<PAGE 1> UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549-1004 Form 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 2-1647 COMMONWEALTH GAS COMPANY (Exact name of registrant as specified in its charter) Massachusetts 04-1989250 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) One Main Street, Cambridge, Massachusetts 02142-9150 (Address of principal executive offices) (Zip Code) (617) 225-4000 (Registrant's telephone number, including area code) (Former name, address and fiscal year, if changed since last report.) 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Outstanding at Class of Common Stock May 1, 1999 Common Stock, $25 par value 2,857,000 shares The Company meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q as a wholly-owned subsidiary and is therefore filing this Form with the reduced disclosure format. <PAGE 2> PART I - FINANCIAL INFORMATION Item 1. Financial Statements COMMONWEALTH GAS COMPANY CONDENSED BALANCE SHEETS MARCH 31, 1999 AND DECEMBER 31, 1998 ASSETS (Dollars in thousands) March 31, December 31, 1999 1998 (Unaudited) PROPERTY, PLANT AND EQUIPMENT, at original cost$394,335 $392,612 Less - Accumulated depreciation 125,772 120,811 268,563 271,801 Add - Construction work in progress 1,141 1,066 269,704 272,867 CURRENT ASSETS Cash 1,201 427 Advances to affiliates 14,025 - Accounts receivable 61,507 39,741 Unbilled revenues 8,250 10,358 Inventories, at average cost 13,134 25,885 Prepaid taxes - Property 889 3,135 Income - 5,034 Other 605 874 99,611 85,454 DEFERRED CHARGES Regulatory assets 19,859 19,616 Other 5,752 5,307 25,611 24,923 $394,926 $383,244 See accompanying notes. <PAGE 3> COMMONWEALTH GAS COMPANY CONDENSED BALANCE SHEETS MARCH 31, 1999 AND DECEMBER 31, 1998 CAPITALIZATION AND LIABILITIES (Dollars in thousands) March 31, December 31, 1999 1998 (Unaudited) CAPITALIZATION Common Equity - Common stock, $25 par value - Authorized and outstanding - 2,857,000 shares, wholly-owned by Commonwealth Energy System (Parent) $ 71,425 $ 71,425 Amounts paid in excess of par value 27,739 27,739 Retained earnings 33,383 17,998 132,547 117,162 Long-term debt, less current sinking fund requirements 102,150 102,150 234,697 219,312 CURRENT LIABILITIES Interim Financing - Advances from affiliates - 30,825 Other Current Liabilities - Current sinking fund requirements 3,650 3,650 Accounts payable - Affiliates 3,813 2,527 Other 20,444 27,153 Accrued taxes - Income 3,943 - Local property and other 2,785 3,251 Other 48,088 20,457 82,723 57,038 82,723 87,863 DEFERRED CREDITS Accumulated deferred income taxes 41,467 40,767 Unamortized investment tax credits 5,215 5,263 Other 30,824 30,039 77,506 76,069 $394,926 $383,244 See accompanying notes. <PAGE 4> COMMONWEALTH GAS COMPANY CONDENSED STATEMENTS OF INCOME AND RETAINED EARNINGS FOR THE THREE MONTHS ENDED MARCH 31, 1999 AND 1998 (Dollars in thousands - unaudited) 1999 1998 GAS OPERATING REVENUES $110,320 $108,788 OPERATING EXPENSES Cost of gas sold 52,913 55,545 Other operation and maintenance 21,240 19,850 Depreciation 4,656 4,658 Taxes - Income 9,590 8,456 Local property 2,823 2,727 Payroll and other 1,141 1,119 92,363 92,355 OPERATING INCOME 17,957 16,433 OTHER INCOME 276 180 INCOME BEFORE INTEREST CHARGES 18,233 16,613 INTEREST CHARGES Long-term debt 2,104 2,186 Other interest charges 744 719 2,848 2,905 NET INCOME 15,385 13,708 RETAINED EARNINGS - Beginning of period 17,998 16,871 Dividends on common stock - - RETAINED EARNINGS - End of period $ 33,383 $ 30,579 See accompanying notes. <PAGE 5> COMMONWEALTH GAS COMPANY CONDENSED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, 1999 AND 1998 (Dollars in thousands - unaudited) 1999 1998 OPERATING ACTIVITIES Net income $ 15,385 $ 13,708 Effects of noncash items - Depreciation and amortization 5,304 5,614 Deferred income taxes and investment tax credits, net 567 207 Change in working capital, exclusive of cash, advances to affiliates and interim financing 26,327 11,851 All other operating items (120) 1,392 Net cash provided by operating activities 47,463 32,772 INVESTING ACTIVITIES Additions to property, plant and equipment (inclusive of AFUDC) (1,839) (2,875) Advances to affiliates (14,025) - Net cash used for investing activities (15,864) (2,875) FINANCING ACTIVITIES Payment of short-term borrowings - (30,925) Proceeds from (payments to) affiliates (30,825) 600 Net cash used for financing activities (30,825) (30,325) Net increase (decrease) in cash 774 (428) Cash at beginning of period 427 1,867 Cash at end of period $ 1,201 $ 1,439 