UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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 September 30, 1997
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 1-5924
TUCSON ELECTRIC POWER COMPANY
(Exact Name of Registrant as Specified in its Charter)
ARIZONA 86-0062700
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)
220 WEST SIXTH STREET, TUCSON, ARIZONA P.O. BOX 711
85701 85702
(Address of Principal Executive Offices) (Zip Code)
(520) 571-4000
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
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 _____
At November 5, 1997, 32,139,434 shares of the registrant's Common Stock,
no par value (the only class of Common Stock), were outstanding.
TABLE OF CONTENTS
Page
------
Definitions.............................................................iii
Independent Accountants' Review Report....................................1
PART I - FINANCIAL INFORMATION
Item 1. -- Financial Statements
Comparative Condensed Consolidated Statements of Income..............2
Comparative Condensed Consolidated Statements of Cash Flows..........3
Comparative Condensed Consolidated Balance Sheets....................4
Notes to Condensed Consolidated Financial Statements
Note 1. Tax Assessments.............................................5
Note 2. Rate Matters................................................5
Note 3. Springerville Coal Contract.................................6
Note 4. Consolidated Subsidiaries...................................6
Note 5. Long-Term Debt..............................................6
Note 6. Income Taxes................................................7
Note 7. New Accounting Standard.....................................8
Note 8. Reclassifications...........................................8
Item 2. -- Management's Discussion and Analysis of Financial Condition and
Results of Operations
Overview.............................................................9
Competition
Wholesale.......................................................10
Retail..........................................................11
Holding Company Proposal............................................14
Retail Rate Proposal................................................14
Accounting for the Effects of Regulation............................15
Investments in Energy Related Ventures..............................15
Dividends on Common Stock...........................................16
Earnings............................................................17
Results of Operations
Results of Utility Operations
Sales and Revenues..............................................18
Operating Expenses..............................................19
Other Income....................................................20
Interest Expense...............................................20
Events Affecting Future Results of Utility Operations
NTUA Wholesale Power Contract...................................20
Springerville Coal Supply Contract..............................21
Liquidity and Capital Resources..........................................21
Cash Flows..........................................................21
Financing Developments
Sale of New Bonds...............................................22
Financing Application Filed with ACC............................23
Year 2000 Issue..........................................................24
Safe Harbor for Forward-Looking Statements...............................24
PART II - OTHER INFORMATION
Item 1. -- Legal Proceedings
Tax Assessments..................................................25
Item 6. -- Exhibits and Reports on Form 8-K.............................25
Signature Page...........................................................26
Exhibit Index............................................................27
DEFINITIONS
The abbreviations and acronyms used in the 1997 Third Quarter Form 10-Q are
defined below:
- ----------------------------------------------------------------------------
ACC.................... Arizona Corporation Commission.
ADOR................... Arizona Department of Revenue.
AET.................... Advanced Energy Technologies, Inc.
Common Stock........... The Company's common stock, without par value.
Company or TEP......... Tucson Electric Power Company.
EITF................... Emerging Issues Task Force of the Financial
Accounting Standards Board.
FAS 71................. Statement of Financial Accounting Standards #71:
Accounting for the Effects of Certain Types of
Regulation.
FAS 101................ Statement of Financial Accounting Standards #101:
Regulated Enterprises - Accounting for the
Discontinuation of Application of FAS 71.
FAS 121................ Statement of Financial Accounting Standards #121:
Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to be Disposed Of.
FERC................... Federal Energy Regulatory Commission.
First Mortgage Bonds... First mortgage bonds issued under the General First
Mortgage.
General First Mortgage. The Indenture, dated as of April 1, 1941, of Tucson
Gas,Electric Light and Power Company to The Chase
National Bank of the City of New York, as trustee,
as supplemented and amended.
IDBs................... Industrial development revenue or pollution control
bonds.
Irvington.............. Irvington Generating Station.
Irvington Lease........ The leveraged lease arrangement relating to Irvington
Unit 4.
kWh.................... Kilowatt-hour(s).
MEH.................... Millenium Energy Holdings, Inc.
MRA.................... Master restructuring agreement between the Company
and the Banks which includes the Renewable Term Loan,
Revolving Credit and certain replacement
reimbursement agreements.
MSR.................... Modesto, Santa Clara and Redding Public Power Agency.
MW..................... Megawatt(s).
NEV.................... New Energy Ventures, LLC.
1994 Rate Order........ ACC Rate Order concerning an increase in the
Company's retail base rates and certain regulatory
write-offs, issued January 11, 1994.
1996 Rate Order........ ACC Rate Order concerning an
increase in the Company's retail base rates and the
recovery of Springerville Unit 2 costs, issued March
29, 1996.
NTUA................... Navajo Tribal Utility Authority.
NOL.................... Net Operating Loss carryforward for income tax
purposes.
Renewable Term Loan.... Credit facility that replaced the Term Loan pursuant
to the MRA Sixth Amendment, dated as of November 1,
1994, and effective March 7, 1995.
Revolving Credit....... $50 million revolving credit facility entered into
between a syndicate of banks and the Company.
SEC.................... Securities and Exchange Commission.
Shareholders........... Holders of Common Stock.
Springerville.......... Springerville Generating Station.
Springerville Coal
Handling Facilities
Leases................ Leveraged lease arrangements relating to the coal
handling facilities serving Springerville.
Springerville Common
Facilities Leases..... Leveraged lease arrangements relating to one-half
interest in certain facilities at Springerville used
in common with Springerville Unit 1 and Springerville
Unit 2.
Springerville Unit 1
Leases................ Leveraged lease arrangements relating to
Springerville Unit 1, and one half interest in
certain facilities at Springerville used in common
with Springerville Unit 1 and Springerville Unit 2.
SSP.................... Shared Savings Proposal filed with the ACC July 9,
1997 requesting a 1.1% annual retail rate reduction.
Valencia............... Valencia Energy Company, previously a wholly owned
subsidiary of the Company, merged into the Company on
May 31, 1996.
VSP.................... Voluntary Severance Plan offered to Company employees
and implemented in May 1996.
WSCC................... Western Systems Coordinating Council.
INDEPENDENT ACCOUNTANTS' REVIEW REPORT
Tucson Electric Power Company and its Stockholders
220 West Sixth Street
Tucson, Arizona 85701
We have reviewed the accompanying condensed consolidated balance sheet of
Tucson Electric Power Company and subsidiaries (the Company) as of September
30, 1997 and the related condensed consolidated statements of income for the
three-month and nine-month periods ended September 30, 1997 and 1996 and cash
flows for the nine-month periods ended September 30, 1997 and 1996. These
financial statements are the responsibility of the Company's management.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and of making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted
in accordance with generally accepted auditing standards, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to such condensed consolidated financial statements for them to be in
conformity with generally accepted accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated balance sheet and statement of capitalization of
the Company as of December 31, 1996 and the related consolidated statements of
income, cash flows, and changes in stockholders' equity (deficit) for the year
then ended (not presented herein); and in our report dated January 27, 1997, we
expressed an unqualified opinion on those consolidated financial statements. In
our opinion, the information set forth in the accompanying condensed
consolidated balance sheet as of December 31, 1996 is fairly stated, in all
material respects, in relation to the consolidated balance sheet from which it
has been derived.
DELOITTE & TOUCHE LLP
Tucson, Arizona
October 20, 1997
PART I - FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
- -----------------------------------------------------------------------------
The September 30 condensed consolidated financial statements are
unaudited but reflect all normal recurring accruals and other adjustments
which are, in the opinion of management, necessary for a fair presentation of
the results for the interim periods covered. Due to seasonal fluctuations in
sales, the quarterly results are not indicative of annual operating results.
Also see Item 2. - Management's Discussion and Analysis of Financial
Condition and Results of Operations. This quarterly report should be
reviewed in conjunction with the Company's 1996 Form 10-K.
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended
September 30,
1997 1996
-Thousands of Dollars-
Operating Revenues
Retail Customers $201,566 $195,261
Amortization of MSR Option Gain Regulatory Liability - 5,014
Sales for Resale 29,523 22,803
--------- ---------
Total Operating Revenues 231,089 223,078
--------- ---------
Operating Expenses
Fuel and Purchased Power 66,243 60,198
Capital Lease Expense 25,786 25,824
Amortization of Springerville Unit 1 Allowance (7,009) (7,273)
Other Operations 28,402 23,535
Maintenance and Repairs 8,284 7,991
Depreciation and Amortization 21,598 24,735
Taxes Other Than Income Taxes 12,517 21,573
Voluntary Severance Plan Expense(Gain) - (3,443)
Income Taxes 19,158 17,322
--------- ---------
Total Operating Expenses 174,979 170,462
--------- ---------
Operating Income 56,110 52,616
--------- ---------
Other Income (Deductions)
Income Taxes 13,337 66,510
Reversal of Loss Provision - 8,472
Interest Income 2,035 1,264
Other Income (Deductions) (1,214) 637
--------- ---------
Total Other Income (Deductions) 14,158 76,883
--------- ---------
Interest Expense
Long-Term Debt - Net 16,935 14,843
Interest Imputed on Losses Recorded at Present Value 8,101 8,006
Other Interest Expense 1,817 4,152
--------- ---------
Total Interest Expense 26,853 27,001
--------- ---------
Net Income $ 43,415 $102,498
========= =========
Average Shares of Common Stock Outstanding (000) 32,136 32,133
========= =========
Net Income per Average Share $ 1.35 $ 3.19
========= =========
See Notes to Condensed Consolidated Financial Statements.
