WISCONSIN ELECTRIC POWER CO - Quarter Report: 2004 September (Form 10-Q)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes [X]    No [  ]

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes [  ]    No [X]

Indicate the number of shares outstanding of each of the Registrant's classes of common stock as of the latest practicable date (September 30, 2004):

All of the common stock of Wisconsin Electric Power Company is owned by Wisconsin Energy Corporation.

Wisconsin Electric Power Company (Wisconsin Electric), a wholly-owned subsidiary of Wisconsin Energy Corporation (Wisconsin Energy), was incorporated in the state of Wisconsin in 1896. We maintain our principal executive offices in Milwaukee, Wisconsin. Unless qualified by their context when used in this document, the terms the Company, Our, Us or We refer to Wisconsin Electric and its subsidiary.

We conduct our operations primarily in three operating segments: an electric utility segment, a natural gas utility segment and a steam utility segment. We serve approximately 1,075,000 electric customers in Wisconsin and the Upper Peninsula of Michigan, approximately 433,200 gas customers in Wisconsin and about 460 steam customers in metro Milwaukee, Wisconsin. For further financial information about our business segments, see Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 8 -- Segment Information in the Notes to Consolidated Condensed Financial Statements.

Wisconsin Energy is also the parent company of Wisconsin Gas LLC (Wisconsin Gas), a natural gas distribution utility, which serves customers throughout Wisconsin; Edison Sault Electric Company (Edison Sault), an electric utility which serves customers in the Upper Peninsula of Michigan; and W.E. Power, LLC (We Power), an unregulated company that was formed in 2001 to design, construct, own, finance and lease to us the new generating capacity included in Wisconsin Energy's Power the Future strategy. We have combined common functions with Wisconsin Gas and operate under the trade name of "We Energies".

Other:   Bostco LLC (Bostco) is our non-utility subsidiary that develops and invests in real estate. As of September 30, 2004, Bostco has $42.1 million of assets.

We have prepared the unaudited interim financial statements presented in this Form 10-Q pursuant to the rules and regulations of the Securities and Exchange Commission. We have condensed or omitted some information and note disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles pursuant to these rules and regulations. Our financial statements should be read in conjunction with the financial statements and notes thereto included in our 2003 Annual Report on Form 10-K.

WISCONSIN ELECTRIC POWER COMPANY
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Unaudited)

Our accompanying unaudited consolidated condensed financial statements should be read in conjunction with Item 8, Financial Statements and Supplementary Data, in our 2003 Annual Report on Form 10-K. In the opinion of management, we have included all adjustments, normal and recurring in nature, necessary to a fair presentation of the results of operations, cash flows and financial position in the accompanying income statements, statements of cash flows and balance sheets. The results of operations for the three and nine months ended September 30, 2004 are not necessarily indicative of the results which may be expected for the entire fiscal year 2004 because of seasonal and other factors.

We have modified certain balance sheet and cash flow presentations. Prior year financial statement amounts have been reclassified to conform to their current year presentation.

Variable Interest Entities:   In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation 46, Consolidation of Variable Interest Entities (FIN 46). This standard requires an enterprise that is the primary beneficiary of a variable interest entity to consolidate that entity. We applied the Interpretation to any existing interests in variable interest entities beginning in the third quarter of 2003. In October 2003, the FASB deferred the adoption of FIN 46 for all entities commonly referred to as special-purpose entities to the first reporting period ending after December 15, 2003. In December 2003, the FASB issued FIN 46R, which revised FIN 46 and deferred the effective date for interests held in variable interest entities other than special purpose entities to financial statements for periods ending after March 15, 2004. We adopted FIN 46R in the first quarter of 2004.

We continue to evaluate our tolling and purchased power agreements with third parties on a quarterly basis. After making an exhaustive effort, we concluded that for three of these agreements, we are unable to obtain the information necessary to determine whether we are the primary beneficiary of these variable interest entities. Pursuant to the terms of two of the three agreements, we deliver fuel to the entity's facilities and receive electric power. We pay the entity a "toll" to convert our fuel into the electric energy. The output of the facility is available for us to dispatch during the term of the respective agreement. In the other agreement, we have rights to the firm capacity of the entity's facility. We have approximately $751.3 million of required payments over the remaining term of these three agreements, which expire over the next 18 years. We believe the required payments will continue to be recoverable in rates. We account for one of these agreements as a capital lease.

We account for asset retirement obligations under Statement of Financial Accounting Standards (SFAS) 143, Accounting for Asset Retirement Obligations. SFAS 143 primarily applies to the future decommissioning costs for our Point Beach Nuclear Plant (Point Beach).