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the period for: Interest, net of amounts capitalized $ 2,716 $ 2,738 Income taxes $ 3,122 $ 1,864 See accompanying notes. <PAGE 6> COMMONWEALTH GAS COMPANY NOTES TO CONDENSED FINANCIAL STATEMENTS (1) General Information Commonwealth Gas Company (the Company) is a wholly-owned subsidiary of Commonwealth Energy System. The parent company is referred to in this report as the "Parent" and together with its subsidiaries is collectively referred to as "COM/Energy." The Parent is an exempt public utility holding company under the provisions of the Public Utility Holding Company Act of 1935 and, in addition to its investment in the Company, has interests in other utility and several non-regulated companies. In December 1998, the Parent signed an Agreement and Plan of Merger with BEC Energy, the parent company of Boston Edison Company, that will create an energy delivery company serving approximately 1.3 million customers located entirely within Massachusetts including more than one million electric customers in 81 communities and the Company's 240,000 gas customers in 51 communities. The Company has 600 regular employees including 406 (68%) who are represented by three collective bargaining units with contracts in place until March and June of 2002 and April of 2003. (2) Significant Accounting Policies (a) Principles of Accounting The Company's significant accounting policies are described in Note 2 of Notes to Financial Statements included in its 1998 Annual Report on Form 10-K filed with the Securities and Exchange Commission. For interim reporting purposes, the Company follows these same basic accounting policies but considers each interim period as an integral part of an annual period and makes allocations of certain expenses to interim periods based upon estimates of revenue from firm sales for the year. Generally, certain expenses which relate to more than one interim period are allocated to other periods to more appropriately match revenues and expenses. Principal items of expense which are allocated other than on the basis of passage of time are depreciation and property taxes. These expenses are recorded for interim reporting purposes based upon projected gas revenue. Income tax expense is recorded using the statutory rates in effect applied to book income subject to tax recorded in the interim period. The unaudited financial statements for the periods ended March 31, 1999 and 1998 reflect, in the opinion of the Company, all adjustments necessary to summarize fairly the results for such periods. In addition, certain prior period amounts are reclassified from time to time to conform with the presentation used in the current period's financial statements. The results for interim periods are not necessarily indicative of results for the entire year because of variations in gas consumption due to the heating season and also because of the Company's seasonal rate structure. <PAGE 7> COMMONWEALTH GAS COMPANY (b) Regulatory Assets and Liabilities The Company is regulated as to rates, accounting and other matters by the Massachusetts Department of Telecommunications and Energy (DTE). Based on the current regulatory framework, the Company accounts for the economic effects of regulation in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation." The Company has established various regulatory assets in cases where the DTE has permitted or is expected to permit recovery of specific costs over time. If all or a separable portion of the Company's operations becomes no longer subject to the provisions of SFAS No. 71, a write-off of related regulatory assets and liabilities would be required, unless some form of transition cost recovery continues through rates established and collected for the Company's remaining regulated operations. In addition, the Company would be required to determine any impairment to the carrying costs of deregulated plant and inventory assets. The principal regulatory assets included in deferred charges were as follows: March 31, December 31, 1999 1998 (Dollars in thousands) Postretirement benefits costs $ 8,309 $ 8,568 FERC Order 636 transition costs 6,206 5,968 Environmental costs 5,344 5,080 $19,859 $19,616 The principal regulatory liability, reflected in deferred credits- other and relating to income taxes, was $8 million at March 31, 1999 and December 31, 1998. (3) Commitments Construction Program The Company is engaged in a continuous construction program presently estimated at $93.4 million for the five-year