WISCONSIN ELECTRIC POWER CO - Quarter Report: 2006 March (Form 10-Q)

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 1,096,100 electric customers in Wisconsin and the Upper Peninsula of Michigan, approximately 447,800 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 7 -- 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 construct, own, and lease to us the new generating capacity included in Wisconsin Energy's Power the Future strategy, which is described further in this report. 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 March 31, 2006, Bostco had $40.2 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 (SEC). 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. This Form 10-Q, including the financial statements contained herein, should be read in conjunction with our 2005 Annual Report on Form 10-K, including the financial statements and notes therein.

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 2005 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 months ended March 31, 2006 are not necessarily indicative of the results which may be expected for the entire fiscal year 2006 because of seasonal and other factors.

Modifications to Prior Statements:   We have changed the presentation of the investing activities within our nuclear decommissioning trusts on the accompanying Consolidated Condensed Statements of Cash Flows to present proceeds from investments within the nuclear decommissioning trusts and purchases of investments within the nuclear decommissioning trusts. Previously, these items were excluded from the Consolidated Statements of Cash Flows as the nuclear decommissioning trusts are considered restricted investments. This reporting change had no impact to net cash provided by, or used in, operating, investing or financing activities.

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

Interim Accounting for Electric Fuel Revenues:   For 2006, we will have to refund to customers any electric fuel revenues that we receive that are in excess of fuel costs that we incur, as defined by the Wisconsin fuel rules. We do not recognize revenue for any amounts that are currently billable if it is probable that we will refund those amounts to customers.

Comprehensive Income:   Comprehensive income includes all changes in equity during a period except those resulting from investments by and distributions to owners. We recorded the following total comprehensive income during the three months ended March 31, 2006 and 2005:

Share-Based Compensation Plans:   Our employees participate in the Wisconsin Energy 1993 Omnibus Stock Incentive Plan, as amended (OSIP), as approved by Wisconsin Energy stockholders. The OSIP enables Wisconsin Energy to provide a long-term incentive through equity interests in Wisconsin Energy, to outside directors, selected officers and key employees of Wisconsin Energy and its subsidiaries,

The exercise price of a Wisconsin Energy stock option under the OSIP is to be no less than 100% of the common stock's fair market value on the grant date and options may not be exercised within six months of the grant date except in the event of a change in control. In December 2004, the Compensation Committee of the Board of Directors of Wisconsin Energy (the Compensation Committee) approved the acceleration of vesting of all unvested options awarded to executive officers and other key employees in 2002, 2003 and 2004. Options granted subsequent to January 1, 2005 are non-qualified stock options which vest on a cliff-basis after a three year period. Generally, options expire no later than ten years from the date of grant.

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (SFAS) 123R, Share-Based Payment, using the modified prospective method and using a binomial pricing model to estimate the fair value of stock options granted subsequent to December 31, 2005. Prior to January 1, 2006, we accounted for share based compensation under Accounting Principles Board Opinion 25 (APB 25), Accounting for Stock Issued to Employees, and Wisconsin Energy disclosed the pro forma impact of share based compensation expense under SFAS 123, Accounting for Stock-Based Compensation. Historically, all stock options have been granted with an exercise price equal to the fair market value of the common stock on the date of grant. Accordingly, no compensation expense was recognized in connection with option grants. Wisconsin Energy allocates stock compensation expense to us based on the relative number of options granted to our employees.

We utilize the straight-line attribution method for recognizing stock-based compensation expense under SFAS 123R and recorded $1.0 million of compensation expense, net of tax, in the first quarter of 2006 for stock option awards made to our employees.

Results for the first quarter of 2005 have not been restated. Had compensation expense for employee stock options been determined based on fair value at the grant date consistent with SFAS 123R, our net income for the first quarter of 2005 would have been reduced to the pro forma amounts indicated below.