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Nine Months Ended
September 30,
1997 1996
-Thousands of Dollars-
Operating Revenues
Retail Customers $490,752 $482,511
Amortization of MSR Option Gain Regulatory Liability 8,105 15,040
Sales for Resale 69,483 58,088
--------- ---------
Total Operating Revenues 568,340 555,639
--------- ---------
Operating Expenses
Fuel and Purchased Power 163,382 156,128
Capital Lease Expense 78,450 78,073
Amortization of Springerville Unit 1 Allowance (21,028) (21,818)
Other Operations 82,785 71,983
Maintenance and Repairs 29,899 26,345
Depreciation and Amortization 64,817 73,285
Taxes Other Than Income Taxes 38,235 51,310
Voluntary Severance Plan Expense(Gain) - 10,555
Income Taxes 21,070 12,934
--------- ---------
Total Operating Expenses 457,610 458,795
--------- ---------
Operating Income 110,730 96,844
--------- ---------
Other Income (Deductions)
Income Taxes 39,280 80,371
Reversal of Loss Provision 10,154 8,472
Interest Income 6,434 4,166
Other Income (Deductions) (3,149) 706
--------- ---------
Total Other Income (Deductions) 52,719 93,715
--------- ---------
Interest Expense
Long-Term Debt - Net 47,505 44,600
Interest Imputed on Losses Recorded at Present Value 24,555 24,592
Other Interest Expense 6,581 8,161
--------- ---------
Total Interest Expense 78,641 77,353
--------- ---------
Net Income $ 84,808 $113,206
========= =========
Average Shares of Common Stock Outstanding (000) 32,135 32,133
========= =========
Net Income per Average Share $ 2.64 $ 3.52
========= =========
See Notes to Condensed Consolidated Financial Statements.
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended
September 30,
1997 1996
-Thousands of Dollars-
Cash Flows from Operating Activities
Cash Receipts from Retail Customers $496,765 $491,791
Cash Receipts from Sales for Resale 67,850 56,096
Fuel and Purchased Power Costs Paid (154,333) (137,145)
Wages Paid, Net of Amounts Capitalized (48,115) (61,657)
Payment of Other Operations and Maintenance Costs (68,277) (56,420)
Capital Lease Interest Paid (80,469) (83,200)
Interest Paid, Net of Amounts Capitalized (47,057) (49,153)
Taxes Paid, Net of Amounts Capitalized (60,735) (65,612)
Contract Termination Fee Paid (40,000) -
Emission Allowance Inventory Sale - 4,120
Interest Received 6,344 4,716
Income Taxes Paid (1,050) (1,066)
Other 1,529 (3,101)
--------- ---------
Net Cash Flows - Operating Activities 72,452 99,369
--------- ---------
Cash Flows from Investing Activities
Construction Expenditures (47,937) (51,092)
Investments in and Loans to Joint Ventures (3,998) (6,116)
Other 1,567 250
--------- ---------
Net Cash Flows - Investing Activities (50,368) (56,958)
--------- ---------
Cash Flows from Financing Activities
Proceeds from Issuance of Long-Term Debt 125,067 31,400
Proceeds from Borrowings on the Renewable Term Loan - 14,000
Payments to Retire Long-Term Debt (112,310) (25,575)
Payments on Renewable Term Loan (31,000) (14,000)
Payments to Retire Capital Lease Obligations (13,969) (35,629)
Other (381) 297
--------- ---------
Net Cash Flows - Financing Activities (32,593) (29,507)
--------- ---------
Net Increase (Decrease) in Cash and Cash Equivalents (10,509) 12,904
Cash and Cash Equivalents, Beginning of Year 130,291 85,094
--------- ---------
Cash and Cash Equivalents, End of Period $119,782 $ 97,998
========= =========
See Notes to Condensed Consolidated Financial Statements.
SUPPLEMENTAL CONDENSED CONSOLIDATED CASH FLOW INFORMATION
Nine Months Ended
September 30,
1997 1996
-Thousands of Dollars-
Net Income $ 84,808 $ 113,206
Adjustments to Reconcile Net Income to Net Cash Flows
Depreciation and Amortization Expense 64,817 73,285
Deferred Income Taxes and
Investment Tax Credits - Net (19,260) (68,504)
Lease Payments Deferred 6,771 3,386
Regulatory Amortizations, Net of Interest Imputed
on Losses Recorded at Present Value (4,578) (12,266)
Contract Termination Fee (39,038) -
Reversal of Loss Provision (10,154) (8,472)
Other (279) (2,673)
Changes in Assets and Liabilities which Provided
(Used) Cash Exclusive of Changes Shown Separately
Accounts Receivable (34,964) (25,611)
Materials and Fuel (6,900) 1,291
Accounts Payable 7,805 582
Taxes Accrued 15,386 25,313
Other Current Assets and Liabilities 4,678 (7,717)
Other Deferred Assets and Liabilities 3,360 7,549
--------- ---------
Net Cash Flows - Operating Activities $ 72,452 $ 99,369
========= =========
See Notes to Condensed Consolidated Financial Statements.
COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
ASSETS
September 30, December 31,
1997 1996
- Thousands of Dollars -
Utility Plant
Plant in Service $2,156,454 $2,129,205
Utility Plant Under Capital Leases 893,064 893,064
Construction Work in Progress 84,181 74,210
----------- -----------
Total Utility Plant 3,133,699 3,096,479
Less Accumulated Depreciation and Amortization (965,695) (922,947)
Less Accumulated Amortization of Capital Leases (69,267) (56,240)
Less Springerville Unit 1 Allowance (166,664) (163,388)
----------- -----------
Total Utility Plant - Net 1,932,073 1,953,904
----------- -----------
Investments and Other Property 71,372 69,289
----------- -----------
Current Assets
Cash and Cash Equivalents 119,782 130,291
Accounts Receivable 100,869 65,905
Materials and Fuel 37,256 30,356
Deferred Income Taxes - Current 6,981 10,223
Other 14,879 14,026
----------- -----------
Total Current Assets 279,767 250,801
----------- -----------
Deferred Debits - Regulatory Assets
Income Taxes Recoverable Through Future Rates 171,921 173,731
Deferred Common Facility Costs 58,857 60,762
Deferred Contract Termination Fee 49,038 -
Deferred Springerville Unit 2 Costs 13,913 21,260
Deferred Lease Expense 12,332 15,067
Other Deferred Regulatory Assets 8,472 8,004
Deferred Debits - Other 16,399 15,723
----------- -----------
Total Deferred Debits 330,932 294,547
----------- -----------
Total Assets $2,614,144 $2,568,541
=========== ===========
See Notes to Condensed Consolidated Financial Statements.
COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
CAPITALIZATION AND OTHER LIABILITIES
September 30, December 31,
1997 1996
- Thousands of Dollars -
Capitalization
Common Stock $ 645,296 $ 645,243
Capital Stock Expense (6,357) (6,357)
Accumulated Deficit (420,790) (505,598)
----------- -----------
Common Stock Equity 218,149 133,288
Capital Lease Obligations 887,820 895,867
Long-Term Debt 1,205,951 1,223,025
----------- -----------
Total Capitalization 2,311,920 2,252,180
----------- -----------
Current Liabilities
Short-Term Debt - 3,567
Current Obligations Under Capital Leases 15,163 10,383
Current Maturities of Long-Term Debt 500 1,635
Accounts Payable 36,611 28,806
Interest Accrued 45,447 57,404
Taxes Accrued 39,393 24,007
Contract Termination Fee Payable 10,000 -
Other 16,462 15,614
----------- -----------
Total Current Liabilities 163,576 141,416
----------- -----------
Deferred Credits and Other Liabilities
Deferred Income Taxes - Noncurrent 74,722 96,422
Accumulated Deferred Investment Tax Credits
Regulatory Liability 12,576 15,188
MSR Option Gain Regulatory Liability - 7,853
Other Regulatory Liabilities 17,602 17,596
Other 33,748 37,886
----------- -----------
Total Deferred Credits and Other Liabilities 138,648 174,945
----------- -----------
Total Capitalization and Other Liabilities $2,614,144 $2,568,541
=========== ===========
See Notes to Condensed Consolidated Financial Statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
- -----------------------------------------------------------------------------
NOTE 1. TAX ASSESSMENTS
- ------------------------
Ruling on Arizona Sales Tax Assessments - Coal Sales
The Arizona Department of Revenue (ADOR) issued transaction privilege
(sales) tax assessments to the Company alleging that Valencia was liable for
sales tax on gross income received from coal sales, transportation and coal-
handling services to the Company for the period November 1985 through May
1996. The Company protested these assessments. On September 12, 1996, the
Arizona Court of Appeals upheld the validity of the assessment issued for the
period November 1985 through March 1990. On July 1, 1997, the Arizona
Supreme Court granted a Petition for Review filed by the Company. Oral
argument for the Petition for Review is scheduled to begin December 18, 1997.
Additionally, the Company is protesting the assessments for the period April
1990 through May 1996.
Previously, the Company had recorded an expense through the Consolidated
Statements of Income and related liability for the amount of sales taxes and
interest thereon which the Company believed was probable of incurrence for
the period November 1985 through May 1996. Generally, Arizona law requires
payment of an assessment prior to pursuing the appellate process. The
Company has previously paid, under protest, a total of $23 million of the
disputed sales tax assessments, subject to refund in the event the Company
prevails.
On May 31, 1996, Valencia was merged into the Company. Effective with
the merger, Valencia no longer supplies coal to the Company. Instead the
Company acquires coal directly from the supplier. As a result, the Company
believes it is not liable for sales tax computed on a basis similar to the
assessments described above subsequent to May 31, 1996. For periods
subsequent to May 31, 1996, the Company continues to record an estimated
interest expense on the above assessments.
Arizona Sales Tax Assessments - Leases
The ADOR has issued transaction privilege (sales) tax assessments to the
lessors from whom the Company leases certain property. The assessments
allege sales tax liability on a component of rents paid by the Company on the
Springerville Unit 1 Leases, Springerville Common Facilities Leases,
Irvington Lease and Springerville Coal Handling Facilities Leases.
Assessments cover the period August 1, 1988 to September 30, 1993. Pursuant
to indemnification provisions of the lease agreements, if the ADOR prevails
the Company must reimburse the lessors for taxes paid by them.
In the opinion of management, the Company has recorded, through the
Consolidated Statements of Income in current and prior years, a liability for
the amount of sales taxes and interest thereon for which the Company believes
incurrence is probable as of September 30, 1997. In the event that the
assessments by the ADOR are sustained, an additional liability would result.
Although it is reasonably possible that the ultimate resolution of such
matter could result in additional sales tax expense of up to approximately
$21 million in excess of amounts recorded, management and outside tax counsel
believe that the Company has meritorious defenses to mitigate or eliminate
the assessed amounts.
Based on the current status of the legal proceedings, the Company
believes that the ultimate resolution of such dispute will occur over a
period of two to four years. Based on consultations with counsel and
considering the amounts already accrued, the Company believes that the
resolution of this tax matter should not have a material adverse effect on
the Company's Consolidated Financial Statements.
NOTE 2. RATE MATTERS
- ---------------------
On July 9, 1997, the Company filed with the ACC a request for an annual
rate reduction of $6.8 million (or 1.1%) for retail customers. This filing
is in the form of a Shared Savings Proposal (SSP) which promotes a sharing of
benefits with customers of cost containment efforts and the mitigation of
potential stranded costs associated with the introduction of retail electric
competition in Arizona. The cost containment savings were realized primarily
from renegotiated fuel contracts and the Company's Voluntary Severance
Program, which reduced the Company's workforce by approximately 15%. No date
has been set for formal consideration of the matter by the ACC.
The Company proposed that additional savings be used by the Company to
mitigate potential stranded costs through accelerated amortization of retail
excess capacity deferrals. Retail excess capacity deferrals represent those
operating and capital costs associated with Springerville Unit 2 capacity,
which were deemed by the ACC to not be recoverable in retail rates prior to
the 1994 and 1996 Rate Orders. Such retail excess capacity deferrals totaled
$89.9 million and $93.6 million at September 30, 1997 and December 31, 1996,
respectively. Such deferrals are not reflected in the accompanying Condensed
Consolidated Balance Sheets because such retail excess capacity deferrals,
while deferred for regulatory purposes, were not deferred for financial
reporting purposes but were expensed as incurred. The proposed $7.2 million
increase in annual amortization expense for such excess capacity deferrals
would decrease the amortization period from 20 years to 7.76 years. The
proposed increase in amortization expense would be reflected in the Company's
regulatory accounting records but would have no impact on the expenses
included in the Company's financial accounting statements.
NOTE 3. SPRINGERVILLE COAL CONTRACT
- ------------------------------------
On June 27, 1997, the Company signed an agreement with the coal supplier
for the Springerville Generating Station to terminate the existing coal
supply contract and enter into a new, more cost effective contract with the
same supplier. A $50 million termination fee was incurred by the Company and
is payable in three installments: $30 million paid on June 30, 1997, $10
million paid on September 30, 1997, and $10 million due March 31, 1998. The
previous coal supply contract covered the useful lives of Springerville Units
1 and 2 and contained a bilateral option to renegotiate the contract price
and escalation procedures in 2009 and every five years thereafter. The new
coal contract has an initial term of 13 years, beginning July 1, 1997, with
an option to extend ten years thereafter. The new contract also contains more
favorable terms to the Company for certain volume, incremental volume, base
price, incremental price and price adjustment mechanism requirements.
The Company applied, as part of the SSP, to the ACC requesting that the
termination fee be recorded as a regulatory asset and amortized to fuel
expense over the 13-year term of the new agreement. On July 29, 1997, the
ACC issued an interim accounting order allowing the Company to defer the $50
million termination fee as a regulatory asset in the Company's Condensed
Consolidated Balance Sheet until the ACC decides whether the $50 million
termination fee should be recovered through retail rates. The interim
accounting order also allowed the Company to begin amortizing the termination
fee to fuel expense. If the ACC ultimately disallows recovery, the
unamortized portion of the $50 million termination fee would immediately be
expensed. No date has been set for formal consideration of the matter by the
ACC.
NOTE 4. CONSOLIDATED SUBSIDIARIES
- ----------------------------------
Upon dissolution of certain subsidiaries which formed a part of the
Company's former investment operations, in June 1997, the Company reversed a
provision for loss, recorded in prior years, resulting in income of
approximately $10.2 million.
Effective September 1, 1997, Millenium Energy Holdings, Inc. (MEH), a
wholly owned subsidiary of the Company, exercised an option to acquire a 50%
ownership in New Energy Ventures, LLC (NEV). NEV is a buyer's agent
providing load aggregation and advisory services to energy consumers.
Concurrently with the exercise of the option, MEH made a capital contribution
in the amount of $0.8 million and extended a $3.0 million member loan to NEV.
The investment in NEV is included in the Company's Condensed Consolidated
Balance Sheet at September 30, 1997 under Investments and Other Property and
in the Company's Condensed Consolidated Statement of Cash Flows for the nine
months ended September 30, 1997 as Investments in and Loans to Joint
Ventures.
NOTE 5. LONG-TERM DEBT
- -----------------------
In February 1997, the Company repaid the outstanding Renewable Term Loan
balance of $31 million thereby reducing its Long-Term Debt. At September 30,
1997, the Company had $127.5 million available for borrowing under the
Renewable Term Loan.
In April 1997, the City of Farmington, New Mexico issued $80.4 million
of Pollution Control Revenue Bonds for the benefit of the Company. The
proceeds were used in June 1997 to redeem $47.9 million principal amount of
previously issued 6.25% bonds that would have matured in 2003 and $32.5
million principal amount of previously issued 6.10% bonds that would have
matured in 2007. The new bonds, which are unsecured, bear interest at 6.95%
and mature in 2020.
In April 1997, the Coconino County, Arizona Pollution Control
Corporation issued $36.7 million of Pollution Control Revenue Bonds for the
benefit of the Company. The net proceeds loaned to the Company were used, in
part, to redeem, in June 1997, $16.7 million principal amount of previously
issued variable rate bonds that would have matured in 2031 and the remaining
portion is being used to fund $20 million of construction costs of additional
pollution abatement facilities at Navajo Generating Station. The new bonds,
which are unsecured, bear interest at 7.125% and mature in 2032.
In April 1997, the Coconino County, Arizona Pollution Control
Corporation issued $14.7 million of Pollution Control Revenue Bonds for the
benefit of the Company. The net proceeds loaned to the Company were used in
June 1997 to redeem $14.7 million principal amount of previously issued
variable rate bonds that would have matured in 2031. The new bonds, which
are unsecured, bear interest at 7.00% and mature in 2032.
In October 1997, the Industrial Development Authority of the County of
Pima, Arizona issued $247.5 million of Industrial Development Revenue Bonds
for the benefit of the Company. The net proceeds from the issuance will be
used in November 1997, to redeem $245 million principal amount of previously
issued variable rate bonds that would have matured between 2018 and 2025 and
to finance improvements to the Company's lower voltage electric transmission
and distribution system in Pima County, Arizona. The new bonds, which are
unsecured, were sold in three series: Series A ($22.5 million) bears interest
at 6.10% and matures in 2025; Series B ($150 million) and Series C ($75
million) bear interest at 6.00% and mature in 2029.
NOTE 6. INCOME TAXES
- ---------------------
The expense (benefit) for income taxes included in the Comparative
Condensed Consolidated Statements of Income consists of the following:
Three Months Ended
September 30,
1997 1996
---------- ----------
- Thousands of Dollars -
Operating Expenses:
Deferred Tax Expense
Federal $ 15,143 $ 13,785
State 4,015 3,552
---------- ----------
Total 19,158 17,337
Investment Tax Credit Amortization - (15)
---------- ----------
Total Expense Included in Operating Expenses 19,158 17,322
---------- ----------
Other Income (Deductions):
Deferred Tax Expense
Federal 339 3,760
State 114 978
---------- ----------
Total 453 4,738
Reduction in Valuation Allowance (13,120) (70,283)
Investment Tax Credit Amortization (670) (965)
---------- ----------
Total Benefit Included in
Other Income (Deductions) (13,337) (66,510)
---------- ----------
Total Expense (Benefit) for Federal
And State Income Taxes $ 5,821 $ (49,188)
========== ==========
Nine Months Ended
September 30,
1997 1996
---------- ----------
- Thousands of Dollars -
Operating Expenses:
Deferred Tax Expense
Federal $ 16,671 $ 10,320
State 4,409 2,659
---------- ----------
Total 21,080 12,979
Investment Tax Credit Amortization (10) (45)
---------- ----------
Total Expense Included in Operating Expenses 21,070 12,934
---------- ----------
Other Income (Deductions):
Deferred Tax Expense
Federal 4,538 3,377
State 1,197 937
---------- ----------
Total 5,735 4,314
Reduction in Valuation Allowance (42,413) (81,296)
Investment Tax Credit Amortization (2,602) (3,389)
---------- ----------
Total Benefit Included in
Other Income (Deductions) (39,280) (80,371)
---------- ----------
Total Expense (Benefit) for Federal
And State Income Taxes $ (18,210) $ (67,437)
========== ==========
The differences between the income tax expense (benefit) and the amount
obtained by multiplying income before income taxes by the U.S. statutory
federal income tax rate are as follows:
Three Months Ended
September 30,
1997 1996
---------- ----------
- Thousands of Dollars -
Federal Income Tax Expense at
Statutory Rate $ 17,233 $ 18,659
State Income Tax Expense,
Net of Federal Deduction 2,656 2,868
Investment Tax Credit Amortization (670) (980)
Reduction in Valuation Allowance (13,120) (70,283)
Other (278) 548
---------- ----------
Total Expense (Benefit) for Federal
and State Income Taxes $ 5,821 $ (49,188)
========== ==========
Nine Months Ended
September 30,
1997 1996
---------- ----------
- Thousands of Dollars -
Federal Income Tax Expense at
Statutory Rate $ 23,309 $ 16,019
State Income Tax Expense,
Net of Federal Deduction 3,591 2,462
Investment Tax Credit Amortization (2,612) (3,434)
Reduction in Valuation Allowance (42,413) (81,296)
Use of Capital Loss Carryforwards - (1,663)
Other (85) 475
---------- ----------
Total Expense (Benefit) for Federal
and State Income Taxes $ (18,210) $ (67,437)
========== ==========
The reduction in the valuation allowance and corresponding NOL benefit are
primarily due to revisions in the estimated amount of NOLs that the Company
expects to utilize on future income tax returns. At September 30, 1997, on a
cumulative basis the Company has recognized in its income statement the full
amount of the NOL benefit that the Company expects to utilize on future
income tax returns. Additional amounts of NOL benefit which may be
recognized in the future in the Company's income statement are at present
indeterminate due to the interplay of open tax years for which tax
assessments may be made and varying expiration dates of federal and state NOL
carryforwards.
NOTE 7. NEW ACCOUNTING STANDARD
- --------------------------------
In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128 (FAS 128), Earnings per
Share. This Statement simplifies the standards for computing earnings per
share (EPS) and replaces the presentation of primary EPS with a presentation
of basic EPS. It requires a dual presentation of basic and diluted EPS for
companies with complex capital structures on the face of the income
statement. The Company is required to adopt FAS 128 in the fourth quarter of
1997. The Company does not expect the adoption of FAS 128 to have a material
impact on the Company's calculation of EPS.
NOTE 8. RECLASSIFICATIONS
- --------------------------
Minor reclassifications have been made to the prior year financial
statements to conform to the current year's presentation.
ITEM 2. - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
- -------------------------------------------------------------------------------
The following contains information regarding the results of the Company's
operations during the third quarter and first nine months of 1997 compared with
the third quarter and first nine months of 1996, the outlook for dividends on
Common Stock, and changes in liquidity and capital resources of the Company
during the third quarter and first nine months of 1997. Also management's
expectations of identifiable material trends are discussed.
OVERVIEW
- --------
Earnings for the Company declined during the third quarter and first nine
months of 1997 relative to the same periods in 1996 primarily due to lower
recognition of NOL tax benefits in the third quarter of 1997. Net income was
$43.4 million in the third quarter of 1997, compared with $102.5 million in the
third quarter of 1996. Income tax benefits related to prior period net
operating losses totaled $13.1 million in the third quarter of 1997 compared
with $70.3 million in the third quarter of 1996. Other one-time items impacting
third quarter results include $3.3 million in pre-tax new business investment
expenses in the third quarter of 1997 and the following items recorded in the
third quarter of 1996: an $8.5 million pre-tax reversal of loss provision
related to the Company's former investment subsidiaries, a $3.4 million pre-tax
pension gain related to the Company's Voluntary Severance Plan, and a $9.2
million pre-tax charge related to a court ruling on contested sales tax
expense. Excluding the recognition of these tax benefits and other one-time
adjustments, the Company's ongoing net income increased by 7% to $32.3 million
in the third quarter of 1997 from $30.1 million in the same period of 1996.
Factors contributing to this improvement were growth in the number of customers
in the Company's retail service area as well as increased kilowatt-hour sales
to both retail and wholesale customers.
Net income for the first nine months of 1997 was $84.8 million, compared
with $113.2 million during the comparable 1996 period. Income tax benefits
related to prior period net operating losses for the nine month periods were
$42.4 million for 1997 and $81.3 million for 1996. Other one-time items
impacting the nine month results, in addition to those listed above for the
third quarter, include a $14.0 million pre-tax VSP expense recorded in the
second quarter of 1996 (resulting in a nine month net pre-tax expense of $10.6
million), a $10.2 million pre-tax reversal of loss provision recorded in the
second quarter of 1997 related to the Company's former investment subsidiaries,
$7.0 million in pre-tax new business investment expenses in 1997 and $2.8
million in pre-tax VSP expense related to post-retirement benefits other than
pensions recorded in the first quarter of 1997. Excluding the recognition of
tax benefits and other one-time adjustments, the Company's ongoing net income
increased by 9% to $42.2 million for the first nine months of 1997 from $38.5
million in the same period in 1996. See Results of Utility Operations below.
Despite such improvements, the Company's financial prospects continue to
be subject to significant economic, regulatory and other uncertainties, some of
which are beyond the Company's control. These uncertainties include the extent
to which the Company, due to continued high financial and operating leverage,
can alter operations and reduce costs in response to industry changes or
unanticipated economic downturns. The Company's success will depend, in part,
on the Company's ability to contain the costs of serving retail customers and
the level of sales to such customers. Although the Company anticipates
continued growth in sales over the next five years primarily as a result of
anticipated population and economic growth in the Tucson area, a number of
factors such as changes in the economic and regulatory environment and the
increasingly competitive electric markets could affect the Company's levels of
sales.
The Company is developing strategies to address the uncertainties
discussed above as well as to position itself to benefit from the changing
regulatory environment. Such strategies include the implementation of enhanced
cost measurement and management techniques, organizational realignment and
staffing reductions, and the development of new entities to provide energy
services to markets beyond the Company's retail service territory. Based on
cost containment measures implemented by the Company, a proposal to share
savings with the Company's retail customers was recently filed by the Company
with the ACC. See Retail Rate Proposal below. Additionally, the Company
successfully extended the power sale agreement with a key wholesale customer
and has taken steps to reduce the cost of fuel supplied to the Company's
largest generating facility. See Results of Operations, Events Affecting
Future Results of Utility Operations below.
If the Company is unable to make sales at prices adequate to recover its
costs or if, for other reasons, the Company fails to maintain or improve its
cash flows, the Company's ability to meet its obligations may be jeopardized.
During the period 1999-2003, $192 million of the Company's long-term debt
obligations will mature. Excluding letters of credit relating to bonds that
will be redeemed in November 1997, letters of credit supporting $529 million of
the Company's long-term variable rate debt obligations also have scheduled
expiration dates between December 31, 1999 and December 31, 2002. See
Financing Developments below. Should the credit ratings on the Company's
senior debt securities reach investment grade levels on certain dates or during
certain periods subsequent to January 1, 1998, the expiration dates for such
letters of credit would move forward to the period December 31, 1998 to
December 31, 2000. In the event that expiring letters of credit are not
replaced or extended, the corresponding variable rate debt obligations would
be subject to mandatory redemption. While the Company intends to pay or
refinance maturing bonds, and to replace or extend expiring letters of credit,
there can be no assurance that the Company will be able to pay such debt or
replace or extend such letters of credit. The Company's future cash flows will
also be affected by the level of interest rates due to the significant amount
of variable rate debt outstanding. See Liquidity and Capital Resources below.
