PG ENERGY INC. TABLE OF CONTENTS PAGE PART I. FINANCIAL INFORMATION Item 1. Financial Statements Statements of Income for the three and nine months ended September 30, 1996 and 1995. . . . . . . . . 2 Balance Sheets as of September 30, 1996, and December 31, 1995 . . . . . . . . . . . . . . . . . . 3 Statements of Cash Flows for the nine months ended September 30, 1996 and 1995. . . . . . . . . 5 Notes to Financial Statements . . . . . . . . . . . . . . . 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. . . . . . . . . . . . 10 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . 19 -1- PART I. FINANCIAL INFORMATION PG ENERGY INC. Statements of Income Three Months Ended Nine Months Ended September 30, September 30, 1996 1995 1996 1995 (Thousands of Dollars) OPERATING REVENUES $ 13,998 $ 12,119 $ 108,870 $ 105,540 Cost of gas 5,979 4,866 58,532 59,147 OPERATING MARGIN 8,019 7,253 50,338 46,393 OTHER OPERATING EXPENSES: Operation 5,716 5,062 18,499 16,342 Maintenance 1,379 1,452 4,085 3,732 Depreciation 1,969 1,785 5,838 5,361 Income taxes (2,005) (2,442) 3,408 1,659 Taxes other than income taxes 1,619 1,399 8,331 7,934 Total other operating expenses 8,678 7,256 40,161 35,028 OPERATING INCOME (LOSS) (659) (3) 10,177 11,365 OTHER INCOME (DEDUCTIONS), NET (8) 20 311 192 INCOME (LOSS) BEFORE INTEREST CHARGES (667) 17 10,488 11,557 INTEREST CHARGES: Interest on long-term debt 1,665 2,295 4,680 6,954 Other interest 68 571 556 1,258 Allowance for borrowed funds used during construction (73) (19) (169) (40) Total interest charges 1,660 2,847 5,067 8,172 INCOME (LOSS) FROM CONTINUING OPERATIONS (2,327) (2,830) 5,421 3,385 LOSS WITH RESPECT TO DISCONTINUED OPERATIONS (Note 2) - - (386) (3,704) NET INCOME (LOSS) (2,327) (2,830) 5,035 (319) DIVIDENDS ON PREFERRED STOCK 363 690 1,383 2,073 EARNINGS (LOSS) APPLICABLE TO COMMON STOCK $ (2,690) $ (3,520) $ 3,652 $ (2,392) COMMON STOCK Earnings (loss) per share of common stock: Continuing operations $ (.81) $ (.63) $ 1.09 $ .24 Discontinued operations - - (.10) (.67) Net income (loss) before premium on repurchase/redemption of preferred stock (.81) (.63) .99 (.43) Premium on repurchase/redemption of preferred stock (.03) - (.37) - Total $ (.84) $ (.63) $ .62 $ (.43) Weighted average shares outstanding 3,314,155 5,585,882 3,697,410 5,561,257 Cash dividends per share (Note 3) $ - $ .64 $ 10.217 $ 2.0525 The accompanying notes are an integral part of the financial statements. -2- PG ENERGY INC. BALANCE SHEETS [CAPTION] September 30, December 31, 1996 1995 (Thousands of Dollars) ASSETS [S] [C] [C] UTILITY PLANT: At original cost $ 311,363 $ 295,895 Accumulated depreciation (80,708) (76,882) 230,655 219,013 OTHER PROPERTY AND INVESTMENTS 5,159 5,089 CURRENT ASSETS: Cash and cash equivalents 632 328 Accounts receivable - Customers 7,948 18,189 Affiliates, net 122 - Others 576 815 Reserve for uncollectible accounts (882) (781) Accrued utility revenues 1,781 10,319 Materials and supplies, at average cost 2,959 2,609 Gas held by suppliers, at average cost 25,439 15,140 Natural gas transition costs collectible 3,134 4,612 Deferred cost of gas and supplier refunds, net 17,545 - Prepaid expenses and other 1,716 3,281 60,970 54,512 DEFERRED CHARGES: Regulatory assets - Deferred taxes collectible 29,687 30,015 Other 4,331 3,013 Unamortized debt expense 1,196 1,340 35,214 34,368 NET ASSETS OF DISCONTINUED OPERATIONS (Note 2) - 204,250 TOTAL ASSETS $ 331,998 $ 517,232 The accompanying notes are an integral part of the financial statements. -3- PG ENERGY INC. BALANCE SHEETS [CAPTION] September 30, December 31, 1996 1995 (Thousands of Dollars) CAPITALIZATION AND LIABILITIES [S] [C] [C] CAPITALIZATION: (Note 4) Common shareholder's investment $ 92,188 $ 208,356 Preferred stock - Not subject to mandatory redemption, net 19,192 33,615 Subject to mandatory redemption 739 1,680 Long-term debt: Parent 37,300 - Other 55,000 55,000 204,419 298,651 CURRENT LIABILITIES: Current portion of long-term debt 20,130 115,801 Preferred stock subject to mandatory redemption 80 80 Note payable - 10,000 Accounts payable - Suppliers 13,785 17,781 Affiliates, net - 826 Deferred cost of gas and supplier refunds, net - 434 Accrued general business and realty taxes 525 1,542 Accrued income taxes 27,445 516 Accrued interest 921 2,062 Accrued natural gas transition costs 2,292 2,278 Other 3,609 3,162 68,787 154,482 DEFERRED CREDITS: Deferred income taxes 46,096 48,848 Accrued natural gas transition costs 384 1,144 Unamortized investment tax credits 4,810 4,938 Operating reserves 3,113 3,709 Other 4,389 5,460 58,792 64,099 COMMITMENTS AND CONTINGENCIES (Note 6) TOTAL CAPITALIZATION AND LIABILITIES $ 331,998 $ 517,232 The accompanying notes are an integral part of the financial statements. -4- PG ENERGY INC. STATEMENTS OF CASH FLOWS [CAPTION] Nine Months Ended September 30, 1996 1995 (Thousands of Dollars) [S] [C] [C] CASH FLOW FROM OPERATING ACTIVITIES: Income from continuing operations $ 5,421 $ 3,385 Effects of noncash charges to income - Depreciation 5,890 5,395 Deferred income taxes, net 519 195 Provisions for self insurance 742 889 Other, net 953 1,659 Changes in working capital, exclusive of cash and current portion of long-term debt - Receivables and accrued utility revenues 18,997 16,664 Gas held by suppliers (10,299) (130) Accounts payable (4,639) (2,334) Deferred cost of gas and supplier refunds, net (16,801) 7,207 Other current assets and liabilities, net 1,291 (10,335) Other operating items, net (4,636) 1,077 Net cash provided (used) by continuing operations (2,562) 23,672 Net cash provided (used) by discontinued operations (35,470) 3,764 Net cash provided (used) by operating activities (38,032) 27,436 CASH FLOW FROM INVESTING ACTIVITIES: Additions to utility plant (18,501) (14,907) Proceeds from the sale of discontinued operations 261,752 - Other, net 212 2,560 Net cash provided (used) by investing activities 243,463 (12,347) CASH FLOW FROM FINANCING ACTIVITIES: Issuance of common stock 339 5,383 Repurchase of common stock (85,007) - Repurchase/redemption of preferred stock (15,364) (80) Dividends on common and preferred stock (35,151) (13,484) Issuance of long-term debt to parent 49,900 - Repayment of long-term debt to parent (12,600) - Repayment of long-term debt (50,000) (3,535) Net decrease in bank borrowings (55,854) (3,125) Other, net (1,390) (25) Net cash used for financing activities (205,127) (14,866) NET INCREASE IN CASH AND CASH EQUIVALENTS 304 223 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 328 304 CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 632 $ 527 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest (net of amount capitalized) $ 5,704 $ 16,353 Income taxes $ 34,386 $ 8,338 The accompanying notes are an integral part of the financial statements. -5- PG ENERGY INC. NOTES TO FINANCIAL STATEMENTS (1) GENERAL Nature of the Business. PG Energy Inc. ("PGE"), formerly known as Pennsylvania Gas and Water Company, a wholly-owned subsidiary of Pennsylvania Enterprises, Inc. ("PEI"), is a regulated public utility subject to the jurisdiction of the Pennsylvania Public Utility Commission ("PPUC") for rate and accounting purposes. PGE distributes natural gas to a ten-county area in northeastern Pennsylvania, a territory that includes 116 municipalities, in addition to the cities of Scranton, Wilkes-Barre and Williamsport. The financial statements of PGE have been prepared in accordance with generally accepted accounting principles, including the provisions of Financial Accounting Standards Board ("FASB") Statement 71, "Accounting for the Effects of Certain Types of Regulation," which give recognition to the rate and accounting practices of regulatory agencies such as the PPUC. On October 30, 1996, PGE signed a purchase agreement to acquire all of the capital stock of Honesdale Gas Company, which distributes natural gas to approximately 3,200 customers in portions of Wayne and Pike Counties in northeastern Pennsylvania. This acquisition, which is subject to approval of the PPUC, is expected to be consummated in early 1997. Interim Financial Statements. The interim financial statements included herein have been prepared by PGE, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although PGE believes that the disclosures are adequate to make the information presented not misleading. The results for the interim periods are not indicative of the results to be expected for the year, primarily due to the effect of seasonal variations in weather. However, in the opinion of management, all adjustments, consisting of only normal recurring accruals, necessary to present fairly the results for the interim periods have been reflected in the financial statements. It is suggested that these financial statements be read in conjunction with the financial statements and the notes thereto included in PGE's latest annual report on Form 10-K. Use of Accounting Estimates. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates involve judgments with respect to, among other things, various future economic factors which are difficult to predict and are beyond the control of PGE. Therefore, actual amounts could differ from these estimates. (2) DISCONTINUED OPERATIONS Pursuant to an Asset Purchase Agreement dated April 26, 1995, as amended (the "Agreement"), among PEI, PGE, American Water Works Company, Inc. ("American") and Pennsylvania-American Water Company ("Pennsylvania-American"), a wholly-owned subsidiary of American, PEI and PGE sold substantially all of the -6- assets, properties and rights of PGE's water utility operations to Pennsylvania- American on February 16, 1996. Under the terms of the Agreement, Pennsylvania- American paid PGE $414.3 million consisting of $262.1 million in cash and the assumption of $152.2 million of PGE's liabilities, including $141.0 million of its long-term debt. PGE continued to operate the water utility business until February 16, 1996. The sale price reflected a $6.5 million premium over the book value of the assets sold. However, after transaction costs and the net effect of other items, principally the write-off of certain deferred regulatory assets and deferred credits and the impact of pension and other postretirement benefit expenses relative to an early retirement plan, the sale resulted in an after tax loss of approximately $6.2 million, net of the income from the water operations during the phase-out period (which for financial reporting purposes was April 1, 1995, through February 15, 1996). The sale involved a gain for income tax purposes, primarily because of the accelerated depreciation that had been claimed by PGE with respect to the water utility plant that was sold. It is estimated that the income taxes payable on the sale, for which deferred income taxes had previously been provided, will be approximately $58.6 million, of which $33.5 million had been paid as of September 30, 1996. The cash proceeds from the sale of approximately $203.5 million, net of the estimated $58.6 million of income taxes, have been used by PEI and PGE to retire debt, to repurchase stock (see Note 4 of these Notes to Financial Statements), for construction expenditures and for other working capital purposes. With the sale of PGE's water utility operations, the principal assets of PEI and PGE now consist of PGE's gas utility operations and approximately 46,000 acres of land. The accompanying financial statements reflect PGE's water utility operations as "discontinued operations" effective March 31, 1995. Interest charges relating to indebtedness of PGE were allocated to the discontinued operations based on the relationship of the gross water utility plant that was sold to the total of PGE's gross gas and water utility plant. This is the same method as was utilized by PGE and the PPUC in establishing the revenue requirements of both PGE's gas and water utility operations. None of the dividends on PGE's preferred stock nor any of PEI's interest expense were allocated to the discontinued operations. -7- Selected financial information for the discontinued operations is set forth below: Net Assets of Discontinued Operations [CAPTION] As of December 31, 1995 (Thousands of Dollars) [S] [C] Net utility plant $ 368,742 Current assets (primarily accounts receivable and accrued revenues) 12,756 Deferred charges and other assets 25,752 Total assets acquired by Pennsylvania-American 407,250 Liabilities assumed by Pennsylvania-American - Long-term debt 141,097 Other 5,983 147,080 Net assets acquired by Pennsylvania-American 260,170 Estimated liability for income taxes on sale of discontinued operations (56,710) Estimated net income of discontinued operations during the remainder of the phase-out period 790 Total net assets of discontinued operations $ 204,250 Loss With Respect to Discontinued Operations Three Months Ended Nine Months Ended September 30, September 30, 1996 1995 1996 1995 (Thousands of Dollars) Income from discontinued operations, net of related income taxes of $1,403,000* $ - $ - $ - $ 2,127 Estimated loss on disposal of discontinued operations, net of income during the phase-out period - - (386) (5,831) Loss with respect to discontinued operations $ - $ - $ (386) $(3,704) * Reflects income only through March 31, 1995, the effective date of the discontinuance of PGE's water utility operations for financial statement purposes. (3) CASH DIVIDENDS The cash dividends per share for the nine months ended September 30, 1996, include $9.077 with respect to a special $30.0 million dividend in the form of a 10.125% promissory note that was issued by PGE to PEI on February 16, 1996, in connection with the sale of PGE's water utility operations on such date. This note was paid in full by PGE on March 8, 1996. -8- (4) REPURCHASES OF STOCK On February 16, 1996, PGE repurchased 2,297,297 shares of its common stock from PEI for an aggregate consideration of $85.0 million. Additionally, during the nine-month period ended September 30, 1996, PGE repurchased 132,988 shares of its 9% cumulative preferred stock for an aggregate consideration of $14.4 million and 18,591 shares of its 4.10% cumulative preferred stock for an aggregate consideration of $947,000, largely pursuant to self tender offers conducted during March and April, 1996. On June 17, 1996, PGE also repurchased 9,408 shares of its 5.75% cumulative preferred stock (including 800 shares redeemed in accordance with annual sinking fund provisions) for an aggregate consideration of $838,000. (5) ACCOUNTING CHANGES Long-Lived Assets. In March 1995, FASB Statement 121, "Accounting for the Impairment of Long-Lived Assets", was issued. The provisions of this statement, which are effective for fiscal years beginning after September 15, 1995, require that long-lived assets, identifiable intangibles, capital leases and goodwill be reviewed for impairment whenever events occur or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. In addition, FASB Statement 121 requires that regulatory assets meet the recovery criteria of FASB Statement 71, "Accounting for Effects of Certain Types of Regulation", on an ongoing basis in order to avoid a writedown. The provisions of FASB Statement 121, which PGE adopted effective January 1, 1996, did not have a material impact on the financial position or results of operations of PGE since the carrying amount of all assets, including regulatory assets, are considered recoverable. (6) COMMITMENTS AND CONTINGENCIES Valve Maintenance On November 16, 1993, the PPUC staff issued an Emergency Order, subsequently ratified by the PPUC (the "Emergency Order"), requiring PGE to survey its gas distribution system to verify the location and spacing of its gas shut off valves, to add or repair valves where needed and to establish programs for the periodic inspection and maintenance of all such valves and the verification of all gas service line information. On March 31, 1995, the PPUC adopted an Order approving a plan submitted by PGE for complying with the Emergency Order. PGE does not believe that its compliance with the terms of such Order will have a material adverse effect on its financial position or results of operations. Environmental Matters PGE, like many gas distribution companies, once utilized manufactured gas plants in connection with providing gas service to its customers. None of these plants has been in operation since 1960, and several of the plant sites are no longer owned by PGE. Pursuant to the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"), PGE filed notices with the United States Environmental Protection Agency (the "EPA") with respect to the former plant sites. None of the sites is or was formerly on the proposed or final National Priorities List. The EPA has conducted site inspections and made preliminary assessments of each site and has concluded that no further remedial action is planned. While this conclusion does not constitute a legal prohibition against further regulatory action under CERCLA or other applicable federal or state law, PGE does not believe that additional costs, if any, related to these manufactured gas plant sites would be material to its financial position or results of operations since environmental remediation costs generally are recoverable through rates over a period of time. -9- PG ENERGY INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS DISCONTINUED OPERATIONS Pursuant to an Asset Purchase Agreement dated April 26, 1995, as amended (the "Agreement"), among Pennsylvania Enterprises, Inc. ("PEI"), the parent company of PG Energy Inc. ("PGE"), PGE, American Water Works Company, Inc. ("American") and Pennsylvania-American Water Company ("Pennsylvania-American"), a wholly-owned subsidiary of American, PEI and PGE sold substantially all of the assets, properties and rights of PGE's water utility operations to Pennsylvania- American on February 16, 1996. Under the terms of the Agreement, Pennsylvania- American paid PGE $414.3 million consisting of $262.1 million in cash and the assumption of $152.2 million of PGE's liabilities, including $141.0 million of its long-term debt. PGE continued to operate the water utility business until February 16, 1996. The sale price reflected a $6.5 million premium over the book value of the assets being sold. However, after transaction costs and the net effect of other items, principally the write-off of certain deferred regulatory assets and deferred credits and the impact of pension and other postretirement benefit expenses relative to an early retirement plan, the sale resulted in an after tax loss of approximately $6.2 million, net of the income from the water operations during the phase-out period (which for financial reporting purposes was April 1, 1995, through February 15, 1996.) The cash proceeds from the sale of approximately $203.5 million, net of an estimated $58.6 million of income taxes, have been used by PEI and PGE to retire debt, to repurchase stock, for construction expenditures and for other working capital purposes. With the sale of PGE's water utility operations, the principal assets of PEI and PGE now consist of PGE's gas utility operations and approximately 46,000 acres of land. In accordance with generally accepted accounting principles, PEI's financial statements reflect PGE's water utility operations as "discontinued operations" effective March 31, 1995, and the following sections of Management's Discussion and Analysis generally relate only to PGE's continuing operations. For additional information regarding the discontinued operations, see Note 2 of the accompanying Notes to Financial Statements. -10- RESULTS OF CONTINUING OPERATIONS The following table expresses certain items in PGE's statements of income as percentages of operating revenues for each of the three and nine-month periods ended September 30, 1996, and September 30, 1995: Percentage of Operating Revenues Three Months Ended Nine Months Ended September 30, September 30, 1996 1995 1996 1995 OPERATING REVENUES........................... 100.0% 100.0% 100.0% 100.0% Cost of gas................................ 42.7 40.2 53.8 56.0 OPERATING MARGIN............................. 57.3 59.8 46.2 44.0 OTHER OPERATING EXPENSES: Operation.................................. 40.8 41.8 17.0 15.5 Maintenance................................ 9.8 12.0 3.8 3.5 Depreciation............................... 14.1 14.7 5.4 5.1 Income taxes............................... (14.3) (20.1) 3.1 1.6 Taxes other than income taxes.............. 11.6 11.5 7.6 7.5 Total other operating expenses........... 62.0 59.9 36.9 33.2 OPERATING INCOME (LOSS)...................... (4.7) (0.1) 9.3 10.8 OTHER INCOME (DEDUCTIONS), NET............... - 0.2 0.3 0.2 INTEREST CHARGES............................. (11.9) (23.5) (4.6) (7.8) INCOME (LOSS) FROM CONTINUING OPERATIONS..... (16.6) (23.4) 5.0 3.2 LOSS WITH RESPECT TO DISCONTINUED OPERATIONS. - - (0.4) (3.5) NET INCOME (LOSS)............................ (16.6) (23.4) 4.6 (0.3) DIVIDENDS ON PREFERRED STOCK(1).............. (2.6) (5.7) (1.2) (2.0) EARNINGS (LOSS) APPLICABLE TO COMMON STOCK... (19.2) (29.1) 3.4 (2.3) (1) None of the dividends on preferred stock was allocated to the discontinued operations. Three Months Ended September 30, 1996, Compared With Three Months Ended September 30, 1995 Operating Revenues. Operating revenues increased $1.9 million (15.5%) from $12.1 million for the three-month period ended September 30, 1995, to $14.0 million for the three-month period ended September 30, 1996, primarily as a result of price increases due to increases in the purchased gas cost component of PGE's tariffs (the "gas cost rate") (See "-Rate Matters") and a 79 million cubic feet (6.8%) increase in consumption by PGE's residential and commercial heating customers largely caused by customer growth and slightly cooler weather. Cost of Gas. The cost of gas increased $1.1 million (22.9%) from $4.9 million for the three-month period ended September 30, 1995, to $6.0 million for the three-month period ended September 30, 1996, primarily because of the aforementioned increases in the gas cost rate (see "-Rate Matters") and increased sales to residential and commercial heating customers. -11- Operating Margin. The operating margin increased $766,000 (10.6%) from $7.3 million in the third quarter of 1995 to $8.0 million in the third quarter of 1996. However, as a percentage of operating revenues, the operating margin decreased from 59.8% for the quarter ended September 30, 1995, to 57.3% for the quarter ended September 30, 1996, primarily because of the increased cost of gas. Other Operating Expenses. Other operating expenses increased $1.4 million (19.6%) for the three-month period ended September 30, 1996, compared to the three-month period ended September 30, 1995, and increased as a percentage of operating revenues from 