls, so we especially appreciate your interest in CenterPoint. Scott Prochazka, President and CEO, Tracy Bridge, Executive Vice President and President of our Electric Division, Joe McGoldrick, Executive Vice President and President of our Gas Division, and Bill Rogers, Executive Vice President and CFO, will discuss our third quarter 2016 results and provide highlights on other key areas. In conjunction with the call today, we will be using slides which can be found under the Investors section on our website, centerpointenergy.com. For a reconciliation of the non-GAAP measures used in providing earnings guidance in today's call, please refer to our earnings press release and our slides, which along with our Form 10-Q, have been posted on our website.
Please note that we may announce material information using SEC filings, press releases, public conference calls, webcasts, and posts to the Investors section of our website. In the future, we will continue to use these channels to communicate important information and encourage you to review the information on our website. Today, management is going to discuss certain topics that will contain projections and forward-looking information that are based on management's beliefs, assumptions, and information currently available to management. These forward-looking statements are subject to risks or uncertainties. Actual results could differ materially based upon factors including weather variations, regulatory actions, economic conditions and growth, commodity prices, changes in our service territories, and other risk factors noted in our SEC filings. We will also discuss our guidance for 2016.
The guidance range considers utility operations performance to date and certain significant variables that may impact earnings, such as weather, regulatory and judicial proceedings, throughput, commodity prices, effective tax rates, and financing activities. In providing this guidance, the company uses a non-GAAP measure of adjusted diluted earnings per share that does not include other potential impacts, such as changes in accounting standards or unusual items, earnings or losses from the change in the value of the ZENS or of the zero-premium exchangeable subordinated notes or ZENS securities and the related stocks, or the timing effects of mark-to-market accounting in the company's energy services business. The guidance range also considers such factors as Enable's most recent public forecast and effective tax rates. The company does not include other potential impacts, such as any changes in accounting standards or Enable Midstream's unusual items.
Before Scott begins, I would like to mention that this call is being recorded. Information on how to access the replay can be found on our website. With that, I will now turn the call over to Scott.
Thank you, David. Good morning, ladies and gentlemen. Thank you for joining us today. Thank you for your interest in CenterPoint Energy. We will begin on slide four. This morning, we reported third quarter 2016 net income of $179 million, or $0.41 per diluted share, compared with a loss of $391 million, or a loss of $0.91 per diluted share in the same quarter of last year. The 2015 loss is inclusive of impairment charges related to midstream investments. On a guidance basis, third quarter 2016 adjusted earnings were $177 million, or $0.41 per diluted share, compared with adjusted earnings of $146 million or $0.34 per diluted share in the same quarter of last year. Utility operations and midstream investments both performed well this quarter.
We had strong contribution from Houston Electric during their peak season, as well as solid results from gas distribution and energy services. On a guidance basis, utility operations contributed $0.31 per diluted share in the third quarter of 2016, compared to $0.24 per diluted share in the same quarter of last year, improving $0.07 per share. Our strong third quarter utility performance was driven by a number of factors. We continue to see solid customer growth in both our electric and gas utilities. Combined, our utilities added over 86,000 metered customers during the last 12 months. Capital expenditures remain strong as we invest to meet growth, safety, and reliability needs within our service territories. Rate relief, driven by capital investment, continues to be an important contributor to earnings growth. Tracy and Joe will provide additional regulatory updates for their business segments later in the call.
Slide five provides some of the highlights from Enable's third quarter results. Midstream investments contributed $0.10 per diluted share for both the third quarter of 2016 and the same period of last year. On their third quarter call Wednesday, Enable guided to the midpoint of their previous 2016 guidance for net income attributable to unit holders. This equates to the high end of our guidance range for midstream investments. For the first three quarters of 2016, Enable has achieved a coverage ratio of 1.26 times. Enable also provided an initial estimate for 2017 net income attributable to unit holders, which represents notable growth over their estimate for 2016. Their 2017 forecast is driven by several favorable developments. Rig counts continue to increase. The number of rigs contractually dedicated to Enable rose more than 13% during the last quarter.