In the first quarter of 2006, the Compensation Committee granted 905,907 options to our employees that had an estimated fair value of $7.55 per share using a binomial option-pricing model. In the first quarter of 2005, the Compensation Committee granted 857,974 options to our employees that had an estimated fair value of $8.32 per share using the Black-Scholes model. The following assumptions were used to value the Wisconsin Energy options on the date of grant:

The risk-free interest rate is based on the U.S. Treasury interest rate whose term is consistent with the expected life of the stock options. Dividend yield, expected volatility and expected life assumptions, for 2006, are based on Wisconsin Energy's historical experience.

The following is a summary of Wisconsin Energy stock options held by Wisconsin Electric employees through March 31, 2006.

The aggregate intrinsic value of stock options exercised by Wisconsin Electric employees during the quarter ended March 31, 2006 was approximately $1.9 million.

The following table summarizes information about Wisconsin Energy stock options outstanding and held by Wisconsin Electric employees at March 31, 2006:

The following table summarizes the status of non-vested options held by our employees since December 31, 2005:

The total fair value of options held by Wisconsin Electric employees and vesting during the three months ended March 31, 2006 was approximately $0.1 million. As of March 31, 2006, we had approximately $13.2 million of total unrecognized compensation expense related to non-vested share based compensation.

The Compensation Committee has also approved Wisconsin Energy restricted stock grants to certain key employees and directors. The following restricted stock activity related to Wisconsin Electric employees occurred during the three months ended March 31, 2006:

Recipients of the Wisconsin Energy restricted shares, who have the right to vote the shares and to receive dividends, are not required to provide consideration to us other than rendering service. Forfeiture provisions on the restricted stock generally expire 10 years after award grant subject to an accelerated expiration schedule based on the achievement of certain financial performance goals.

Wisconsin Energy records the market value of the restricted stock awards on the date of grant. We then amortize our share of allocated expense over the vesting period of the awards. We also adjust expense for acceleration of vesting due to achievement of performance goals.

In January 2004, the Compensation Committee granted 113,750 Wisconsin Energy performance shares to our officers and other key employees. In January 2006 and 2005, the Compensation Committee granted 88,305 and 65,376 Wisconsin Energy performance units to our officers and other key employees under the Wisconsin Energy Performance Unit Plan. Under the grants, the ultimate number of shares of Wisconsin Energy common stock or cash which will be awarded is dependent upon the achievement of certain financial performance of Wisconsin Energy's common stock over a three year period. Under the terms of the award, participants may earn between 0% and 175% of the base performance award. We are accruing compensation costs over the three year period based on our estimate of the final expected value of the award. The 2004 grant will be settled in Wisconsin Energy common stock. The 2005 and 2006 grants will be settled in cash.

Our asset retirement obligations under SFAS 143, Accounting for Asset Retirement Obligations, primarily relate to the future decommissioning costs for our Point Beach Nuclear Plant (Point Beach) and to asbestos related removal costs associated with other power plants. Our asset retirement obligations at March 31, 2006 were $359.5 million.

We adopted FASB Interpretation 47 (FIN 47), Accounting for Conditional Asset Retirement Obligations, an interpretation of SFAS 143, effective December 31, 2005. FIN 47 defines a conditional asset retirement obligation as a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. The adoption of FIN 47 had no effect on net income due to the regulatory treatment of asset retirement costs.

If we had adopted interpretation FIN 47 at the beginning of fiscal 2005, we would have reported the following asset retirement obligations on our Consolidated Condensed Balance Sheets in "Asset Retirement Obligations" as of March 31:

We follow SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS 149, an amendment of SFAS 133 on Derivative Instruments and Hedging Activities, which requires that every derivative instrument be recorded on the balance sheet as an asset or liability measured at its fair value and that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. For most energy related physical and financial contracts in our regulated operations that qualify as derivatives under SFAS 133, the Public Service Commission of Wisconsin (PSCW) allows the effects of the fair market value accounting to be offset to regulatory assets and liabilities.