59.9% in the third quarter of 1995 to 62.0% in the third quarter of 1996. These increases were attributable to a number of factors, the most significant of which was a higher level of operation expenses, which increased $654,000 (12.9%) principally as a result of higher payroll and payroll-related costs. Payroll and payroll-related costs increased largely because of charges, which were previously allocated to PGE's discontinued operations, that are now being absorbed by its continuing operations. Also contributing to the increase in other operating expenses was a $220,000 (15.7%) increase in taxes other than income taxes as a result of increased gross receipts tax, which is based on revenues collected from customers, and increased depreciation expense of $184,000 (10.3%) attributable to additions to utility plant. Income taxes increased $437,000 (17.9%) from a credit of $2.4 million in the third quarter of 1995 to a credit of $2.0 million in the third quarter of 1996 due to a lower level of loss before income taxes (for this purpose, operating income net of interest charges). Operating Income (Loss). As a result of the above, the operating loss increased by $656,000 from $3,000 for the three-month period ended September 30, 1995, to $659,000 for the three-month period ended September 30, 1996, and increased as a percentage of total operating revenues for such periods from 0.1% in 1995 to 4.7% in 1996, primarily because of the aforementioned increase in other operating expenses, the effects of which were partially offset by the increased operating margin. Interest Charges. Interest charges decreased by $1.2 million (41.7%) from $2.8 million for the three-month period ended September 30, 1995, to $1.7 million for the three-month period ended September 30, 1996. This decrease was largely attributable to the lower level of indebtedness resulting from the repayment of PGE's $50.0 million term loan and all of its then outstanding bank borrowings on February 16, 1996, with proceeds from the sale of its regulated water utility operations on such date. Income (Loss) From Continuing Operations. The loss from continuing operations decreased $503,000 (17.8%) from $2.8 million for the quarter ended September 30, 1995, to $2.3 million for the quarter ended September 30, 1996. This decrease was largely the result of the matters discussed above, principally the increase in operating margin and decrease in interest charges, the effects of which were partially offset by the increased other operating expenses. Dividends on Preferred Stock. Dividends on preferred stock decreased $327,000 (47.4%) from $690,000 for the three-month period ended September 30, 1995, to $363,000 for the three-month period ended September 30, 1996, primarily as a result of the repurchase by PGE in 1996 of 132,988 shares of its 9% cumulative preferred stock, 9,408 shares of its 5.75% cumulative preferred stock and 18,591 shares of its 4.10% cumulative preferred stock, largely during the second quarter of the year. -12- Earnings (Loss) Applicable to Common Stock. The decrease in loss applicable to common stock of $830,000 (23.6%) from $3.5 million for the three-month period ended September 30, 1995, to $2.7 million for the three-month period ended September 30, 1996, was largely the result of the factors discussed above. As a result of PGE's repurchase of 2,297,297 shares of its common stock from PEI on February 16, 1996, which acted to reduce the weighted average number of shares outstanding for the three-month period ended September 30, 1996, by 40.6%, and the $.03 per share charge for the premium on the repurchase of preferred stock, the loss per share of common stock increased by $.21 per share from $.63 per share for the three-month period ended September 30, 1995, to $.84 per share for the three-month period ended September 30, 1996. While premiums on the repurchase of preferred stock are charged to retained earnings and are not a determinant of earnings applicable to common stock, the premiums associated with repurchases must be taken into account in calculating the earnings (loss) per share of common stock. Nine Months Ended September 30, 1996, Compared With Nine Months Ended September 30, 1995 Operating Revenues. Operating revenues increased $3.3 million (3.2%) from $105.5 million for the nine-month period ended September 30, 1995, to $108.9 million for the nine-month period ended September 30, 1996, primarily as a result of a 1.9 billion cubic feet (13.0%) increase in sales to residential and commercial heating customers. There was a 660 (17.9%) increase in heating degree days from 3,696 (90.7% of normal) during the first nine months of 1995 to 4,356 (106.9% of normal) during the first nine months of 1996. The effects of the increased sales to heating customers were partially offset by lower levels in the purchased gas cost component of PGE's tariffs (the "gas cost rate"). See "-Rate Matters." Cost of Gas. The cost of gas decreased $615,000 (1.0%) from $59.1 million for the nine-month period ended September 30, 1995, to $58.5 million for the nine-month period ended September 30, 1996, primarily because of the aforementioned lower levels in PGE's gas cost rate (see "-Rate Matters"), the effects of which were partially offset by the increased sales to residential and commercial heating customers. Operating Margin. The operating margin increased $3.9 million (8.5%) from $46.4 million in the nine-month period ended September 30, 1995, to $50.3 million in the nine-month period ended September 30, 1996, primarily because of the 1.9 billion cubic feet (13.0%) increase in consumption by residential and commercial heating customers. As a percentage of operating revenues, the