period 1999 through 2003. Of that amount, $18.6 million is estimated for 1999. As of March 31, 1999, the Company's actual construction expenditures amounted to approximately $1.8 million, including an allowance for funds used during construction. The Company expects to finance these expenditures on an interim basis with internally-generated funds and short-term borrowings which are ultimately expected to be repaid with the proceeds from the issuance of long-term debt and/or equity securities. The program is subject to periodic review and revision because of factors such as changes in business conditions, rates of growth, effects of inflation, equipment delivery schedules, licensing delays, availability and cost of capital and environmental regulations. <PAGE 8> COMMONWEALTH GAS COMPANY Item 2. Management's Discussion and Analysis of Results of Operations The following is a discussion of certain significant factors which have affected operating revenues, expenses and net income during the periods included in the accompanying Condensed Statements of Income. This discussion should be read in conjunction with the Notes to Condensed Financial Statements appearing elsewhere in this report. A summary of the period to period changes in the principal items included in the Condensed Statements of Income for the three months ended March 31, 1999 and 1998 is shown below: Three Months Ended March 31, 1999 and 1998 Increase (Decrease) (Dollars in thousands) Gas Operating Revenues $ 1,532 1.4 % Operating Expenses - Cost of gas sold (2,632) (4.7) Other operation and maintenance 1,390 7.0 Depreciation (2) - Taxes - Federal and state income 1,134 13.4 Local property and other 118 3.1 8 - Operating Income 1,524 9.3 Other Income 96 53.3 Income Before Interest Charges 1,620 9.8 Interest Charges (57) (2.0) Net Income $ 1,677 12.2 Firm Unit Sales BBTU 1,840 12.7 The following is a summary of total throughput for the periods indicated: Total Throughput - In Billions of British Thermal Units (BBTU) Total Interruptible Total Trans- Through- Firm and Other Sales portation put Three Months Ended March 31, 1999 16,298 1,899 18,197 2,781 20,978 March 31, 1998 14,458 1,563 16,021 3,159 19,180 <PAGE 9> COMMONWEALTH GAS COMPANY Operating Revenues and Unit Sales Operating revenues for the current quarter increased by $1.5 million due primarily to the 13.6% increase in unit sales and a $1.4 million increase in transportation revenues offset, in part, by a $2.6 million decrease in the cost of gas sold. The increase in unit sales to firm customers reflects higher sales to all customer segments due to cooler weather conditions experienced during the first quarter of 1999 compared to the same period last year. Heating degree days for the quarter were 7.6% greater than the first quarter of 1998 but 7.2% less than normal. The fluctuation in interruptible and other sales reflects the competitive market that exists today in the natural gas industry. Other Operation and Maintenance The $1.4 million (7%) increase in other operation and maintenance costs for the current quarter reflects higher costs associated with a services company affiliate which provides accounting, legal, computer-related and other services (approximately $600,000), and the absence in the current period of an adjustment to year-end 1997 payroll (made in January 1998) related to the 1997 personnel reduction program ($527,000). Also contributing to the increase were higher maintenance costs associated with the Company's distribution system ($188,000). Taxes The increase in federal and state income taxes was due to the level of pre-tax income. Local property and other taxes increased due primarily to higher tax rates and valuations in the Company's service territory. Other Income The increase in other income for the first quarter of 1999 was due primarily to higher revenues associated with the Company's merchandising program for water heaters and heating systems. Environmental Matters The Company is participating in the assessment of a number of former manufactured gas plant (MGP) sites and alleged MGP waste disposal locations to determine if and to what extent such sites have been contaminated and whether the Company may be responsible for remedial actions. The DTE has approved recovery of costs associated with MGP sites. The Company is also involved in certain other known or potentially contaminated sites where the associated costs may not be recoverable in rates. For further information on other related environmental matters, refer to the Company's 1998 Annual Report on Form 10-K. <PAGE 10> COMMONWEALTH GAS COMPANY Gas Industry Restructuring Unbundled Gas Rates New unbundled rates for the Company went into effect on November 1, 1998. The unbundled rates were developed in accordance with a Settlement Agreement reached by participants in the Massachusetts Gas Unbundling Collaborative (the Collaborative) that was filed with the Massachusetts Department of Telecommunications and Energy on June 29, 1998 and approved on August 15, 1998. The new unbundled rates reflect the separation of the Company's gas supply function from its local distribution function. Commencing with the billing month of November 1998, the Company has a Seasonal Cost of Gas Adjustment Clause (CGAC) and a Local Distribution Adjustment Clause (LDAC) that provide for the recovery, from firm customers or Default Service customers, of certain costs previously recovered through base rates. The CGAC provides for rates that must be approved semi-annually by the DTE. The LDAC provides for rates that require annual approval. As part of its new unbundled rates, the Company modified its existing CGAC to allow for the following changes: (a) the addition of provisions that allow for the recovery of certain bad-debt expenses; (b) new formulas that no longer adjust the Gas Adjustment Factors for the seasonal embedded gas costs that were in existing sales rates; (c) updated provisions reflecting the ratemaking requirements for non-core revenue margins; and (d) the removal of provisions for the recovery of environmental remediation costs and FERC Order 636 transition costs, which will instead be recovered through the LDAC. The Company's new LDAC recovers conservation charges, environmental remediation costs, balancing penalty revenue credits, and costs associated with its participation in the Collaborative. For additional information related to gas industry restructuring, refer to the Company's 1998 Annual Report on Form 10-K. Merger with BEC Energy The electric utility industry has continued to change in response to legislative and regulatory mandates that are aimed at lowering prices for energy by creating a more competitive marketplace. These pressures have resulted in an increasing trend in the electric industry to seek competitive advantages and other benefits through business combinations. On December 5, 1998, the Parent and BEC Energy (BEC), headquartered in Boston, Massachusetts, entered into an Agreement and Plan of Merger (the Merger Agreement). Pursuant to the Merger Agreement, the Parent and BEC will be merged into a new holding company to be known as NSTAR. The merger is expected to occur shortly after the satisfaction of certain conditions, including the receipt of certain regulatory approvals including that of the DTE. The regulatory approval process is expected to be completed during the second half of 1999. The merger will create an energy delivery company serving approximately 1.3 million customers located entirely within Massachusetts, including more than one million electric customers in 81 communities and the Company's 240,000 gas customers in 51 communities. <PAGE 11> COMMONWEALTH GAS COMPANY Shareholder votes on the merger will be held as part of each of the Parent's and BEC's annual shareholder meetings scheduled for June 24, 1999. The Merger Agreement may be terminated under certain circumstances, including by any party if the merger is not consummated by December 5, 1999, subject to an automatic extension of six months if the requisite regulatory approvals have not yet been obtained by such date. The merger will be accounted for using the purchase method of accounting. Upon effectiveness of the merger, Thomas J. May, BEC's current Chairman, President and Chief Executive Officer (CEO), will become the Chairman and CEO of NSTAR. Russell D. Wright, the Parent's current President and CEO, will become the President and Chief Operating Officer of NSTAR and will serve on NSTAR's board of trustees. Also, upon effectiveness of the merger, NSTAR's board of trustees will consist of the Parent's and BEC's current trustees. Year 2000 The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any computer program that has date sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a temporary inability to process transactions or engage in normal business activities. COM/Energy has been involved in Year 2000 compliancy since 1996. COM/Energy, on a coordinated basis and with the assistance of RCG Informa- tion Technologies and other consultants, is addressing the Year 2000 issue. COM/Energy has followed a five-phase process in its Year 2000 compliance efforts, as follows: Awareness (through a series of internal announcements to employees and through contacts with vendors); Inventory (all computers, applications and embedded systems that could potentially be affected by the Year 2000 problem); Assessment (all applications or components and the impact on overall business operations and a plan to correct deficiencies and the cost to do so); Remediation (the modification, upgrade or replacement of deficient hardware and software applications and infrastructure modifications); and Testing (a detailed, comprehensive testing program for the modified critical component, system or software that involves the planning, execution and analysis of results). COM/Energy's inventory phase required an assessment of all date sensitive information and transaction processing computer systems and determined that approximately 90% of its software systems needed some modifications or replacement. Plans were developed and are being implemented to correct and test all affected systems, with priorities assigned based on the importance of the activity. COM/Energy has identified the software and hardware installa- tions that are necessary. All installations are expected to be completed and tested by mid-1999. COM/Energy has also inventoried its non-information technology systems that may be date sensitive (facilities, electric and gas operations, energy supply/production and distribution) that use embedded technology such as micro-controllers and micro-processors. COM/Energy has completed its assess- ment of these non-information technology systems and determined that 20% of these systems required remediation or replacement. COM/Energy is approxi- mately 94% complete in its efforts to resolve non-compliance with Year 2000 <PAGE 12> COMMONWEALTH GAS COMPANY requirements related to these systems and anticipates that these systems willbe updated or replaced as necessary and tested by mid-1999. At present, the remediation phase for information technology as it applies to hardware and non-technology issues is scheduled for completion by June 1, 1999. The testing phase for Year 2000 compliance is approximately 85% complete and is scheduled to be concluded by June 30, 1999. All other phases are complete. Modifying and testing COM/Energy's information and transaction processing systems from 1996 through 2000 is currently expected to cost approximately $9.85 million, including approximately $900,000, $3.1 million and $1.9 million incurred through 1997, 1998 and the first quarter of 1999, respectively. Approximately $3.95 million is expected to be spent in the remainder of 1999 and in 2000. Year 2000 costs have been expensed as incurred and will continue to be funded from operations. In addition to its internal efforts, COM/Energy has initiated formal communications with its significant suppliers to determine the extent to which COM/Energy may be vulnerable to its suppliers' failure to correct their own Year 2000 issues. As of April 1, 1999, COM/Energy has received responses from approximately 82% of those entities contacted, and nearly all have indicated that they are or will be Year 2000 compliant. Failure of COM/Energy's significant suppliers to address Year 2000 issues could have a material adverse effect on COM/Energy's operations, although it is not possible at this time to quantify the amount of business that might be lost or the costs that could be incurred by COM/Energy. Contact with significant vendors is continu- ing and inadequate or marginal responses arebeing pursued by COM/Energy. COM/Energy is prepared to replace certain suppliers or to initiate other contingency plans should these vendors not respond to COM/Energy's satisfac- tion by July 1, 1999. In addition, parts of the global infrastructure, including national banking systems, electrical power grids, gas pipelines, transportation facilities, communications and governmental activities, may not be fully functional after 1999. Infrastructure failures could significantly reduce COM/Energy's ability to acquire energy and its ability to serve its customers as effectively as they are now being served. COM/Energy is identifying elements of the infrastructure that are critical to its operations and is obtaining information as to the expected Year 2000 readiness of these ele- ments. COM/Energy has started its contingency planning for critical operational areas that might be effected by the Year 2000 issue