The components of our net periodic pension and other post-retirement benefit costs for the three months ended March 31, 2006 and 2005 were as follows:

Employee Benefit Plans and Post-retirement Benefits:   In October 2005, we announced that we were offering to our retirees a Medicare Advantage program as an option within our existing post-retirement medical and drug plans. The Medicare Advantage program is part of the Medicare Prescription Drug, Improvement and Modernization Act of 2003. The program offers post-65 medical and drug benefits through private insurance carriers. The Medicare Advantage program is expected to reduce the cost of post-65 medical and drug costs for our retirees and us. Due to this change, we remeasured the fair value of our other post-retirement plans in the fourth quarter of 2005 in accordance with SFAS 106, Employer's Accounting for Post-Retirement Benefits Other than Pensions. As a result of the Medicare Advantage program, our 2006 post-retirement costs for the three months ended March 31, 2006 are less than our 2005 costs in the comparative period.

We enter into various guarantees to provide financial and performance assurance to third parties. As of March 31, 2006, 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, excluding severance benefits, for such benefits was $13.7 million as of March 31, 2006 and $12.8 million as of December 31, 2005.

Summarized financial information concerning our reportable operating segments for the three month periods ended March 31, 2006 and 2005 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.

Cautionary Factors Regarding Forward - Looking Statements:   Certain statements contained herein are "Forward-Looking Statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-Looking Statements include, among other things, statements regarding management's expectations and projections regarding completion of construction projects, regulatory matters, fuel costs, sources of electric energy supply, coal and gas deliveries, remediation costs, environmental and other capital expenditures, liquidity and capital resources and other matters. Also, 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, those risks and uncertainties described in Item 1A. Risk Factors in Part II of this report and under the heading "Cautionary Factors" in this Item 2, other matters described under the heading "Factors Affecting Results, Liquidity and Capital Resources" in this Item 2, and other risks and uncertainties detailed from time to time in our filings with the SEC or otherwise described throughout this document.

We recorded net income of $87.4 million for the first quarter of 2006, an increase of $16.7 million or 23.6% from the first quarter of 2005. Net income increased primarily due to improved recovery of fuel costs. 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 first quarter of 2006 with similar information for the first quarter of 2005 including favorable (better (B)) or unfavorable (worse (W)) variances.

Total electric utility operating revenues increased by $85.5 million, or 16.5%, when compared with the first quarter of 2005. We estimate that our first quarter 2006 revenues were $72.5 million higher than the first quarter of 2005 due to pricing increases that we received during 2005 and in January 2006. The most significant increases authorized by the PSCW were to recover higher fuel and purchased power costs, capital costs associated with the new plants under Wisconsin Energy's Power the Future plan, and increased transmission costs. For more information on the pricing increases, see Utility Rates and Regulatory Matters in Factors Affecting Results, Liquidity and Capital Resources below.

Our electric sales volumes increased by 1.6 % as compared to the same period last year. Sales volumes to other utilities during the first three months of 2006 were approximately three times greater than the same period in 2005. The increase in sale volumes to other utilities is attributed to the availability of Unit 1 at Port Washington Generating Station (PWGS), which provided additional generation capacity. PWGS Unit 1 was not operational until the third quarter of 2005. Residential sales volumes were flat due to milder winter weather as heating degree days were approximately 10.7% lower than the prior year. Sales volumes in the Other Retail/Municipal class decreased approximately 18.8% compared to the prior year due, in part, to the expiration of a wholesale contract on December 31, 2005.

Our fuel and purchased power expenses increased by $11.1 million, or 7.1%, when compared to the first quarter of 2005. The increase was due, in part, to the following: (1) the average combined cost of purchased power and natural gas-fired units was approximately 10.2% higher in the first quarter of 2006 as compared to the same period in 2005 and (2) the cost of coal, including transportation, rose 17.4% when compared to last year. These increases were partially offset by increased generation from our lower cost base-load coal units which generated approximately 5.7% more megawatt-hours in the first quarter of 2006 as compared to the same period in 2005. The increased coal unit output reduced the need for higher cost purchased power and gas-fired generation.