Enable also signed a new 10-year gathering and processing agreement in the STACK, replacing an existing percent of proceeds contract and adding 61,000 additional gross dedicated acres to their STACK footprint. The terms of the contract increases their fee-based margin and reduces their commodity exposure. We are very pleased to see these improvements and the positive impact it has on their 2017 forecast. On Monday, we announced the purchase of Atmos Energy Marketing from Atmos Energy. Our gas marketing and sales business continues to be a steady contributor to earnings growth and is a valuable complement to the organic growth of our natural gas utilities. Joe will share more about this purchase in his remarks. As most of you are aware, in February, we announced our intention to evaluate strategic alternatives for our midstream investment segment. Our objective is twofold.
First, explore ways to reduce CenterPoint share price volatility caused by commodity price impacts on Enable's earnings and unit price. Second, only take action if we can create sustained value for our long-term shareholders. The options open for consideration are a sale, a spin of a new company containing CenterPoint's stake in Enable, or keep our current stake in Enable and work to reduce exposure to commodity price influences. That process continues. Bill will provide more detail on the sale evaluation process and tax considerations in connection with a spin. Turning to slide six. Given the year-to-date performance and outlook for both utility operations and midstream investments, we are updating our 2016 full-year earnings guidance to $1.16 to $1.20 per diluted share. Our investors value consistent, steady growth, and we continue to target 4%-6% annual earnings growth through 2018.
Tracy will now update you on Houston Electric.
Thank you, Scott. I am pleased with Houston Electric's operational and financial results this quarter. Starting on slide eight, core operating income in the third quarter of 2016 was $234 million, compared with $219 million for the same period last year. The business benefited from rate relief, customer growth, and higher equity return, primarily related to true-up proceeds. These benefits were partially offset by higher depreciation and other taxes. By the time we have our next earnings call, Houston will have hosted Super Bowl LI. It's great to see Houston getting ready with enhancements throughout the city. Houston's growing economy continues to require substantial electric infrastructure improvements and capital investment. Through the end of the third quarter, we've invested $638 million in capital, and our meter count is up 2% from the third quarter of 2015.
As a reminder, 2% customer growth equates to approximately $25 million-$30 million of incremental revenue annually. O&M expense in the third quarter of 2016 was 1.7% higher than the same period last year, excluding certain expenses that have revenue offsets. We continue to focus on keeping annual O&M growth under 2%. Slide nine provides an overview of regulatory developments year-to-date. Our regulatory strategy remains on track. Since the last earnings call, we received approval for our July Transmission Cost of Service, or TCOS, filing. Adjusted rates from our TCOS filing, as well as our April Distribution Cost Recovery Factor, or DCRF, filing went into effect in September. Additionally, we recently received approval for our $10.6 million energy efficiency performance incentive, and we will recognize those earnings in the fourth quarter. Joe will now update you on the results for natural gas operations.
Thank you, Tracy. Our natural gas operations, which includes both our natural gas distribution business and our non-regulated energy services business, had a strong third quarter. Turning to Slide 11. Natural gas distribution's third-quarter operating income was $22 million, compared to $11 million for the same period in 2015. Operating income was higher due to several factors, including rate relief, revenue from decoupling mechanisms, lower bad debt expense, and lower sales and use tax. These increases were partially offset by higher depreciation in labor and benefits expense. We continue to see solid natural gas distribution customer growth of approximately 1%, having added nearly 35,000 customers since the third quarter of 2015. O&M expenses were approximately 1.5% higher in the third quarter of 2016 compared to the same period last year, excluding certain expenses that have revenue offsets. Despite the quarter-to-quarter variability that can occur, O&M expense discipline remains a priority.
We continue to benefit from our long-standing regulatory strategy of utilizing constructive rate mechanisms, like the decoupling mechanisms in Arkansas and Minnesota, that contributed to earnings this quarter. For a complete overview of regulatory developments this year, please see Slides 12 and 13. I'll speak to a few of the highlights. In September, we received a final order for our Arkansas rate case, which provided for an annual increase of $14.2 million. This increase, implemented in September, reflects a 9.5% ROE. It also established a formula rate tariff, which allows rates to be adjusted based on a ±50 basis point banded ROE approach and a projected test year. In Minnesota, the $12.7 million Conservation Improvement Program incentive, which we filed in May 2016, was approved by the Minnesota Commission and recognized in the third quarter this year.
Later this month, we plan to file a Houston and Texas coast rate case that seeks to combine two rate jurisdictions that are operationally and geographically aligned. We are required to file a rate case in our Houston jurisdiction, and once finalized, this case will reset rate base and allow us to utilize the GRIP mechanism in the future. We do not anticipate receiving incremental GRIP revenues in these two jurisdictions while the case is active. Because we have not filed the rate case yet, we cannot share any further details at this time. Turning to Slide 14, operating income for our energy services business was $7 million for the third quarter of 2016 compared with $2 million for the same period last year, excluding a mark-to-market loss of $2 million and a gain of $5 million, respectively.
As announced on Monday, we have signed an agreement with Atmos Energy to acquire their retail energy services business, Atmos Energy Marketing or AEM. This business is complementary to our existing energy services business and will allow us to grow our customer base and revenues while maintaining a low-VAR operating model and a cost-effective organization. This deal will increase our scale, geographic reach, and expand our capabilities. We are particularly excited about AEM's impressive large industrial customer mix and their talented and experienced employees. Energy services continues to be a steady and growing contributor to CenterPoint's earnings growth. I'll close by pointing out that in addition to Houston Electric being the host of electric utility serving the upcoming Super Bowl, gas distribution will also be serving the Super Bowl in Houston, as well as Super Bowl LII in Minneapolis at U.S. Bank Stadium.
I'll now turn the call over to Bill, who will cover financial performance and forecast.
Thank you, Joe, and good morning, everyone. I will begin on slide 16. Today, we reported third quarter 2016 earnings of $0.41 per diluted share. On a guidance basis, earnings were also $0.41 per diluted share versus $0.34 for third quarter 2015. Guidance basis earnings per share increased $0.07 for our utility operations segment compared to last year. Our midstream investment segment was $0.10 per share for this quarter and for third quarter 2015. As Tracy and Joe discussed, combined core operating income improved $31 million, excluding mark-to-market adjustments. Year-to-date, we have delivered $0.90 in guidance basis EPS, consisting of $0.68 in utility operations earnings and $0.22 in midstream investment earnings. We are updating our full year 2016 EPS guidance range to $1.16 to $1.20.
Based on the strength of our combined performance year-to-date, our expectations for the fourth quarter and Enable's recent confirmation of its 2016 guidance. We are also confirming our year-over-year EPS growth target of 4%-6% in 2017 and 2018. Dividend increases will come with earnings growth at a rate that will allow us to gradually move our payout ratio lower. As Scott and Joe have mentioned, we announced an agreement to purchase Atmos Energy Marketing on Monday. We plan to finance this through internally generated cash flow and/or debt financing. We expect this acquisition to be modestly accretive in 2017 after costs associated with the acquisition and integration into CES. As Joe reviewed in our second quarter call, we are forecasting that our CES business will provide $45 million-$55 million in operating income in 2017. We expect AEM to be additive to this forecast.
As previously disclosed, in 2017, we expect a benefit of approximately $12 million in net income from a full year of our investment in Enable preferred securities and from interest expense savings. Slide 17 details our expected financing plans, interest expense, and effective tax rate. Cash from operations remains strong. We continue to believe we will not need equity in either 2017 or 2018. We foresee modest incremental debt requirements in those years. We are committed to strong credit metrics with a target consolidated FFO debt metric of 18%-20%. As of the third quarter, we are well above that target credit metric. We expect our effective tax rate for the full year 2016 to be 37% due to the one-time recognition of deferred tax for midstream segment income in the second quarter. On a going-forward basis, we expect the effective tax rate to be 36%.
I'll take a moment to expand on the Enable strategic review. We recognize this process is taking longer than expected. We continue to explore three options: sale, spin, or keep. You can review our objectives for a potential transaction on slide 18. Our criteria for consideration of a sale or spin include comparable earnings and dividends per share, improved visibility and certainty of future earnings, and lower volatility from our midstream investments. We would seek to meet these criteria without a change to our credit ratings. With respect to the sale option, we continue our discussions with third parties that have an interest in our midstream investment. Should those discussions continue past mid-January, the partnership agreement requires that we submit a Right of First Offer or ROFO notice to OG&E to continue such discussions.
Due to the confidential nature of our discussions, we are not providing any further comment at this time. With respect to the spin option, we are working to gain certainty regarding the tax characteristics of a spin and confirmation of minimal tax leakage that may occur as a result of a spin. We continue to research capital market considerations with our existing investors and others, including whether the resulting entity from a spin would be an attractive security for our portfolio managers. Let me conclude by reminding you that our board of directors declared a $0.2575 dividend per share on October 27th, payable on December 9th. With that, I will turn the call back over to David.
Thank you, Bill. We will now open the call to questions. In the interest of time, I will ask you to limit yourself to one question and a follow-up. Thea?
At this time, we will begin taking questions. If you wish to ask a question, please press star one on your touchtone keypad. To withdraw your question, press the pound key. The company requests that when asking a question, callers pick up their telephone handsets. Thank you. Please hold for the first question. The first question will come from Greg Gordon with ISI.
Hey, good morning, guys. Actually, Durgesh on for Greg. Can you hear me?
Yes. Good morning, Greg. We can hear you.
Hey, good morning. I'm Durgesh. I've got it. Thanks. Okay. Sorry. Our question is, given the significant improvements in the outlook at Enable, why are you not reassessing the consolidated 4%-6% growth rate in the context of a no transaction scenario? It seems that your expectations that underpin 4-6 would be a scenario where Enable would be range bound in terms of its earnings and cash flow contribution. It appears that they're poised to see significant potential growth in earnings and distributions.
Yeah, Greg, I'd say the answer to this is more of a timing issue than anything. We are going through now the process of finalizing our own plan for the utilities as we speak. Our board approves our financial plan in December as we get near the end of the year. Our time for providing updated forecasts will be at our fourth quarter call. I think your observations are valid certainly, and what we've seen from Enable as well as the work we're doing with our utilities will be reflective in the new guidance that we provide on the fourth quarter call.
Thank you very much. Have a great day.
Yep.
The next question will come from Insoo Kim with RBC Capital.
Hey, good morning, everyone.
Good morning.
First, given your comment on the ongoing spin option, are you currently awaiting a response from the IRS? If so, do you have any expectations on a timeframe as to whether you'll get a confirmation that it'll be largely a tax-free transaction?
Insoo, good morning. It's Bill. We have not shared whether or not we have filed or will file with the IRS. What we have shared in my comments in the call is we must confirm that we have minimal tax leakage associated with a spin should we continue down that path.
Understood. The third option is keeping Enable, and I think you've mentioned reducing the volatility associated with that. Would that just involve Enable or working with Enable to increase their fee-based contract structures?
Yeah, it is working with Enable. The dialogue between governance and management is a constructive one. Management's focused on this as evidenced by the renegotiation of some contracts that they've been working on to accomplish that. That comment about trying to reduce commodity exposure is with what management will do at Enable.
Understood. Finally, just regarding the Atmos Energy Marketing acquisition, is the strategy for the energy services business to continue to make ongoing acquisitions to grow that business?
Yeah, let me characterize the strategy this way. We see it as an important part of our business mix. It's a great complement to our gas utilities. We will continue to look for opportunities organically through the management team for growing that business just as we're growing our utilities. I would characterize any thoughts around M&A as opportunistic as opposed to a stated strategy in that direction. Our goal, though, is to continue to grow that business just as we're growing our utilities.
Got it. Thank you. I'll see you in a few days.
Yep.
The next question is from Abe Azar with Deutsche Bank.
Morning.
Good morning.
Is your new 2016 guidance, is that the new base for the 4%-6% growth from here?
Yes, it is.
Okay. Can you comment a little bit more on the dividend growth? I heard you mention the goal to decrease the payout ratio. Is there any targets for dividend growth from here?
There are no specific targets with respect to dividend growth. Of course, at the end of the day, it's the board of directors' responsibility to review a number of factors prior to their declaration of a dividend. Having said that, we do intend to grow the dividend. It just may not be at the same robust pace of our earnings growth. This will allow us to grow the dividend and bring down the payout ratio at the same time.
Right. Okay, that's it.
The next question is from Ali Agha with SunTrust.
Thank you. Good morning.
Good morning.
Scott, I just wanted to clarify. In the past, you had mentioned that your plans for what you want to do with Enable, you'd firm them up and communicate to us in the second half of this year. Am I hearing it right that the time may slip, given some of these things playing out, and maybe it's more early next year we will hear from you? Or is it still by the end of this year, we should definitively hear from you?
Yeah, Ali, as Bill said, the process is taking a little bit longer than originally anticipated. I can't tell you when the process will specifically end. As Bill said, we still are in conversations with third parties, and should those dialogues continue past the end of the year, then I guess it's technically possible that it goes on into the following year. As long as we're having these dialogues, the process will continue.
I see. Second question, just so that we're clear on the conversion from the Enable numbers to yours. I know there's basis differential, et cetera. If you just took their 2017 net income guidance, what does that translate into for CenterPoint Energy? Just taking their numbers as they publicly stated those.
Ali Agha, this is Bill Rogers. They confirmed that around the midpoint of their guidance. That number would translate into $0.21 per share for us on an annual basis, plus another $0.07 due to the accretion for a total of $0.28. That's why in our prepared remarks, we said we should be at the high end of the guidance that we have provided.
Right. They've also put out their 2017 net income number as well. I was more focused on that.
They've put out their 2017 net income number. We have not translated what that might mean into earnings per unit and from that earnings per share of CenterPoint Energy.
Okay. The basis differential, Bill, we should assume is roughly the same as it is for 2016?
That'll be unchanged.
Okay. Thank you.
The next question will come from Neel Mitra with Tudor, Pickering.
Hi, good morning.
Good morning, Neel.
How do we look at the sale option for Enable after the 120-day period has passed since you rejected OG&E or its partner's offer? At that point, would you preclude the option of a sale or would you restart the process, and how would that work?
Neel, good morning. It's Bill. I think to be clear, we haven't commented on OG&E's offer. What we said in our prepared remarks is that we remain in discussions with other parties, and should those discussions continue past mid-January, per our partnership agreement, we would need to give OG&E another right of first offer or ROFO.
Got it. Okay. It seems like you're evaluating the possibility of a spin more, and it seems you're getting a little bit more comfortable with that, if I'm reading right. How do you consider the possibility of that trading as a standalone C corp versus the MLP aspects that OG&E and the public float would own?
Right. When we announced the strategic review process, we said we would be on concurrent paths of thinking about either a sale or a spin. I wouldn't want to imply that we're weighting one of those more heavily than the other. We are attentive to what I refer to as capital markets considerations, including how that C corp would trade and how portfolios managers would think of it as a security.
Okay. Thank you.
The next question will come from Nick Raza with Citigroup.
Thank you, guys. Just a couple of quick cleanup questions on the Atmos acquisition. Are we to assume it's a similar multiple as the prior acquisition, the Continuum acquisition?
The way we take a look at these is the internal rate of return and the return on equity from the total investment.
Okay.
That's the way we evaluate them. With respect to a multiple, we haven't disclosed that, but it's $40 million for their business.
Plus working capital.