if compliance by COM/Energy is delayed. COM/Energy's gas and electric operations currently have emergency operating plans as well as information technology disaster recovery plans as components of its standard operating procedures. These plans will be enhanced to identify potential Year 2000 risks to normal operations and the appropriate reaction to these potential failures including contingency plans that may be required for any third parties that fail to achieve Year 2000 compliance. All necessary contingency plans are expected to be completed by June 30, 1999, although in certain cases, especially infra- structure failures, there may be no practical alternative course of action available to COM/Energy. <PAGE 13> COMMONWEALTH GAS COMPANY COM/Energy is working with other energy industry entities, both regionally and nationally with respect to Year 2000 readiness and is cooperating in the development of local and wide-scale contingency planning. While COM/Energy believes its efforts to address the Year 2000 issue will allow it to be successful in avoiding any material adverse effect on COM/Energy's operations or financial condition, it recognizes that failing to resolve Year 2000 issues on a timely basis would, in a "most reasonably likely worst case scenario," significantly limit its ability to acquire and distrib- ute energy and process its daily business transactions for a period of time, especially if such failure is coupled with third party or infrastructure failures. Similarly, COM/Energy could be significantly effected by the failure of one or more significant suppliers, customers or components of the infrastructure to conduct their respective operations after 1999. Adverse affects on COM/Energy could include, among other things, business disruption, increased costs, loss of business and other similar risks. The foregoing discussion regarding Year 2000 project timing, effective- ness, implementation and costs includes forward-looking statements that are based on management's current evaluation using available information. Factors that might cause material changes include,but are not limited to, the availability of key Year 2000 personnel, the readiness of third parties, and COM/Energy's ability to respond to unforeseen Year 2000 complications. New Accounting Standard In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 (SFAS No. 133), "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts possibly including fixed-price gas supply contracts) be recorded on the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999 and may be implemented as of the beginning of any fiscal quarter after issuance but cannot be applied retroactively. SFAS No. 133 must be applied to derivative instruments and certain derivative instruments embedded in hybrid contracts that were issued, acquired or substantively modified after December 31, 1997 and, at the company's election, before January 1, 1998. The Company has not yet quantified the impacts of adopting SFAS No. 133 on its financial statements and has not determined the timing of its method of adopting SFAS No. 133. <PAGE 14> COMMONWEALTH GAS COMPANY Forward-Looking Statements This discussion contains statements which, to the extent it is not a recitation of historical fact, constitute "forward-looking statements" and is intended to be subject to the safe harbor protection provided by the Private Securities Litigation Reform Act of 1995. A number of important factors affecting the Company's business and financial results could cause actual results to differ materially from those reflected in the forward-looking statements or projected amounts. Those factors include developments in the legislative, regulatory and competitive environment, certain environmental matters, demands for capital and the availability of cash from various sources. <PAGE 15> COMMONWEALTH GAS COMPANY PART II - OTHER INFORMATION Item 1. Legal Proceedings The Company is not a party to any pending material legal proceeding. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 27 - Financial Data Schedule Filed herewith as Exhibit 1 is the Financial Data Schedule for the three months ended March 31, 1999. (b) Reports on Form 8-K No reports on Form 8-K were filed for the three months ended March 31, 1999. <PAGE 16> COMMONWEALTH GAS COMPANY SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. COMMONWEALTH GAS COMPANY (Registrant) Principal Financial and Accounting Officer: JAMES D. RAPPOLI James D. Rappoli, Financial Vice President and Treasurer Date: May 17, 1999