The recovery of our fuel and purchased power costs (fuel costs) in Wisconsin is governed by rules established by the PSCW. For 2006, if our annual fuel recoveries exceed our annual fuel costs, as defined by the PSCW, then we will have to refund the excess fuel recoveries. If we under-collect our fuel costs by more than 2% on an annual basis, we have an opportunity to seek a rate increase prospectively. For the first quarter of 2006, we over-collected fuel costs by approximately $28.5 million; however, on an annual basis, we project that we will under-recover our annual fuel costs in the range of approximately $0.0 to $10.0 million. For the first quarter of 2005, we under-collected our fuel costs by $11.1 million and, on an annual basis, we under-collected our fuel costs by $35.6 million. When comparing the results of our first quarter 2006 with 2005, we saw a $39.6 million improvement in the collection of fuel costs.

A comparison follows of gas utility operating revenues, gross margin and gas deliveries during the first quarter of 2006 with similar information for the first quarter of 2005. We believe 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. Between the comparative periods, total gas operating revenues increased by $27.8 million or 11.9%.

The following table compares gas utility gross margin and natural gas therm deliveries by customer class during the first quarter of 2006 with similar information for the first quarter of 2005.

Our gas utility gross margin decreased by $1.8 million when compared to the first quarter of 2005 due to a decline in gas sales volumes that was driven by mild winter weather and by lower customer usage. The winter temperatures (as measured by heating degree days) were approximately 10.7% warmer than the first quarter in 2005. The mild winter weather reduced customer demand for heating. In addition, with the increase in natural gas prices, we have experienced a reduction in the normalized use of gas per customer. The decline in sales volumes was partially offset by a pricing increase that was granted by the PSCW and implemented in January 2006. The gas pricing increase was primarily granted to recover increased operating costs, including bad debt expenses. Our margins increased between the comparative periods by approximately $5.0 million due to this pricing increase. We anticipate that the 2006 annual impact of the rate increase for our gas margins would be approximately $19.1 million under normal customer usage; however, we believe that the actual amount will be lower due to reduced customer usage.

Our other operation and maintenance expenses increased by $50.2 million, or 23.2%, when compared to the first quarter of 2005. As discussed above, we received pricing increases during 2005 and in January 2006 to cover increased costs. Our increases in other operation and maintenance expenses that relate to the pricing increases include increased Power the Future lease costs of $25.1 million and increased transmission expenses of $13.0 million. In addition, other operation and maintenance expenses increased approximately $5.3 million due to PWGS operating costs and the timing of scheduled outages and maintenance projects at our plants.

Depreciation, Decommissioning and Amortization expenses decreased by $0.9 million or 1.3% when compared to the first quarter of 2005. In January 2006, we implemented new depreciation rates approved by the PSCW which reduced annual depreciation expenses. The decline was offset by increased depreciation expenses on plant additions.

Other income, net increased by $6.7 million when compared to the first quarter of 2005. The increase primarily reflects increased carrying costs on regulatory assets of $2.1 million, an increase in Allowance for Funds used During Construction (AFUDC) of $1.9 million due to a higher average balance of AFUDC - qualifying utility construction projects between the comparative periods, and an increase of $0.9 million in our interest in the earnings of our transmission affiliate during the first quarter of 2006.

Interest expense decreased by $0.4 million in the three months ended March 31, 2006 compared with the same period in 2005. This decrease reflects increased capitalized interest in 2006 due to a higher average balance of construction projects in 2006. In addition, in the first quarter of 2005, we expensed approximately $3.0 million related to the amortization of costs associated with prior debt redemptions. These costs were fully amortized as of July 2005; therefore, there were no similar expenses in the first quarter of 2006. These items were partially offset by higher debt levels and higher short-term interest rates.

For the first quarter of 2006, our effective tax rate was 37.9% compared with a 37.2% rate during the first quarter of 2005.

The following summarizes our cash flows during the first three months of 2006 and 2005: