Turning Growth into Shareholder Value
We’re confident in our ability to continue long-term improvement in earnings and cash flow. To attract the capital we need to keep up with growth, we must continue to compensate investors for shouldering risk. That’s also the key that unlocks our ability to continue improving reliability while protecting our natural environment. We won’t diminish our obligation to secure Arizona’s energy future for our customers or concede our commitment to a fair return for shareholders.

Growth is good news for investors because it drives revenue growth that, well managed, produces earnings growth. We’re confident we can continue to capture the benefits of growth for investors in the form of greater overall profitability, improved cash flow and higher dividends.

We have an enviable track record of converting growth into shareholder value, and we will continue that value creation in the future. Our strategy to secure the benefits of customer growth for investors is built around four major elements: achieving regulatory collaboration, controlling operating and capital costs through operational excellence and risk management, etching a strong financial profile and embracing technology and innovation.

First, we will continue to work with regulators to refine our newly restructured regulatory platform. After avoiding the structural failures of California-style deregulation, we expanded our approach to competition and regulation. We reached agreement last year with major customer groups on a new regulatory platform, the main elements of which were endorsed in early March by an administrative law judge. As this report goes to press, we are awaiting approval by our Arizona regulators.

The new platform will remedy our most urgent regulatory issues: it consolidates our company by putting the Arizona plants built by Pinnacle West Energy, our unregulated generation subsidiary, into the APS rate base. There, the plants will earn a regulated return and provide valuable, reliable, cost-effective and environmentally suitable capacity for our customers. It provides for a fuel and purchased power adjustment clause, our first since 1989, and includes a 4.2 percent rate increase.

Perhaps most important, this long overdue restructured regulatory platform will give us the opportunity to look forward not backward. Instead of re-doing the regulatory decisions of the late 90s, we can anticipate the infrastructure and service needs of our customers. We are responsible for meeting our customers’ needs. We’ve done it before and we will continue to do so.

Second, we will manage power costs and capacity needs with excellent operations of a broad resource base and effective risk management strategies. With our low-cost nuclear and coal units fully deployed and achieving high capacity factors, we are well positioned to supply economical power for our customers. The new gas units at Redhawk, West Phoenix and Saguaro will enable a diverse energy supply mix of nuclear, coal and gas. As supplies tighten and spark spreads widen over the next few years, our gas units will allow us to capture opportunities in the wholesale market as well as supply our customers’ needs.

We’ve controlled fuel and purchased power risk for years, and we will continue to do so. With a fuel adjust-ment clause added to our risk management tools, we will not reduce our intensity on minimizing cost. This fuel adjuster will become increasingly important as we achieve a more diverse generation fuel mix and as we contract for additional purchased power. Our new regulatory platform calls for a hiatus on building generation until 2015 – unless regulators agree the market is failing to provide adequate new capacity.

Third among our strategies for capturing the benefits of growth, we will achieve an improved financial profile. The new regulatory platform will provide some revenue boost. In addition, with the Arizona gas-fired units expected soon to be in the APS rate base, our corporate risk profile will be much lower, which will bolster our financial flexibility.

We’ve enhanced our cash flow over the last two years with asset sales, primarily by SunCor, our real estate subsidiary. As we’ve often said in the past about SunCor, we will maximize the value of our assets for shareholders over the long term with sales or purchases depending on opportunity and the economy. Years ago, we adopted a two-pronged financial strategy – maintaining an investment-grade rating on all corporate-level debt and targeting a steady pace of dividend increases. The former keeps our financing costs low – essential for a rapidly growing utility like APS – and the latter sets our financial profile apart from many other utilities.

Finally, innovation and further deployment of technology will help control our generation costs, but the potential for digital advances on the delivery side – the “wires” and customer service part – of our business is truly exciting. Technology will allow us to fully utilize our current assets and leverage our talented employee base. With computer software and digital intelligence facilitating and enhancing our operations, we will continue to provide better as well as more efficient customer service. In 1994, we served about 160 customers per employee. In 2004, we served 224 customers per employee while providing outstanding customer service, including more information, faster response to outages and higher reliability. Over the next decade, we expect to see equal or greater productivity gains and continuing service enhancements.

Over the long term, despite 10 years of regulatory uncertainty, market blowups in California and rate decreases in Arizona, we’ve generated a positive earnings and cash flow trend. With historic deregulation tremors behind us, we look forward to a more stable regulatory environment, a more robust wholesale power market, a better economy – and a resumption of earnings growth.

The past offers strong evidence of our ability to manage growth for the benefit of investors, but the earnings blip and dip from power marketing over the last few years may disguise the underlying stability of our core regulated utility business. Every year over the last 10 years, with the exception of the recession year 2001, our electricity sales growth exceeded both the Arizona population growth and our customer growth rates. The regulated core business gave us solid earnings and now it will drive future earnings growth.

What makes this all possible?
The answer is simple – our people. Each day, they come to the job ready to work hard, solve challenges and deliver unmatched service to our customers. They are the reasons we have succeeded for 118 years. They are the reasons we will continue to succeed in the future.

William J. Post
Chairman