margin increased from 44.0% in the first nine months of 1995 to 46.2% in the first nine months of 1996. Other Operating Expenses. Other operating expenses increased $5.1 million (13.2%) from $35.0 million for the nine-month period ended September 30, 1995, to $40.2 million for the nine-month period ended September 30, 1996, and increased as a percentage of operating revenues from 33.2% during the first nine months of 1995 to 36.9% during the first nine months of 1996, in part because of the decrease in cost of gas and the corresponding reduction in revenues. The $5.1 million increase in other operating expenses was attributable to a number of factors, the most significant of which was a $2.2 million (13.2%) increase in operation expenses, primarily as a result of higher payroll and payroll-related costs. Payroll and payroll-related costs increased largely because of charges, which were previously allocated to PGE's discontinued operations, that are now being absorbed by its continuing operations. Also contributing to the higher -13- operating expenses was a $477,000 (8.9%) increase in depreciation expense attributable to additions to PGE's utility plant, as well as a $353,000 (9.5%) increase in maintenance expenses caused by charges relating to the maintenance of gas valves and a $397,000 (5.0%) increase in taxes other than income taxes as a result of increased gross receipts tax. Income taxes increased $1.7 million (105.4%) from $1.7 million in the first nine months of 1995 to $3.4 million in the first nine months of 1996 due to an increase in income before income taxes (for this purpose, operating income net of interest charges). Operating Income (Loss). As a result of the above, operating income decreased by $1.2 million (10.5%) from $11.4 million for the nine-month period ended September 30, 1995, to $10.2 million for the nine-month period ended September 30, 1996, and decreased as a percentage of total operating revenues for such periods from 10.8% in 1995 to 9.3% in 1996, primarily because of the higher level of other operating expenses. Interest Charges. Interest charges decreased by $3.1 million (38.0%) from $8.2 million for the nine-month period ended September 30, 1995, to $5.1 million for the nine-month period ended September 30, 1996. This decrease was largely attributable to the lower level of indebtedness resulting from the repayment of PGE's $50.0 million term loan and all of its then outstanding bank borrowings on February 16, 1996, with proceeds from the sale of its regulated water utility operations on such date. Income (Loss) From Continuing Operations. Income from continuing operations increased $2.0 million (59.9%) from $3.4 million for the nine months ended September 30, 1995, to $5.4 million for the nine months ended September 30, 1996. This increase was largely the result of the matters discussed above, principally the increase in operating margin and the decrease in interest charges, the effects of which were partially offset by the higher level of other operating expenses. Net Income (Loss). The increase in net income of $5.4 million from a loss of $319,000 for the nine-month period ended September 30, 1995, to income of $5.0 million for the nine-month period ended September 30, 1996, was largely the result of the higher income from continuing operations, as discussed above, and the decreased loss with respect to discontinued operations. Dividends on Preferred Stock. Dividends on preferred stock decreased $690,000 (33.3%) from $2.1 million for the nine-month period ended September 30, 1995, to $1.4 million for the nine-month period ended September 30, 1996, primarily as a result of the repurchase by PGE in 1996 of 132,988 shares of its 9% cumulative preferred stock, 9,408 shares of its 5.75% cumulative preferred stock and 18,591 shares of its 4.10% cumulative preferred stock, largely during the second quarter of the year. Earnings (Loss) Applicable to Common Stock. The increase in earnings applicable to common stock of $6.0 million from a loss of $2.4 million for the nine-month period ended September 30, 1995, to income of $3.7 million for the nine-month period ended September 30, 1996, as well as the increase in earnings per share of common stock of $1.05 from a loss of $.43 per share for the nine months ended September 30, 1995, to income of $.62 per share for the nine months ended September 30, 1996 (after a $.37 per share charge for premiums on the repurchase of preferred stock), were the result of higher income from continuing operations and reduced dividends on preferred stock, as discussed above, and the decrease of $.57 per share from $.67 per share for the nine-month period ended -14- September 30, 1995, to $.10 per share for the nine-month period ended September 30, 1996, in the loss with respect to discontinued operations. The increase in earnings applicable to common stock occurred despite a 33.5% decrease in the weighted average number of shares outstanding for the nine-month period ended September 30, 1996, resulting from the aforementioned repurchase of common stock on February 16, 1996. RATE MATTERS Proposed Rate Increase. On May 24, 1996, PGE filed an application with the PPUC seeking an increase in its base gas rates, designed to produce $14.1 million in additional annual revenue, to be effective July 23, 1996. On June 20, 1996, the PPUC suspended this rate increase for seven months (until February 23, 1997) in order to investigate the reasonableness of the proposed rates. On November 7, 1996, PGE and certain parties filing objections to the rate increase request filed a "Settlement Agreement and Joint Petition for Settlement of Rate Investigation" (the "Settlement Petition") with