FIRSTENERGY CORP quarterly report, Q3 FY2011

FirstEnergy Corp. — Q3 2011 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2011. This combined filing covers FirstEnergy and specified subsidiaries. FirstEnergy’s results include Allegheny Energy from its February 25, 2011 merger date; reported year-over-year comparisons are therefore not fully like-for-like.

Financial performance and position

• Operating margin was approximately 21.7% in Q3 versus 11.1% a year earlier, and 14.8% for the nine months versus 13.3%. Net margin was approximately 10.8% and 5.9%, respectively, compared with 4.7% and 5.7%.
• Quarterly earnings improved substantially, mainly reflecting the absence of a $292m prior-year impairment charge, higher competitive energy margins, and the addition of Allegheny results. Nine-month earnings increased, but diluted EPS fell because average diluted shares rose to 394m from 305m following the merger-related issuance of shares.
• Operating cash flow was $2.229bn for the first nine months, versus $2.073bn. Investing used $555m, while financing used $2.402bn, including $1.581bn of long-term debt repayments and $651m of common dividends. Cash declined to $291m from $1.019bn at year-end 2010.
• At September 30, current assets were $3.591bn and current liabilities $4.863bn, a working-capital deficit of about $1.272bn, principally reflecting $1.840bn of current maturities and puttable debt. Short-term borrowings were nil. Long-term debt and other long-term obligations were $15.823bn; total equity was $13.015bn.
• The company reported a 55.1% debt-to-total-capitalization ratio under its credit-facility definition, below the 65% covenant ceiling. As of October 28, available liquidity was reported at $5.720bn, including $4.886bn of undrawn facilities and $834m cash; the cash figure is not the September 30 balance.
• Dividends declared were $1.10 per share for Q3 and $1.65 per share for the first nine months, unchanged from the comparable 2010 periods.

Material changes and unusual items

• The merger added substantial scale and debt, assets, goodwill, and new operating segments. FirstEnergy issued 113m shares; preliminary purchase accounting recorded $873m of merger goodwill. Allegheny contributed $1.273bn of revenue and $130m of earnings available to FirstEnergy in Q3 after merger costs.
• Management reported $88m of merger integration costs and $91m of merger transaction costs in the first nine months, plus $33m of merger-settlement charges. Integration costs included a $67m inventory valuation adjustment. Management said settlement charges were not expected to be material in future periods.
• A below-market fuel contract was assigned for approximately $130m cash proceeds; the replacement contract runs for the remaining nine years. The transaction reduced Q3 fuel costs by approximately $123m.
• Hurricane Irene affected approximately one million customers. Restoration costs were about $78m; $3m reduced Q3 pre-tax income and $75m was capitalized or deferred for future customer recovery.
• After quarter-end, FirstEnergy sold a one-third interest in Signal Peak for approximately $257.5m, retained a one-third interest, and estimated an after-tax gain of approximately $370m, including revaluation of its retained interest. The sale was expected to deconsolidate $360m of debt. It also sold the Richland and Stryker peaking facilities for about $80m; proceeds were intended to reduce net debt.

Outlook, risks and contingencies

• No consolidated EPS or revenue guidance is provided in the supplied filing text. Management expected to achieve its $210m annual merger-benefits target for 2011; completed initiatives represented approximately $165m of annualized pre-tax savings, or 79% of target, through September.
• Management cited market prices, customer demand and shopping, weather, generation availability, coal and transportation costs, transmission expenses, and regulatory outcomes as drivers of results. Competitive Energy Services benefited from growth in direct and aggregation sales but faced lower POLR and structured sales, higher operating costs, and greater PJM transmission expenses.
• Environmental compliance could require substantial spending or changes to operations. Risks include evolving air rules (including CSAPR and proposed MACT standards), water-intake requirements, coal-combustion residual rules, and potential water-quality controls. The company stated some potential costs could be material and could not be reliably estimated.
• Regulatory and legal matters include Met-Ed and Penelec’s appeal of an approximately $254m disallowance of historical marginal transmission-loss recovery; unresolved ATSI/MISO transmission-cost and MISO project-cost proceedings; and pending environmental litigation. The filing says outcomes and some potential losses cannot be predicted or estimated.
• Nuclear risks include regulatory follow-up at Perry, which was placed in the NRC’s degraded cornerstone category and temporarily shut down after a startup-transformer failure, and the Davis-Besse outage. Management expected Davis-Besse to return around the end of November 2011 while investigating shield-building cracks; it reported that identified architectural cracking did not affect structural integrity or safety. NRC post-Fukushima recommendations could require material plant upgrades.
• FirstEnergy had $3.8bn of guarantees and other assurances outstanding. Maximum exposure under specified downgrade or adverse-event collateral provisions was $594m, rising to $662m under stress assumptions. A 10% adverse commodity-price change was estimated to reduce net income by about $14m over the next 12 months.
• Other notable exposures include a $92.5m identified decommissioning funding shortfall for Beaver Valley Unit 1 and Perry, supported by a submitted $95m parental guarantee; accrued environmental remediation liabilities of $103m; and an ICG coal-contract verdict of $104m, which was appealed.

Important facts for investors to verify

• Separate merger-related growth from underlying performance; confirm the timing and full-period pro forma comparison, since reported 2011 results include Allegheny only after February 25.
• Reconcile the sharp Q3 earnings increase and nine-month EPS decline to merger effects, prior-year impairments, share dilution, and recurring segment margins.
• Track whether merger savings reach the $210m annual target and whether integration, inventory, and other merger costs persist.
• Monitor cash conversion, the working-capital deficit, debt maturities, rating changes, covenant headroom, and the availability of committed credit facilities.
• Check outcomes and recovery prospects for the $254m Pennsylvania transmission-cost dispute, transmission realignment costs, environmental proceedings, and nuclear plant matters.
• Verify completion and accounting effects of the post-quarter asset sales, including the Signal Peak gain and debt deconsolidation, and whether proceeds are used to reduce debt as stated.