UIL Holdings (UIL)

UIL Holdings Corporation (NYSE:UIL) is the holding company for The United Illuminating Company (UI), a New Haven, Connecticut-based regional distribution utility providing electricity to more than 320,000 customers in the Greater New Haven and Greater Bridgeport areas. Its retail electric service rates are subject to regulation by the Connecticut Department of Public Utility Control (DPUC). UIL's non-utility business is United Capital Investments, Inc. (UCI) which was established to make minority ownership interest investments. UIL Holdings' utility business generated nearly 100% of the company's 2006 revenues of $846.0 million, whereas non-utility operations contributed nominally less than 1%. A break-down of sales per customer reveals that UIL's Retail sector accounted for almost 93% of revenue, the Wholesale sector for 3.3% of revenue, and Other Utility accounted for 3.8% in the 3rd quarter of 2007. The dependence on utility business increased as is evident from a meager $0.005 million generated by the non-utility business during the 3rd quarter of 2007. This amount comprises 0.002% of consolidated revenue in the 3rd quarter of 2007.

OUTLOOK

Several concerns must be addressed before investors should view UIL stock in a more positive light. The company's regional subsidiary, The United Illuminating Company, operates within the highly unfavorable Connecticut regulatory environment. Most recently, regulators authorized only a slight increase in the utility s distribution rates. Under the four-year plan, the total allowed annual rate increases are 1.98% in 2006, 0.6% in 2007, 1.4% in 2008 and 0.9% in 2009. However, UI filed a petition for reconsideration in the rates and on following a favorable outcome of the hearing there will be a $37.9 million revenue increase which will be equal to a 5.3% increase in 2009 over the 2005 rate. However, the commission reduced the utility s base-level authorized return-on-equity (ROE) to 10.2% from 10.45%, for 2006 which was down from the earlier reduction from 11.5%. The DPUC s final decision is disappointing for the company near the peak in the Fed funds rate cycle. As the utility s first rate increase in ten years, the DPUC s regulatory "relief" is insufficient to support the company as an attractive investment vehicle. Furthermore, the company also filed a revised local network service transmission tariff with the FERC during the 3rd quarter of 2005. UI seeks to recover its transmission revenue requirements on a prospective basis, subject to reconciliation with actual revenue requirements. Under UI's current transmission tariff, the annual period during which wholesale transmission rates are effective begins after the end of the annual period used to calculate the required transmission rates. The proposed changes to the tariff are expected to reduce the lag between the period in which transmission-related costs are incurred and the period in which rates become effective. UI also received the approval to include 50% of new construction work-in-progress (CWIP) in its transmission base rate in order to improve cash flow during design and construction of planned transmission facility improvements. Emphasis in the filing has been placed on the $260 million Middletown/Norwalk 345 kV transmission upgrade project which accounts for about 80% of UI's expected transmission costs over the next five years. In addition, it plans to invest another $232 million on transmission infrastructure through 2009. The $1.75 billion program from 2007 through 2016 is set to replace aging infrastructure, address capacity problems in Connecticut and maintain standard compliance. On March 23, 2007, UI filed with the FERC to obtain incentive rate treatment for costs associated with the Middletown/Norwalk project. In particular, UI seeks approval for: (i) the inclusion of 100% of construction work-in-progress in the transmission rate base, as opposed to the 50% currently approved and (ii) a 50 basis point ROE adder for the project's use of advanced transmission technologies. A final decision is expected soon. Again, we are not optimistic towards adequate regulatory relief from the state utility commission. In another case, the final decision issued by the DPUC on the re-opening of the UI docket relating to the recovery of increased pension and post-retirement benefit expenses effectively eliminates some of the regulatory uncertainty surrounding the company. In July 2006, FERC issued a final ruling which provides transmission rate incentives to promote capital investment and also provides for recovery of all prudent compliance costs and costs related to transmission infrastructure development. The ruling includes provisions to allow an incentive return on equity for new infrastructure, 100% construction-work-in-progress expenditures in its base rate and accelerated book depreciation. However, in June of 2007, the DPUC and other interveners filed requests with the FERC for a rehearing of the decision granting UI these incentives. The Competitive Transmission Assessment (CTA) earnings forecast reflects the allowed return on equity of 9.75% and an allowed capital structure of 48% equity and 52% debt. The CTA rate base has declined from year to year for a number of reasons, including: amortization of stranded costs, the sale of UI's nuclear units, and adjustments made through the annual DPUC review process. On October 31, 2006 FERC issued a final decision authorizing a return on equity for owners of the ISO New England transmission grid. This decision has resulted in customer refunds of $3.7 million, covering the period from February 2005 to December 2006. In 2006, kWh consumption of electricity was 3.1% lower than 2005, mainly due to the impact of milder weather in 2006 compared to 2005. In 2006, UIL sold substantially all of its interest in Xcelecom. In December 2006, Xcelecom entered into an arrangement to sell McPhee Electric, Ltd, JBL Electric, Inc and JE Richards to Phalcon Ltd. The net loss incurred by the company was primarily due to the impact of operations on investment and a contingent earn-out payment by UIL to former owners of JE Richards. On the same date Xcelecom also entered into an agreement to sell Allen/Briteway Electrical Contractors, Inc to SAIDS, LLC. These transactions resulted in combined net losses of $36.0 million or $1.47 per share.

Finally, income-oriented investors may someday be disappointed here, for despite the company's above industry average 4.9% dividend yield, the $1.73 per share annual dividend payout represents potentially unsustainable projected earnings payouts of 105% in 2007 and 92% in 2008. As interest rates may have reached their peak in this business cycle and investors move out of dividend plays into higher yielding fixed income securities, the stock price could fall if only modest earnings growth materializes. As an attempted solution to this problem, UIL Holdings announced a 5-for-3 common stock split for shareholders of record on June 6, 2006. Debt level increased in the company in recent times. UIL filed with the Connecticut DPUC on April 3, 2007 to raise $375 million of debt. Its $175 million of long-term debt offered through private placement during the 3rd quarter 2007 was over-subscribed. Also, the company identifying peaking power shortages in Connecticut, along with NRG Energy, Inc. (NYSE: NRG), plans to submit a proposal to the Connecticut Department of Public Utility Control (DPUC). The proposal for adding new power generation units throughout Connecticut is in response to Act-07-242 passed in June 2007 in Connecticut. The act authorizes regulated utilities to build/own/acquire power generation assets in the state of Connecticut. Pursuant to the legislation, proposals to DPUC are due by February 1, 2008 with a final decision anticipated by June 2008. However the capex for generation enhancement may call for incremental debt in the near future. All this would notably hamper earnings through higher interest expense and an over-burdened balance sheet. Additionally, in May of 2007, UIL amended its certificate of incorporation to increase the authorized number of shares of common stock from 30 million shares to 75 million shares. The company's Board of Directors and its shareowners subsequently approved the amendment at the UIL's annual meeting of the shareholders.

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