the Administrative Law Judge ("ALJ") assigned to conduct the investigation of the rate increase request. This Settlement Petition provides for an overall 5.3% rate increase that is designed to produce $7.5 million of additional annual revenue. The Settlement Petition requests PPUC approval for the rate increase to become effective by January 15, 1997. Additionally, under the terms of the Settlement Petition, to the extent the proposed rate increase is approved and permitted to become effective no later than January 31, 1997, billing for the impact of the rate increase relative to PGE's residential heating customers (which it is estimated will total $6.6 million on an annual basis) will be deferred, without carrying charges, until July, 1997. It is not presently possible to determine what action either the ALJ or the PPUC will ultimately take with respect to this rate increase request or the Settlement Petition. Gas Cost Adjustment. The provisions of the Pennsylvania Public Utility Code (the "Code"), require that the tariffs of gas distribution companies, such as PGE, be adjusted on an annual basis, and on an interim basis when circumstances dictate, to reflect changes in their purchased gas costs. In addition, effective September 14, 1995, the PPUC adopted regulations that provide for the quarterly adjustment of the annual purchased gas cost rate of larger gas distribution companies, including PGE. Such quarterly adjustments are allowed when the actual purchased gas costs vary from the estimated costs reflected in the respective company's tariffs by 2% or more. In accordance with these procedures, PGE has been permitted to make the following changes since January 1, 1995, to the gas costs contained in its gas tariff rates: [CAPTION] Change in Calculated Effective Rate per MCF Increase (Decrease) Date From To in Annual Revenue [S] [C] [C] [C] December 1, 1996 $3.01 $4.18 $35,500,000 September 1, 1996 2.88 3.01 3,600,000 June 1, 1996 2.75 2.88 3,400,000 December 1, 1995 2.42 2.75 9,600,000 May 15, 1995 3.68 2.42 (8,200,000) The changes in gas rates on account of purchased gas costs have no effect on PGE's earnings since the change in revenue is offset by a corresponding change in the cost of gas. -15- Recovery of FERC Order 636 Transition Costs. On October 15, 1993, the PPUC adopted an annual purchased gas cost ("PGC") order (the "PGC Order") regarding recovery of Federal Energy Regulatory Commission ("FERC") Order 636 transition costs. The PGC Order stated that Account 191 and New Facility Costs ("Gas Transition Costs") are subject to recovery through the annual PGC rate filings made with the PPUC by PGE and other larger local gas distribution companies. The PGC Order also indicated that while Gas Supply Realignment and Stranded Costs ("Non-Gas Transition Costs") are not natural gas costs eligible for recovery under the PGC rate filing mechanism, such costs are subject to full recovery by local distribution companies through the filing of a tariff pursuant to either the existing surcharge or base rate provisions of the Code. The PGC Order further stated that all such filings would be evaluated on a case-by-case basis. PGE was billed a total of $1.3 million of Gas Transition Costs by its interstate pipelines. Of this amount, $858,000 was recovered by PGE over a twelve-month period ended January 31, 1995, through an increase in its PGC rate, $252,000 is being recovered by PGE in its annual PGC rate that the PPUC has approved effective December 1, 1995, and the remaining $213,000 will be recovered by PGE in its PGC rate that the PPUC has approved effective December 1, 1996. By Order of the PPUC entered August 26, 1994, PGE began recovering the Non- Gas Transition Costs that it estimates it will ultimately be billed pursuant to FERC Order 636 through the billing of a surcharge to its customers effective September 12, 1994. It is currently estimated that $10.0 million of Non-Gas Transition Costs will be billed to PGE, generally over a four-year period extending through the fourth quarter of 1997, of which $7.3 million had been billed to PGE and $6.8 million had been recovered from its customers as of September 30, 1996. PGE has recorded the estimated Non-Gas Transition Costs that remain to be billed to it and the amounts remaining to be recovered from its customers. LIQUIDITY AND CAPITAL RESOURCES Sale of Water Utility Operations On February 16, 1996, PGE sold its regulated water operations and certain related assets to Pennsylvania-American for $414.3 million, consisting of $262.1 million in cash and the assumption of $152.2 million of PGE's liabilities, including $141.0 million of its long-term debt. PGE used the $203.5 million of cash proceeds from the sale, after the payment of an estimated $58.6 million of federal and state income taxes (of which $33.5 million had been paid as of September 30, 1996), to retire debt, to repurchase stock, for construction expenditures and for other working capital purposes. In this regard, on February 16, 1996, PGE repurchased 2,297,297 shares of its common stock from PEI for an aggregate consideration of $85.0 million, repaid its $50.0 million term loan due 1996 and all of its then outstanding bank borrowings and temporarily invested the balance of the proceeds. -16- During the nine months ended September 30, 1996, as part of the recapitalization following the sale of its water utility operations PGE repurchased 132,988 shares of its 9% cumulative preferred stock for an aggregate consideration of $14.4 million and 18,591 shares of its 4.10% cumulative preferred stock for an aggregate consideration of $947,000, largely pursuant to self tender offers conducted during March and April, 1996. On