Okay. Then, in terms of, just going back to your response on Enable about managing the commodity volatility and working with Enable to essentially fix some of their contracts. Is there an appetite to get rid of some of that volatility by doing more preferred issuances?
Well, I think that's probably a question better set for Enable than for us. Are you asking about it from our perspective?
Yep.
Yeah. The preferred investment we made was essentially taking an amount of money that we had invested as debt and investing it as preferred at a time when that would be helpful for Enable. Our stated objective, as we have stated for quite some time, is that we see Enable as a source of cash rather than a use of cash. I think that general theme still holds.
Okay. Fair enough. Thanks, guys.
The next question will come from Charles Fishman with Morningstar.
Hi, good morning. Tracy, unless I missed it, I didn't hear you mention right-of-way revenue, which was always a nice little earnings stream in your segment. Can you update that?
Good morning, Charles. We anticipate for 2016 that our miscellaneous revenue, including right-of-way, will be in the range of $10 million.
Okay, it's continuing to have that lower trajectory, as you've stated in the past, correct?
That's correct.
Okay. The second question I had on the Atmos acquisition. I assume just because Atmos is based up in Dallas, that maybe their concentration of customers was heavier in the Dallas and North Texas area than your existing business. Is that what made it such a good fit?
This is Joe. Actually, they are based in Houston for this business, and they have two primary offices, Houston, Texas, and Franklin, Tennessee. We have some overlapping service territories. In this acquisition, we would pick up six additional states with new customers, and they have a pretty heavy concentration in the Tennessee, Kentucky area. That's a nice complement to our existing portfolio.
It was almost non-Texas stuff that maybe was a benefit on this?
That's clearly part of it, yes.
Okay. Thank you. That's all I had.
Please remember, if you wish to ask a question, press star one on your telephone keypad. Thank you for your cooperation. The next question will come from Lasan Johong with Auvila Research.
Thank you. On the acquisition, could you talk about the differences in unit margins between your existing retail business and the Atmos acquisition?
This is Joe again. We don't give comments on unit margins by type of customer. I will say that they definitely have a bigger mix of large industrial customers. It's almost 400 BCF of throughput on approximately 1,000 customers. That's much higher use customers than we currently have in our portfolio. We actually like that aspect of it. We don't comment on specific unit margins by customer type.
Okay. Given your comments just now, is there a preference of which way CenterPoint is leaning, more towards the small commercial and residential or to the larger customers?
We like the addition that this gives us. We'll concentrate on all of our customer segments and make sure we provide them with great service. We think this complements our portfolio nicely, it gets us into, as I mentioned earlier, some additional markets where we didn't have a presence.
Got it. One follow-up on Enable. What is the point of trying to convert, and I'm not saying one is better than the other, trying to convert a racehorse into a farm horse when you're talking about pulling back on the commodity volatility? I mean, isn't the whole point of owning something like an Enable is to gain that upside in the commodities?
Well, I think the way to think about it is, the actions we were talking about earlier about reducing volatility have to do with the structure of the contract, not the pace at which Enable may pursue opportunities and grow. It has to do with reducing volatility, not taking away from the growth possibilities of that segment.
I think I understand. Okay, thank you very much.
The final question will come from Noah Hauser.
Hi. Thanks, guys.
Good morning.
During the September conference season, you gave some drivers to 2017 for utility net income. Are those drivers still intact, or how should we be thinking about that now?
Noah, this is Bill, and those drivers are intact, and we will be updating all of that in our year-end conference call after we have a board approval for our budgets and our capital expenditures for the 2017 year.
Is there anything else aside from the Atmos acquisition that would presumably be additive to that, or is there anything else we should be focused on that could have changed?
I would say only on the margin.
Okay. Thank you.
Thank you, everyone, for your interest in CenterPoint Energy. We look forward to seeing you at EEI. We will now conclude our third quarter 2016 earnings call. Have a nice day.
This concludes CenterPoint Energy's third quarter 2016 earnings conference call. Thank you for your participation. You may now disconnect.