BKH

Business Context and Reporting Period

Company: Black Hills Corporation
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2008
Headquarters: Rapid City, South Dakota

Black Hills Corporation is a diversified energy company operating in two primary business groups: Utilities (Electric and Gas) and Non-regulated Energy (Oil and Gas, Power Generation, Coal Mining, and Energy Marketing). The 2008 fiscal year was defined by significant strategic transformation, including the July 14, 2008 acquisition of five utility properties from Aquila, Inc. (the "Aquila Transaction") and the July 11, 2008 sale of seven independent power plants (the "IPP Transaction"). The company operates in a challenging macroeconomic environment characterized by a global financial crisis, volatile commodity prices, and tight credit markets.

Key Financial Metrics

Note: 2008 capital expenditures include $938.4 million for the Aquila acquisition. 2008 Net Income is heavily influenced by a $139.7 million after-tax gain on the IPP Transaction.

Material Changes vs. Prior Period

• Revenue Growth: Consolidated revenues increased 75% to $1.0 billion, driven primarily by the inclusion of the Aquila utility properties (acquired July 2008) and increased Oil and Gas and Coal Mining revenues.
• Continuing Operations Loss: The company reported a loss from continuing operations of $52.2 million, a reversal from the $75.3 million profit in 2007. This was caused by:
  • A $59.0 million after-tax non-cash "ceiling test" impairment charge on Oil and Gas assets due to low year-end commodity prices.
  • A $61.4 million after-tax unrealized mark-to-market loss on interest rate swaps that were de-designated as hedges.
  • Lower earnings from the Energy Marketing segment.
• Discontinued Operations: Income from discontinued operations surged to $157.2 million, primarily due to a $139.7 million after-tax gain on the sale of seven IPP plants.
• Debt Structure: Short-term debt increased significantly to $705.9 million, reflecting the drawdown of the $383 million Acquisition Facility to fund the Aquila Transaction. The facility maturity was extended to December 29, 2009.
• Segment Performance:
  • Utilities: Earnings increased 39% to $43.9 million, aided by the Aquila acquisition and rate increases.
  • Oil and Gas: Reported a loss of $49.7 million due to the ceiling test impairment and a 7% production decrease.
  • Power Generation: Earnings improved to $3.1 million due to lower gas costs and increased equity investment earnings.

Guidance, Outlook, and Risks

Management Commentary & Outlook: Management expects to focus on integrating the Aquila utilities and achieving synergies over the next 18-24 months. The company plans to replace the Acquisition Facility with long-term financing in 2009. Capital expenditures for 2009 are forecasted at approximately $287.4 million, excluding the Aquila acquisition costs. The company maintains a strategy of growing utility operations through selective acquisitions and expanding non-regulated power generation via long-term contracts.

Key Risks and Contingencies:

• Credit Market Access: The global financial crisis has restricted access to capital. The company faces the risk of being unable to refinance the Acquisition Facility or the Enserco Facility (expiring May 2009) on reasonable terms.
• Commodity Price Volatility: Low oil and gas prices triggered a significant impairment charge in 2008. Management warns that if low prices persist, additional non-cash impairment charges may be required in 2009.
• Regulatory Risk: Pending rate cases in Iowa and Colorado could impact revenue recovery. Additionally, new environmental regulations (e.g., renewable portfolio standards, carbon emissions) may increase generation costs.
• Counterparty Credit Risk: Deteriorating creditworthiness of financial institutions and energy counterparties increases the risk of default and potential collateral requirements.
• Interest Rate Swaps: The de-designation of $250 million in interest rate swaps as hedges has resulted in significant earnings volatility due to mark-to-market adjustments recorded directly in the income statement.

Investor Verification Checklist

• Refinancing Status: Verify the company's progress in refinancing the $383 million Acquisition Facility (due Dec 2009) and the $300 million Enserco Facility (due May 2009) given tight credit markets.
• Commodity Price Sensitivity: Monitor oil and natural gas prices to assess the likelihood of further "ceiling test" impairment charges in the Oil and Gas segment.
• Interest Rate Swap Exposure: Review the impact of the $250 million de-designated interest rate swaps on future earnings volatility as market rates fluctuate.
• Regulatory Rate Cases: Track the outcomes of pending rate cases for Iowa Gas and Colorado Gas, which could affect future revenue recovery.
• Integration Synergies: Assess the progress of integrating the Aquila utility properties and the realization of projected cost savings and operational efficiencies.