June 17, 1996, PGE also repurchased 9,408 shares of its 5.75% cumulative preferred stock (including 800 shares redeemed in accordance with annual sinking fund provisions) for an aggregate consideration of $838,000. Liquidity The primary capital needs of PGE are the funding of its construction program and the seasonal funding of its gas purchases and increases in customer accounts receivable. PGE's revenues are highly seasonal and weather-sensitive, with approximately 75% of its revenues normally being realized in the first and fourth quarters of the calendar year when the temperatures in its service area are the coldest. The cash flow from PGE's operations is generally sufficient to fund a portion of its construction expenditures. However, to the extent external financing is required, it is the practice of PGE to use bank borrowings to fund such expenditures, pending the periodic issuance of stock and long-term debt. Bank borrowings are also used by PGE for the seasonal funding of its gas purchases and increases in customer accounts receivable. With the repayment of its term loan and all its bank borrowings on February 16, 1996, and the availability of cash proceeds from the sale of its regulated water operations, PGE terminated its $60.0 million bank credit agreement. However, in order to finance construction expenditures and to meet its seasonal borrowing requirements, PGE has since made arrangements for a total of $55.5 million of unsecured revolving bank credit, which is deemed adequate for its immediate needs. Specifically, PGE currently has five bank lines of credit with an aggregate borrowing capacity of $55.5 million which provide for borrowings at interest rates generally less than prime and which mature during mid-1997. As of November 7, 1996, PGE had $25.7 million of borrowings outstanding under these bank lines of credit. In addition, PGE can borrow up to $70.0 million from PEI during 1996, and also 1997 (at interest rates generally less than prime), to repay bank borrowings and for construction expenditures and other working capital requirements, to the extent that PEI has funds available for lending to PGE. As of November 7, 1996, PGE had $37.3 million outstanding under its borrowing arrangement with PEI. Such interim borrowings by PGE from PEI will be repaid with proceeds from bank borrowings by PGE. PGE plans to arrange new and replacement bank lines of credit when the funds that are available for borrowing from PEI are no longer available and as it requires additional funding for working capital and other purposes. PGE believes that it will be able to raise in a timely manner such funds as are required for its future construction expenditures, refinancings and other working capital requirements. Long-Term Debt and Capital Stock Financings PGE periodically engages in long-term debt and capital stock financings in order to obtain funds required for construction expenditures, the refinancing of existing debt and various working capital purposes. No long-term debt or capital stock financings were consummated by PGE during the nine-month period ended September 30, 1996. -17- PGE also obtains external funds from the sale of its common stock to PEI in connection with PEI's Dividend Reinvestment and Stock Purchase Plan (the "DRP"). PEI has, however, temporarily suspended the sale of stock to the DRP as a result of the proceeds received from the sale of PGE's water utility operations. As a consequence, although PGE realized $340,000 from the issuance of common stock to PEI in connection with the DRP during the six-month period ended June 30, 1996, PGE has not subsequently so issued any common stock. Construction Expenditures and Related Financings Expenditures for the construction of utility plant by PGE totaled $18.2 million during the first nine months of 1996 and are currently estimated to be $11.4 million during the remainder of the year. Such expenditures are being financed with proceeds from the sale of PGE's regulated water operations, internally-generated funds, loans from PEI and bank borrowings, pending the periodic issuance of stock and long-term debt. Current Maturities of Long-Term Debt and Preferred Stock As of September 30, 1996, $80,000 of PGE's preferred stock and $20.1 million of PGE's bank borrowings were required to be repaid within twelve months. Forward-Looking Statements Certain statements made above relating to plans, conditions, objectives and economic performance go beyond historical information and may provide an indication of future results. To that extent, they are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, and each is subject to factors that could cause actual results to differ from those in the forward-looking statement. -18- PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 10-1 Employment Agreement dated as of June 26, 1996, by and among PEI, PGE and Kenneth L. Pollock -- filed as Exhibit 10-1 to PEI's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996, File No. 0-7812. 10-2 Employment Agreement dated as of August 28, 1996, by and among PEI, PGE and Thomas F. Karam -- filed as Exhibit 10-2 to PEI's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996, File No. 0-7812. 27-1 Financial Data Schedule -- filed herewith. (b) Reports on Form 8-K No reports on Form 8-K were filed during the quarter for which this report is filed. -19- PG ENERGY INC. 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. PG ENERGY INC. (Registrant) Date: November 12, 1996 By: /s/ Thomas J. Ward Thomas J. Ward Secretary Date: November 12, 1996 By: /s/ John F. Kell, Jr. John F. Kell, Jr. Vice President, Financial Services (Principal Financial Officer and Principal Accounting Officer) -20-