SFAS 143 also applies to a smaller extent to several other utility assets, including the dismantlement of certain hydro facilities and the removal of certain coal handling equipment and water intake facilities located on lakebeds. We have not recorded any asset retirement obligations for the removal of the coal

The following table presents the change in our asset retirement obligations, which are included on the consolidated balance sheet in Deferred Credits and Other Liabilities.

Comprehensive Income:   Comprehensive income includes all changes in equity during a period except those resulting from investments by and distributions to owners. We had the following total comprehensive income during the nine months ended September 30, 2004 and 2003:

In August 2004, we retired $140 million of 7-1/4% First Mortgage Bonds at their scheduled maturity. We financed this redemption through the issuance of short-term commercial paper.

The components of our net periodic pension and other post-retirement benefit costs for the three and nine months ended September 30, 2004 and 2003 were as follows:

During September 2004, we contributed $12.7 million, the maximum deductible amount, to our qualified pension plan for the 2003 plan year. We anticipate that we may make an additional discretionary contribution for the 2004 plan year to the qualified pension plan of approximately $39.0 million in the fourth quarter of 2004, depending upon market conditions and other factors. Any discretionary contributions in 2004 to other post-retirement benefit plans are expected to occur in December. Contributions to other post-retirement benefit plans are discretionary.

Employee Benefit Plans and Post-retirement Benefits:   In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (Act) was signed into law. The Act introduced a prescription drug benefit program under Medicare as well as a federal subsidy to sponsors of retiree health care benefit plans. In the second quarter of 2004, the FASB issued FASB Staff Position (FSP) SFAS 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.

In accordance with FSP 106-2, we chose to recognize the effects of the Act retroactively effective January 1, 2004 with the impacts calculated actuarially. As of September 30, 2004, the total pre-tax reduction in other post-retirement expense was $3.2 million under SFAS 106, Employers' Accounting for Post-Retirement Benefits Other Than Pensions. The annual pre-tax reduction in SFAS 106 expense is expected to total $4.2 million. Assumptions used to develop this reduction include those used in the determination of the annual SFAS 106 expense and also include expectations of how the federal program will ultimately operate. There are currently no written regulations that provide this level of detail regarding the ultimate operation of the subsidy program. It is expected that final regulations will be published in early 2005.

We enter into various guarantees to provide financial and performance assurance to third parties. As of September 30, 2004, we had the following guarantees:

We guarantee the potential retrospective premiums that could be assessed under our nuclear insurance program.

Postemployment benefits:   Postemployment benefits provided to former or inactive employees are recognized when an event occurs. The estimated liability for such benefits as of September 30, 2004 was $22.9 million and $10.2 million as of December 31, 2003.

Summarized financial information concerning our reportable operating segments for the three and nine month periods ended September 30, 2004 and 2003 is shown in the following table.

Environmental Matters:   We periodically review our exposure for remediation costs as evidence becomes available indicating that our remediation liability has changed. Based on current information, we believe that future costs in excess of the amounts accrued and/or disclosed on all presently known and quantifiable environmental contingencies will not be material to our financial position or results of operations.

EPA Information Requests:   We received a request for information in December 2000 from the United States Environmental Protection Agency (EPA) regional offices pursuant to Section 114(a) of the Clean Air Act and a supplemental request in December 2002. In April 2003, we and the EPA announced that a consent decree had been reached which resolved all issues related to this matter. Under the consent decree, we will significantly reduce our air emissions from our coal-fired generating facilities. The reductions will be achieved by 2013 through a combination of installing new pollution control equipment, upgrading existing equipment, and retiring certain older units. The capital cost of

The agreement has gone through the public comment period. In October 2003, three citizen groups filed a motion with the court to intervene in the proceeding to contest the consent decree; the court granted their motion. Also, in October 2003, the government filed its response to public comments and a motion asking the court to approve the amended consent decree. The intervenor groups subsequently filed a motion requesting that the court stay the government's motion for approval of the decree to allow the intervenors to conduct discovery. Briefing was completed and the judge heard oral arguments from the parties in August 2004. In September 2004, the court granted the intervenors' request for limited discovery with respect to two facilities within our generation fleet and ordered that discovery be completed by December 2004, followed by briefing, and, if necessary, a hearing.

 10 -- SEVERANCE PLANS

Voluntary Separation Plan for Management Employees:   On September 28, 2004, Wisconsin Energy announced an enhanced severance package for selected non-officer management employees of it and its subsidiaries that elect to voluntarily resign (Voluntary Separation Plan) to help reduce upward pressure on operating expenses. Eligible employees have from October 4, 2004 through November 12, 2004 to apply to participate in this plan. Wisconsin Energy expects that at least 120 employees will volunteer for the Voluntary Separation Plan. As of September 30, 2004 we have recorded an accrual of $8.8 million ($5.3 million after tax) representing our estimate of the minimum obligation related to Wisconsin Electric. We expect to record additional costs in the fourth quarter of 2004, when the actual number of employees will be known.

In November 2004, we announced a Voluntary Separation Plan for certain represented employees. We expect that at least 50 positions will be eliminated as a result of this Voluntary Separation Plan. The costs associated with this Voluntary Separation Plan will be recorded in the fourth quarter.

We do not expect the total pre-tax cost of these two Voluntary Separation plans for Wisconsin Electric to exceed $18 million.

Cautionary Factors:   Certain statements contained herein are Forward-Looking Statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-Looking Statements may be identified by reference to a future period or periods or by the use of forward looking terminology such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "may," "objectives," "plans," "possible," "potential," "projects" or similar terms or variations of these terms. Actual results may differ materially from those set forth in Forward-Looking Statements as a result of certain risks and uncertainties, including but not limited to, changes in political and economic conditions, equity and bond market fluctuations, varying weather conditions, governmental regulation and supervision, as well as other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission (SEC) including factors described throughout this document and below in Factors Affecting Results, Liquidity and Capital Resources.

We had net income of $59.1 million for the third quarter of 2004, a decrease of $8.9 million or 13.1% from the third quarter of 2003. Net income declined primarily due to severance costs and a weather-related decline in electric sales during 2004. A more detailed analysis of our financial results follows.

The following table compares our electric utility operating revenues and megawatt-hour sales by customer class during the third quarter of 2004 with similar information for the third quarter of 2003 including favorable (better (B)) or unfavorable (worse (W)) variances.

During the third quarter of 2004, total electric utility operating revenues increased by $0.5 million or 0.1% when compared with 2003. We estimate that our electric operating revenues were approximately $18.0 million lower during the third quarter of 2004 than the same period in 2003 as a result of

Total electric megawatt-hour sales decreased by 276.1 thousand megawatt-hours or 3.3% during the third quarter of 2004 compared with the same period in 2003. Residential sales were down 4.0% due to weather. As measured by cooling degree days, the third quarter of 2004 was 33.5% cooler than both the third quarter of 2003 and normal, limiting cooling load sales to residential customers who are more weather sensitive and contribute higher margins than other customer classes. Weather-normalized residential base sales growth, however, partially mitigated reduced electric sales and operating revenues caused by the unfavorable weather in 2004. Sales volumes to large commercial/industrial customers fell by 2.3% between the comparative periods, much of which was attributable to our largest customers, two iron ore mines. Excluding these two mines, sales volumes to remaining large commercial/industrial customers dropped by 1.2%. Sales for resale to other utilities, the Resale-Utilities customer class, decreased 46.5% between the periods due to a lower demand for wholesale power. However, these wholesale sales result in relatively low margins.

Total fuel and purchased power expenses increased by $0.3 million or 0.2% when compared to the third quarter of 2003. The drop in electric sales due to very cool summer weather significantly reduced our need to use higher cost peak generating units and purchased power during the third quarter of 2004, mitigating the impact of higher average natural gas prices on purchased energy costs and of higher coal and purchased power capacity costs.

A comparison follows of gas utility operating revenues, gross margin and gas deliveries during the third quarter of 2004 with similar information for the third quarter of 2003. Gross margin is a better performance indicator than revenues because changes in the cost of gas sold flow through to revenue under gas cost recovery mechanisms.

For the three months ended September 30, 2004, gas utility gross margin decreased by $1.5 million or 7.6% when compared to the three months ended September 30, 2003 due to a $1.5 million reduction in gas cost incentive revenues recognized under gas cost recovery mechanisms. Total gas operating revenues, however, increased by $0.8 million or 1.6% between the comparative periods primarily

The following table compares our gas utility gross margin and natural gas therm deliveries by customer class during the third quarter of 2004 with similar information for the third quarter of 2003.

Other operation and maintenance expenses increased by $16.7 million or 8.5% during the third quarter of 2004 compared with the third quarter of 2003, primarily due to $13.6 million of expenses recognized during the third quarter of 2004 associated with construction of a power plant in Port Washington, Wisconsin under Wisconsin Energy's Power the Future plan. Additional revenue from an electric rate increase authorized by the PSCW in May 2004 for Power the Future construction costs offset this increase in expenses. In addition, we recognized $8.8 million of severance costs during the third quarter of 2004.

Other income, net increased by $3.5 million in the third quarter of 2004 compared to the third quarter of 2003. This increase is primarily due to an increase in our interest in the earnings of unconsolidated affiliates during the third quarter of 2004, the recognition of higher carrying costs on deferred electric transmission costs and higher equity-related Allowance for Funds Used During Construction (AFUDC) due to a higher average balance of utility construction projects between the comparative periods.

Total financing costs decreased by $1.7 million in the three months ended September 30, 2004 compared to the same period in 2003. This decrease primarily reflects the replacement of higher cost long-term debt outstanding during 2003 with lower cost borrowings outstanding during 2004. In August 2004, we retired $140 million of 7-1/4% First Mortgage Bonds at their scheduled maturity through the issuance of lower-cost short-term debt.

For the third quarter of 2004, our effective tax rate was 38.4% compared with a 37.5% rate during the third quarter of 2003. This increase in the effective income tax rate was due primarily to a reduction in the amount of Federal and State rehabilitation and housing credits from 2003 to 2004.

We had net income of $175.8 million for the first nine months of 2004, a decrease of $17.4 million or 9.0% from the first nine months of 2003. Net income declined primarily due to the timing of a scheduled refueling outage at Point Beach Nuclear Plant, higher benefit costs and severance costs recognized during the third quarter of 2004. The scheduled refueling outage occurred during the second quarter of 2004. In 2003, we did not have a comparable outage at Point Beach until the fourth quarter.

The following table compares electric utility operating revenues and megawatt-hour sales by customer class during the first nine months of 2004 with similar information for the same period in 2003 including favorable or unfavorable variances.

During the first nine months of 2004, total electric utility operating revenues increased by $58.1 million or 3.9% when compared with 2003, primarily because the impacts of rate increases and growth in base business significantly offset the effects of unfavorable weather.

We realized approximately $40.4 million in additional revenues during 2004 as a result of rate increases which were not completely in effect during the comparative first nine months of 2003. In May 2004, we received an order from the PSCW authorizing an annualized increase in electric rates of approximately $59 million to cover construction costs associated with Wisconsin Energy's Power the Future program and with low income uncollectible expenses transferred to Wisconsin's public benefits fund. In March

We estimate that our electric operating revenues were approximately $22.8 million lower during the first nine months of 2004 compared to the same period in 2003 as a result of unfavorable weather. Cool summer weather as compared to 2003 negatively impacted electric sales during the first nine months of 2004, especially to residential customers who are more weather sensitive and contribute higher margins than other customer classes. As measured by cooling degree days, the first nine months of 2004 were 26.7% cooler than the same period in 2003 and 37.9% cooler than normal, limiting cooling load sales.

Total electric sales increased by 351.8 thousand megawatt-hours or 1.5% between the comparative periods. Residential sales were flat and small commercial/industrial sales were up just 0.8% due to the unfavorable weather during 2004. However, we estimate that growth in the number of customers and in higher weather-normalized use per customer in both of these customer classes during the first nine months of 2004 mitigated much of the impact of unfavorable weather on electric sales and operating revenues. Sales volumes to large commercial/industrial customers improved by 2.4%. Excluding our largest customers, two iron ore mines, sales volumes to the remaining large commercial/industrial customers improved by 1.0%.

Fuel and Purchased Power expenses increased by $19.7 million or 4.6% when compared to the first nine months of 2003. This increase is related to the 1.5% increase in our total megawatt-hour sales and to higher coal and purchased capacity costs. Increased availability of several of our coal-fired generating units during the first nine months of 2004 offset the impact on fuel and purchased power costs of a scheduled outage at Point Beach Unit 1 during the second quarter of 2004. We did not have a comparable outage at Point Beach until the fourth quarter of 2003. Very cool summer weather significantly reduced the need to use higher cost peak generating units and purchased power during 2004, mitigating much of the rise in fuel and purchased power costs between the comparative periods.

A comparison follows of gas utility operating revenues, gross margin and gas deliveries during the first nine months of 2004 with similar information for the same period in 2003. Gross margin is a better performance indicator than revenues because changes in the cost of gas sold flow through to revenue under gas cost recovery mechanisms. Gas operating revenues decreased by $14.5 million or 3.9% between the comparative periods due to a combination of a weather-related decline in therm deliveries, lower gas cost incentive revenues and a $3.4 million or 1.3% decrease in purchased gas costs.