The Company's capital structure is highly leveraged. Although the Company has
been successful in 1997 in refinancing certain of its tax-exempt variable rate
debt on an unsecured fixed rate basis, the Company's ability to raise capital
(through either public or private financings) is limited. The Company's ability
to obtain debt financing is limited due to the restrictive covenants contained
in existing obligations to creditors. To the extent the Company refinances its
debt obligations in order to repay them when due, such refinancing may be made
on terms which may be adverse to the Company. Such terms could include, among
other things, higher interest rates and various restrictive covenants, such as
dividend payment restrictions. Access to equity capital may be limited because
of the Company's present inability to pay dividends. See Dividends on Common
Stock below.
As described in Liquidity and Capital Resources, Financing Developments
below, the Company filed an application with the ACC for authority to implement
various financings intended to address the financial uncertainties outlined
above. This strategy includes the proposed refinancing of certain variable
rate tax-exempt obligations on a fixed-rate basis, the proposed replacement
of the credit facilities provided under the MRA with one or more new credit
facilities, the proposed refinancing of certain first mortgage bonds, and the
proposed implementation of a direct stock purchase plan. The ACC approved a
portion of this financing application on August 26, 1997, which allowed the
Company to proceed with the refinancing of certain tax-exempt variable rate
debt obligations on October 1, 1997. The ACC is expected to rule on the
remaining portions of the financing application in the fourth quarter of 1997.
During the next twelve months, the Company expects to be able to fund
operating activities and construction expenditures with internal cash flows,
existing cash balances, and, if necessary, drawdowns under the Renewable Term
Loan and/or borrowings under the Revolving Credit. As discussed in
Liquidity and Capital Resources below, there are a variety of factors that
could cause actual cash flows to differ materially from projected cash flows.
As of November 5, 1997, the Company's cash balance including cash equivalents
was approximately $137 million. Cash balances are invested in investment grade,
money-market securities with an emphasis on preserving the principal amount
invested.
COMPETITION
- -----------
WHOLESALE
The Company competes with other utilities, marketers and independent power
producers in the sale of electric capacity and energy in the wholesale market.
The Company's prices for wholesale sales of capacity and energy, generally, are
not permitted to exceed rates determined on a cost of service basis. In the
current market, wholesale prices are substantially below costs determined on a
fully allocated cost of service basis, but, in all instances, wholesale sales
have been made at prices which exceed the level necessary to recover fuel and
other variable costs. It is expected that competition to sell capacity will
remain vigorous, and that prices may remain at or near current levels for at
least the next several years, due to increased competition and surplus capacity
in the southwestern United States. Competition for the sale of capacity and
energy is influenced by many factors, including the availability of capacity in
the southwestern United States, the availability and prices of natural gas and
oil, spot energy prices and transmission access. In addition, the Energy Policy
Act of 1992 has promoted increased competition in the wholesale electric power
markets by encouraging the participation of utility affiliates, independent
power producers and other non-utility participants in the development of power
generation.
The FERC issued two orders pertaining to transmission access in April
1996. FERC Order No. 888, among other things, requires all public utilities
that own, control, or operate interstate transmission facilities to offer
transmission service to others under a single tariff that incorporates certain
minimum terms and conditions of transmission service established by the FERC.
This tariff must also be used by public utilities for their own wholesale
market transactions. Transmission and generation services for new wholesale
service are to be unbundled and priced separately. A Phase I open access tariff
containing the terms and conditions outlined in the Order was filed by the
Company on July 9, 1996. The Company subsequently filed a Stipulation in Offer
of Settlement regarding the proposed tariff. On July 17, 1997, the FERC
approved the settlement. That settlement approved the Company's rates for
service,made amendments to certain wholesale contracts and required the Company
to make a Section 205 filing for its 69kV-138kV transmission system, the rates
for which were agreed upon in the settlement. The Company made its Section 205
filing for its 69kV-138kV on August 15, 1997. FERC accepted that filing on
October 10, 1997, thereby incorporating the rates for 69kV-138kV transmission
service into the Company's Open Access Tariff.
FERC Order No. 889 requires transmission service providers to establish or
participate in an open access same-time information system (OASIS) that provides
information on the availability of transmission capacity to wholesale market
participants. The order also establishes standards of conduct that are designed
to prevent employees of a public utility engaged in marketing functions from
obtaining preferential access to OASIS-related information or from engaging in
unduly discriminatory business practices. The Company is in compliance with
these requirements.
On March 4, 1997, the FERC issued Orders 888-A and 889-A which require the
Company to make an additional compliance filing of its tariff and to comply
with certain additional OASIS requirements. The Company has made its compliance
tariff filing and is in the process of complying with the additional OASIS
requirements.
The Company and several other electric utilities located in the
southwestern United States have recently begun to investigate the feasibility
of forming an independent system operator for the region. It is presently
contemplated that such an organization, if formed, would be responsible for
ensuring transmission reliability and nondiscriminatory access to the regional
transmission grid. All of the major transmission owners in the Southwest, as
well as a number of users of the transmission system, are involved in the
feasibility study. Three sets of public meetings were held in order to obtain
public input to the study. The initial feasibility study was completed in
September 1997 and the participants are reviewing the results prior to deciding
whether to proceed with the detailed developmental work. The formation of an
independent system operator would be subject to approval by the FERC and state
regulatory authorities in the region. The financial aspects of forming an
independent system operator, including the potential effects on the Company's
future results of operations, will be examined as part of the development work.
Given the level of competition already present in the wholesale market for
electricity, the Company does not believe that FERC Order No. 888 or Order No.
889 will have a material effect on the Company's future results of operations.
However, such orders could assume greater significance if the Company's retail
service territory were to be opened to competing suppliers of electricity.
RETAIL
Under current law, the Company is not in direct competition with any other
regulated electric utility for electric service in the Company's retail service
territory. However, the Company does compete against gas service suppliers and
others who may provide energy services which would be substitutes for,or permit
bypass of, the Company's services. In addition, in December 1996, the ACC
adopted rules that, if implemented, require a phase-in of retail electric
competition in Arizona over a four year period beginning January 1, 1999.
Currently, electric energy for meeting retail customers' needs primarily
competes with natural gas, an alternative fuel source for certain retail energy
uses. Such uses may include heating, cooling and a limited number of other
energy applications. In most applications, electric energy is a cost effective
source of energy compared with natural gas. Also, customers, particularly
industrial and large commercial customers, may own and operate facilities to
generate their own electric energy requirements. If such facilities meet
certain technical and operational standards, they may be eligible for treatment
under federal law as "qualifying facilities", which in turn would permit the
owner to require the local electric utility to purchase the output of such
facilities at the latter's "avoided cost" pursuant to the Public Utility
Regulatory Policies Act of 1978, as amended. Such facilities may be operated by
the customers themselves or by other entities engaged for such purpose. The
company presently does not have any material contracts which require it to
purchase the output of qualifying facilities.
The Company actively markets energy and customized energy-related services
to meet customer needs. The Company has to date lost no customers to self-
generation in part because of such efforts. For example, the Company's two
principal mining customers, which provide approximately 8% of the Company's
total annual revenues from retail customers, each have considered self-
generation. However, new contracts and/or amendments were executed with both of
such mining customers that included, among other things, price reductions and
term extensions. In 1996, the Company negotiated contract amendments with its
largest mining customer. The contract amendments include, among other things,
price reductions and a change in service from a firm basis to an interruptible
basis, which includes a market pricing mechanism covering a portion of the
customer's electrical load. Such contract is scheduled to expire in January
2003. The contract with the Company's other principal mining customer is
scheduled to expire in March 2001. In June 1997, the Company entered into a new
electric service agreement with this customer to furnish additional load to a
new copper solvent extraction plant. Also, in September 1997, the ACC approved
an amendment to this customer's electric service agreement which allows for a
reduction in price, an increase in load, the provision of interruptible service
and a change in payment procedures. The conditions of this amendment will
expire with the contract. Early terminations of the contracts by mining
customers require at least one and up to two years prior notice. No such
notices have been received. The ability to enter into or extend contracts, to
avoid early termination, and to retain customers will be dependent on, among
other things, the Company's ability to contain its costs, market conditions and
alternatives available to customers. Changes in service requirements (from a
firm basis to an interruptible basis) may also permit the Company to delay
additions to peaking capacity.
In December 1996, the ACC voted to adopt rules on retail electric
competition. The rules, if implemented, require each "Affected Utility"
(defined below) to open its retail service area to competing electric service
providers on a phased-in basis over the period 1999 to 2003. Beginning no later
than January 1, 1999, retail customers representing at least 20% of each
Affected Utility's 1995 peak demand will be eligible to choose their electric
service provider from companies certificated by the ACC. Such service providers
would include Affected Utilities as well as other entities (including power
marketers and out-of-state utilities) that apply for and receive a certificate
of convenience and necessity from the ACC. Beginning no later than January 1,
2001,retail customers representing at least 50% of each Affected Utility's 1995
peak demand will be eligible to choose their service provider. All remaining
retail customers would then be eligible to choose from certificated service
providers by January 1, 2003. Under the rules, Affected Utilities will be
required to provide distribution wheeling services (i.e., retail wheeling) at
rates approved by the ACC in order to facilitate sales by competing energy
providers. Such wheeling services would involve the transmission of energy
produced by other entities over the Company's transmission and distribution
system to consumers located in the Company's present retail service area.
While retail wheeling will expose the Company's service area to increased
competition, it will also open additional retail markets into which the Company
may sell its electric power.
The Affected Utilities whose service territories will be open to competing
service providers under the rules include the Company, Arizona Public Service
Company, Citizens Utilities Company, and several electric cooperatives.
However, electric cooperatives will be permitted to request a modification to
the phase-in schedule in order to preserve their tax exempt status or to modify
power supply arrangements and related loan agreements. Each of the Affected
Utilities will be eligible to offer electric service to customers of other
certificated entities within Arizona. Participation in competitive retail
markets by other electric utilities which are not regulated by the ACC, such as
the Salt River Project and certain municipal utilities, will be permitted under
the rules on a similar reciprocal basis (i.e., these utilities would have to
allow their service territories to be similarly open to competing service
providers).
The rules require new market entrants to obtain a certificate of
convenience and necessity from the ACC prior to offering retail electric
service. New market entrants will be required to demonstrate adequate technical
and financial capabilities to the ACC prior to certification. In addition, by
January 1, 1999, all competitive market participants, including Affected
Utilities, will be required to obtain at least one-half of one percent of the
energy sold competitively in the Arizona retail market from new solar
generating resources. This required percentage will increase to one percent on
January 1, 2002. New solar resources are defined under the rules as
photovoltaic or solar thermal resources that are installed on or after January
1, 1997. Electric service providers not in compliance with these solar
resource standards will be subject to a penalty of up to 30 cents per kWh to
be applied to the kWh deficiency in solar energy provided.
The rules specify that the ACC will allow the recovery of unmitigated
stranded costs by Affected Utilities. Stranded cost is defined in the rules as
the net difference between the value of prudent jurisdictional assets and
obligations under traditional regulation and the market value of those assets
and obligations in a competitive retail market. In order to recover stranded
costs,utilities would have to demonstrate to the ACC that they have taken every
feasible, cost effective measure to mitigate or offset stranded costs, and
utilities would have to file estimates of unmitigated stranded costs with the
ACC which are fully supported by analyses and records of market transactions
undertaken by willing buyers and sellers. Furthermore, Affected Utilities would
have to seek ACC approval of distribution charges or other means of recovering
unmitigated stranded costs from customers who reduce or terminate service as a
direct result of retail competition. The rules specify that other issues
related to the analysis and recovery of stranded costs would be examined by a
working group following adoption of the rules. Until such time as the ACC
adopts specific guidelines for quantifying unmitigated stranded costs,including
the methods used to identify and value jurisdictional assets and obligations,
the Company believes that any estimate of unmitigated stranded costs would be
highly speculative.
Each Affected Utility will be required to file unbundled service tariffs
with the ACC by December 31, 1997, for the following services: distribution
wheeling service, metering and meter reading services, billing and collection
services, open access transmission service (as approved by the FERC, if
applicable), ancillary services (as defined by FERC Order No. 888), information
services such as the provision of customer information to other service
providers, and other ancillary services necessary for safe and reliable system
operation. Until such time as the ACC determines that retail competition has
been substantially implemented, each Affected Utility will also have to provide
standard offer bundled service equivalent to the services currently being
provided at regulated rates to all consumers located in their current retail
service areas.
Pursuant to the rules, working groups have been formed to analyze various
issues related to retail competition. Each working group consists of members
representing a wide variety of interests including the ACC Staff, consumers,
Affected Utilities, and potential new service providers. Separate working
groups have been established to investigate issues related to the
quantification and recovery of stranded costs, the unbundling of utility
services and rates,the maintenance of system reliability and safety, the
methods to be used in determining consumer participation during the early phase
- -in periods, and certain legal issues related to the rules. Reports by the
working groups for stranded costs and unbundling of utility services and rates
have been delivered to the ACC and are in the process of being reviewed.
Reports by the other working groups are expected in the fourth quarter of 1997.
The Company is actively participating in each of the working groups
investigating retail competition issues.
On January 10, 1997, the Company filed with the ACC a motion for
reconsideration and request for stay of the rules. Concerns expressed by the
Company in its motion included the potential impact on system reliability,
mechanisms for stranded cost quantification and recovery,the ability to compete
fairly with public power entities and recipients of federal preference power,
and certain legal deficiencies which would likely result in legal appeals and
litigation. On January 30, 1997, the Company's motion for reconsideration was
deemed denied by the ACC by operation of law. On February 28,1997, the Company
filed an appeal of the ACC order in both the Arizona Superior Court and the
Arizona Court of Appeals. On June 19, 1997, the Arizona Court of Appeals
dismissed the appeal at the request of the Company. At the same time, the
Company filed a motion for Summary Judgment in the Arizona Superior Court. This
motion was argued and the results are pending before the judge. At the present
time, the Company is unable to predict the outcome of the Superior Court appeal
or the effects such rules, in their present form, would have on the Company's
future results of operations.
The Arizona Legislature is also investigating the potential merits of
retail electric competition. Legislation was passed in 1996 requiring the
establishment of a joint legislative study committee on electric industry
competition. This committee is charged with studying and making recommendations
on a wide variety of issues related to electric industry competition. The
committee is to complete a report to the legislature no later than December 31,
1997. Such report is to contain a proposal for electric utility competition for
implementation by December 31, 1999. An advisory committee on electric industry
competition was also created, consisting of members representing electric
consumers, electric utilities, various State offices and agencies, and other
interested parties. The Company has a representative on such advisory committee
who is actively participating as a committee member. Three subcommittees of the
advisory committee were formed for purposes of evaluating the timing of retail
competition, reviewing tax issues related to retail competition and identifying
specific legislative actions necessary to implement retail competition. The
reports have been issued and the Legislature is now considering the
recommendations.
The Company cannot predict whether or not there will be competing or
conflicting initiatives on industry restructuring from both the ACC and the
Arizona Legislature. However, the Company believes that certain matters
contained in the ACC's rules on retail competition may require legislative
changes, while other matters may require constitutional amendments.
Additionally, several federal initiatives regarding retail electric competition
have been introduced in Congress which, if passed, could modify, augment or
preempt the actions taken by the ACC or the Arizona Legislature. The Company
will continue to assess the likely impact of the ACC's rules on retail
competition, proposed legislation on retail competition, and other potential
market reforms on the Company. At the present time the Company is unable to
predict the ultimate impact of increased retail competition on the Company's
future results of operations. See Accounting for the Effects of Regulation
below for a discussion of the potential impact of increased competition on the
Company's accounting policies.
HOLDING COMPANY PROPOSAL
- ------------------------
On April 4, 1997, the Company filed with the ACC a notice of
intent to organize a public utility holding company. If approved, the
Company intends to establish, through a one-for-one share exchange, a
new corporate structure in which the Company will be a subsidiary of a
new holding company named UniSource Energy Corporation. The Company
is seeking to establish a holding company structure because the
Company believes that it is in the best interests of its Shareholders
for the Company to participate in various segments of the evolving and
expanding electric energy business. The Company believes that such
participation would be facilitated and enhanced by the holding company
structure, a structure commonly used in the electric industry and
other industries to conduct different lines of business. In May 1995,
Shareholders approved the formation of a holding company and the
related one-for-one share exchange. If regulatory approvals are
received, it is likely that no further Shareholder approval would be
required to effect the share exchange. On September 25, 1997, the
FERC approved the Company's application to form a holding company. On
October 2 and 3, 1997, the ACC held hearings on the Company's holding
company application. The Company expects a decision from the ACC
sometime in the fourth quarter of 1997.
If the holding company structure is established, substantially
all of the assets of the holding company initially following the share
exchange would consist of the Company's Common Stock. The holding
company would rely primarily on funding sources other than TEP to fund
its operations and to capitalize affiliate companies because the
Company is currently prohibited from paying dividends (see
Dividends on Common Stock below) and because the Company may be
prohibited from making investments in the holding company or
affiliated companies. Also, the ACC's affiliated interest rules would
limit certain transactions between the holding company and the Company
unless approved by the ACC. Accordingly, funds for the holding
company would be limited until the holding company obtains outside
financing or until the affiliate companies are able to pay cash
dividends to the holding company. The Company is reviewing various
methods for the holding company to obtain outside financing, including
the issuance of new equity by the holding company.
In the unlikely event the holding company incurs liabilities in
excess of cash flow available from the Company, the affiliate
companies or outside financings, the holding company might not have
sufficient cash available to meet such liabilities. Under such
circumstances the Company may be required to seek waivers of the
provisions of certain of its credit agreements and leases and the
affiliated interest rules in order to permit the Company to provide
interim financing to the holding company. There can be no assurance
that a holding company structure will be implemented in the future,
that the holding company will be able to obtain outside financing, or
that the Company would be able to obtain necessary waivers if so
required.
RETAIL RATE PROPOSAL
- --------------------
On July 9, 1997, the Company filed with the ACC a request for an
annual rate reduction of $6.8 million (or 1.1%) for retail customers.
Previously, pursuant to the March 1996 Rate Order by the ACC, the
Company implemented a 1.1% retail rate increase, and agreed to a rate
moratorium period whereby the Company committed not to file for a
change in base rates prior to January 1, 2000, except under certain
circumstances which include the sharing with customers of benefits of
cost containment efforts.
The July 1997 filing is in the form of a Shared Savings Proposal
(SSP) which promotes a sharing of benefits with customers of cost
containment efforts and the mitigation of potential stranded costs
associated with the introduction of retail electric competition in
Arizona. In the SSP, the Company identified approximately $23 million
in annual pre-tax cost containment measures of which $20.8 million is
allocable to ACC jurisdictional operation. These savings were
realized primarily from renegotiated fuel contracts and the Company's
Voluntary Severance Program, which reduced the Company's workforce by
approximately 15%. No date has been set for formal consideration of
the matter by the ACC.
The proposed $6.8 million rate reduction represents a 50/50
sharing with customers of $13.6 million of cost containment efforts.
The Company proposed that additional savings be used by the Company to
mitigate potential stranded costs through accelerated amortization of
retail excess capacity deferrals. Retail excess capacity deferrals
represent those operating and capital costs associated with
Springerville Unit 2 capacity, which were deemed by the ACC to not be
recoverable in retail rates prior to the 1994 and 1996 Rate Orders.
Such retail excess capacity deferrals totaled $89.9 million and $93.6
million at September 30, 1997 and December 31, 1996, respectively.
The proposed $7.2 million increase in annual amortization expense for
such retail excess capacity deferrals would decrease the amortization
period from 20 years to 7.76 years. The proposed increase in
amortization expense would be reflected in the Company's regulatory
accounting records but would have no impact on the expenses included
in the Company's financial accounting statements. See
Note 2 of Notes to Condensed Consolidated Financial Statements,Rate
Matters.
ACCOUNTING FOR THE EFFECTS OF REGULATION
- ----------------------------------------
The Company prepares its financial statements in accordance with
the provisions of FAS 71. This statement requires a cost-based rate-
regulated utility to reflect the effect of regulatory decisions in its
financial statements. In certain circumstances, FAS 71 requires that
certain costs and/or obligations be reflected in a deferral account in
the balance sheet and not be reflected in the statement of income or
loss until matching revenues are recognized. Therefore, the Company's
Consolidated Balance Sheets at September 30, 1997, and at December 31,
1996, contain certain line items (for example, Deferred Debits -
Regulatory Assets, Accumulated Deferred Investment Tax Credits
Regulatory Liability, MSR Option Gain Regulatory Liability, and Other
Regulatory Liabilities) solely as a result of the application of FAS
71. In addition, a number of line items in the Company's Consolidated
Statements of Income for the quarters ended September 30, 1997 and
1996, and the nine months ended September 30, 1997 and 1996, also
reflect the application of FAS 71.
As noted in Competition, Retail above, on December 23, 1996,
the ACC voted to adopt rules on retail electric competition. However,
the ACC has not yet adopted specific guidelines for quantifying
unmitigated stranded costs, including the methods used to identify and
value jurisdictional assets and obligations. The Company, in reliance
on previous rate orders, believes that it will recover the full costs
of its investments in utility plant assets and regulatory assets. If
less than full recovery is provided, write-offs of assets may occur
and the Company may be unable to continue to apply FAS 71.
Further, in response to the legislation adopted by the State of
California in 1996 establishing competitive markets for electricity in
that state, the SEC questioned the continued applicability of FAS 71
by the generation operations of California investor-owned utilities
even though the recovery of stranded costs is provided through a
statutory funding mechanism. In May and July 1997 the Financial
Accounting Standards Board Emerging Issues Task Force (EITF)
considered this issue, as similar legislation has been passed or
initiated in states other than California. Based on the conclusions
of the EITF, at some point in the future, the Company may be unable to
continue to apply FAS 71 to the generation portion of the business,
even if it believes it will recover the full amount of its costs under
the ACC competition phase-in plan. The Company is unable to predict
the outcome of these matters.
If, at some point in the future, the Company determines that all
or a portion of the Company's regulated operations no longer meet the
criteria for continued application of FAS 71, the Company would be
required to adopt the provisions of FAS 101 for that portion of the
operations for which FAS 71 no longer applied. Adoption of FAS 101
would require the Company to write off its regulatory assets and
liabilities as of the date of adoption of FAS 101 and would preclude
the future deferral in the balance sheet of costs not recovered
through rates at the time such costs were incurred, even if such costs
were expected to be recovered in the future. Based on the balances of
the Company's regulatory assets and liabilities as of September 30,
1997, the Company estimates that if FAS 101 were adopted and applied
to all segments of the Company's operations, an extraordinary loss of
$183 million, which includes a reduction for the related deferred
income taxes of $101 million, would be required. The Company's cash
flows would not be affected by the adoption of FAS 101.
At the present time, the Company recovers the costs of its plant
assets through its regulated revenues. If in the future the Company
discontinues accounting according to the provisions of FAS 71, the
Company would also need to consider whether the markets in which the
Company is then selling power will allow the Company to recover the
costs of its plant assets. At that time, if market prices and other
recoveries are not expected to allow the Company to recover the costs
of its plant assets, additional write-downs may be required in
accordance with the provisions of FAS 121.
INVESTMENTS IN ENERGY-RELATED VENTURES
- --------------------------------------
As described in Note 4 of Notes to Condensed Consolidated Financial
Statements,Consolidated Subsidiaries, a wholly owned subsidiary of the
Company, Millenium Energy Holdings, Inc., exercised an option to acquire a
50% ownership interest in New Energy Ventures, LLC (NEV) effective
September 1, 1997. NEV is a buyer's agent providing load aggregation
and advisory services to customers in California and the Northeastern
region of the United States. Prior to exercising its option to
acquire NEV, the Company provided funding to NEV pursuant to a
consulting services contract since its formation in 1995. NEV seeks
contracts to operate on either (i) a fixed commodity basis or a
limited shared savings basis, such that NEV will be paid a percentage
of the electricity cost saving that accrue to their clients, or (ii)
as a fee based advisor on energy services, cogeneration, independent
power or third party provider options.
In addition to the Company's investment in NEV, the Company
continues to evaluate and pursue other energy related investment
opportunities. Nations Energy Corporation (Nations), a wholly-owned
subsidiary established for the purpose of investing in independent
power projects, continues to pursue projects in both the domestic and
foreign markets. Advanced Energy Technologies, Inc. (AET), a wholly
owned subsidiary of the Company, holds a 50% ownership interest in
Global Solar Energy, LLC (Global Solar), an energy-related company
which developed a proprietary process for manufacturing flexible,
thin-film, photo-voltaic cells. Global Solar has recently established
a manufacturing facility in Tucson, AZ and currently plans to begin
commercial production in 1998. In July 1997, SWPP Investment Company
(SWPP), a wholly-owned subsidiary, entered into a joint venture with
three Mexican investment partners to form Sentinel Concrete Utility
Poles, a domestic distributor of concrete power poles and related
products. SWPP holds a 50% ownership interest in this joint venture.
SWPP International, Ltd. (SWPPI), a wholly owned subsidiary of SWPP,
holds a 50% ownership interest in a manufacturer and international
distributor of concrete power poles and related products. Southwest
Energy Solutions, Inc. (SES), a wholly owned subsidiary formed in
January 1997, provides ancillary energy products and services to
retail customers.
In comparison to the Company's investment in regulated utility
assets, the Company's current investments in Nations, AET, SWPP, SES,
and NEV are not material in terms of recorded assets or net income.
As of September 30, 1997, the Company's Condensed Consolidated Balance
Sheet reflects an investment in energy-related ventures of
approximately $26 million (included in Investments and Other
Property).
DIVIDENDS ON COMMON STOCK
- -------------------------
The Company is precluded by restrictive covenants in certain
debt agreements from declaring or paying dividends. No dividend on
common stock has been declared or paid since 1989.
Under the applicable provisions of amendments to the Arizona
General Corporation Law, a company is permitted to make distributions
to shareholders unless, after giving effect to such distribution,
either (i) the company would not be able to pay its debts as they come
due in the usual course of business, or (ii) the company's total
assets would be less than the sum of its total liabilities plus the
amount necessary to satisfy any liquidation preferences of
shareholders with preferential rights. The Company is not currently
prevented from declaring and paying a dividend under such provisions.
The Company's ability to pay a dividend is restricted by certain
covenants of the General First Mortgage. So long as certain series of
First Mortgage Bonds (aggregating $184 million in principal amount)
are outstanding, these covenants restrict the payment of dividends on
Common Stock if certain cash flow coverage and retained earnings tests
are not met. The cash flow coverage test would prevent the Company
from paying dividends on its Common Stock until such time as the
Company's cash flow coverage ratio, as defined therein, is greater or
equal to a ratio of 2 to 1, and the retained earnings test would
permit dividend payments if the Company has positive retained earnings
rather than an accumulated deficit. As of September 30, 1997, the
Company had a cash flow coverage ratio in excess of 2 to 1 and the
Company's accumulated deficit was $421 million. Such covenants will
remain in effect until the First Mortgage Bonds of such series have
been paid or redeemed. The latest maturity of such First Mortgage
Bonds is in 2003.
The MRA contains a dividend restriction based on the amount of
retained earnings. Such restriction will no longer apply if (i) the
Renewable Term Loan and the Revolving Credit have been paid in full
and the commitments relating thereto have been terminated and (ii) the
Company's senior long-term debt is rated investment grade. At
November 5, 1997, there was no outstanding balance due under the
Renewable Term Loan, and to date no amounts have been borrowed under
the Revolving Credit. Commitments relating to such facilities permit
the Company to borrow $127.5 million under the Renewable Term Loan and
$50 million under the Revolving Credit. The Company's senior long-
term debt is currently rated below investment grade.
In order for the Company to pay a dividend when such covenants
would otherwise restrict such payment, the Company would have to (i)
obtain a waiver or an amendment to the MRA's retained earnings
covenant, or replace the MRA with one or more new bank credit
facilities, and (ii) redeem all outstanding First Mortgage Bonds of
the series that contain dividend restrictions or amend the General
First Mortgage. Such General First Mortgage amendment would require
approval by holders of 75% of all First Mortgage Bonds.
In addition to such restrictive covenants, the Federal Power Act
states that dividends shall not be paid out of funds properly included
in the capital account. It is unclear whether such provisions of the
Federal Power Act restrict the Company from paying dividends.
EARNINGS
- --------
The Company recorded net income of $43.4 million in the third
quarter of 1997 compared with net income of $102.5 million in the
third quarter of 1996. The net income per average share of Common
Stock was $1.35 for the third quarter of 1997 compared with net income
per average share of Common Stock of $3.19 for the third quarter of
1996. Excluding the impact of the recognition of tax benefits and
other one-time adjustments, 1997 third quarter ongoing net income was
$32.3 million or $1.01 per share compared with ongoing net income of
$30.1 million or $0.94 per share for the third quarter of 1996.
For the first nine months of 1997, the Company recorded net
income of $84.8 million, compared with net income of $113.2 million
for the first nine months of 1996. The net income per average share
of Common Stock was $2.64 for the first nine months of 1997, compared
with a net income per average share of Common Stock of $3.52 for the
first nine months of 1996. Excluding the impact of the recognition of
tax benefits and other one-time adjustments, ongoing net income for
the first nine months of 1997 was $42.2 million or $1.31 per share
compared with $38.5 million or $1.20 million per share for the first
nine months of 1996.
RESULTS OF OPERATIONS
- ---------------------
RESULTS OF UTILITY OPERATIONS
SALES AND REVENUES
Comparisons of kilowatt-hour sales and electric revenues are
shown below:
Three Months Ended Increase/(Decrease)
September 30 1997 1996 Amount Percent
- ------------------------- --------- --------- -------- -------
Electric kWh Sales (000):
Retail Customers 2,321,385 2,240,499 80,886 3.6%
Sales for Resale 921,220 836,721 84,499 10.1
--------- --------- -------
Total 3,242,605 3,077,220 165,385 5.4
Electric Revenues (000):
Retail Customers $201,566 $195,261 $ 6,305 3.2%
Amortization of MSR
Option Gain
Regulatory Liability 0 5,014 (5,014) (100.0)
Sales for Resale 29,523 22,803 6,720) 29.5
--------- --------- ---------
Total $231,089 $223,078 $ 8,011 3.6
========= ========= =========
Nine Months Ended Increase/(Decrease)
September 30 1997 1996 Amount Percent
- -------------------------- --------- --------- -------- -------
Electric kWh Sales (000):
Retail Customers 5,830,042 5,718,042 112,000 2.0%
Sales for Resale 2,385,481 2,231,072 154,409 6.9
---------- --------- ---------
Total 8,215,523 7,949,114 266,409 3.4
Electric Revenues (000):
Retail Customers $490,752 $482,511 $ 8,241 1.7%
Amortization of MSR
Option Gain
Regulatory Liability 8,105 15,040 (6,935) (46.1)
Sales for Resale 69,483 58,088 11,395 19.6
---------- -------- ---------
Total $568,340 $555,639 $ 12,701 2.3
========== ======== =========
KWh sales to retail customers increased by 3.6% in the third
quarter of 1997 compared with the third quarter of 1996 due to warmer
weather conditions and a 2.1% increase in the average number of retail
customers. KWh sales to retail customers increased by 2.0% in the
first nine months of 1997 compared with the same period in 1996, due
primarily to a 2.4% increase in average number of retail customers for
the nine month period. Based on cooling degree days, a commonly used
measure in the electric industry that is calculated by subtracting 75
from the average of the high and low daily temperatures, the Tucson
area registered an increase of approximately 18% in such cooling
degree days for the third quarter of 1997 compared with the same
period in 1996, and an increase of approximately 7% in such cooling
degree days compared with the ten year average for the same period
from 1987 to 1996. Cooling degree days for the third quarter of 1997
were 1016, compared to 862 for the third quarter of 1996 and 953 for
the ten year average.
Revenues from sales to retail customers increased by 3.2% in the
third quarter of 1997 compared with the third quarter of 1996 due to
the higher kWh sales discussed above. The increase in retail revenues
for the quarter was slightly less than the increase in retail kWh
sales due to a 6% decrease in revenues per kWh sold to mining
customers. The change in average price of sales to mining customers
reflects the impact of the renegotiation of the contract with the
Company's largest mining customer in 1996. Revenues from sales to
retail customers in the first nine months of 1997 increased by 1.7%
compared with the same period in 1996. The increase in kWh sales for
the first nine months of the year offset the average price decrease to
mining customers discussed above.
KWh sales for resale increased by 10.1% in the third quarter and
by 6.9% in the first nine months of 1997 relative to the same periods
in 1996. Higher economy energy sales accounted for the third quarter
increase. Revenues from sales for resale were 29.5% higher in the
third quarter and 19.6% higher in the first nine months of 1997
compared to the same periods in 1996 due to higher market prices for
wholesale economy energy in all quarters of 1997. Factors
contributing to higher market prices in the third quarter include
higher natural gas prices, increased demand due to warmer temperatures
in the southwestern United States, and WSCC imposed restrictions on
the Pacific Intertie, limiting energy availability from the Northwest.
Higher natural gas prices and a reduction in regional generating
capacity due to planned and force outages of generating facilities in
the southwestern United States contributed to the higher market prices
in the first half of 1997.
Revenue from the Amortization of the MSR Option Gain Regulatory
Liability was $5.0 million lower in the third quarter and $6.9 million
lower in the first nine months of 1997 compared with the same periods
in 1996. This Regulatory Liability was fully amortized as of May
1997.
OPERATING EXPENSES
Fuel and Purchased Power expense increased by 10% in the third
quarter and 4.6% in the first nine months of 1997 compared with the
same period in 1996. The increases in fuel and purchased power
expense outpaced the growth in total kWh sales for both periods, with
increased usage of gas-fired generation in the third quarter and
increased purchases of higher cost economy energy in the second and
third quarters of 1997 due to unscheduled outages at remote plants and
to meet retail and wholesale energy requirements. The increase in
purchased power expense was partially offset by the absence of take-
or-pay payments for fuel in the first nine months of 1997, compared to
take-or-pay payments of $3.0 million for the same period in 1996.
Other Operations expense increased by $4.9 million in the third
quarter and $10.8 million in the first nine months of 1997 relative to
the same periods in 1996. These increases include higher expenses
related to funding of new energy-related businesses, as well as a
first quarter 1997 VSP-related adjustment to post-retirement benefits
expense.
Maintenance and Repairs expense increased by $0.3 million in the
third quarter and $3.6 million in the first nine months of 1997
compared to the same periods in 1996 due primarily to scheduled
maintenance work at the Springerville station in the first and second
quarters of 1997.
Depreciation and Amortization expense decreased by $3.1 million
in the third quarter and $8.5 million in the first nine months of 1997
compared with the same periods in 1996. These decreases were
attributable to the completion in January 1997 of a three year
amortization for Springerville Unit 2 Rate Synchronization Costs
established in the 1994 Rate Order, as well as an extension of the
depreciable life for pollution control facilities as required by the
Company's 1996 Rate Order.
Taxes Other Than Income Taxes decreased by $9.1 million in the
third quarter and $13.1 million in the first nine months of 1997
compared with the same periods in 1996. This was primarily due to a
charge of $7.3 million in the third quarter of 1996 related to a court
ruling on contested sales tax assessments. See Note 1 of Notes to
Condensed Consolidated Financial Statements, Tax Assessments.
Property tax rates and property valuations for tax purposes were also
lower in 1997.
Voluntary Severance Plan Expense (Gain) for the third quarter of
1996 reflected a net gain of $3.4 million. This net gain was
comprised of a $3.7 million benefit reflecting curtailments and
settlements of pension liabilities related to the VSP, as well as
additional charges of $0.3 million related to the VSP. During the
first nine months of 1996, a net expense of $10.6 million was recorded
to reflect the Company's implementation of the VSP.
Income Tax expense included in Operating Expenses increased by
$1.8 million in the third quarter and by $8.1 million in the first
nine months of 1997 compared with the same periods in 1996 due to an
increase in pre-tax operating income, net of interest expense.
OTHER INCOME
Income tax benefits included in Other Income decreased $53.2
million in the third quarter and $41.1 million in the first nine
months of 1997 compared with the same periods of 1996 due primarily to
decreased NOL benefit recognition. The company recognized $13.1
million of NOL benefit in the third quarter of 1997 compared to $70.3
million in the third quarter of 1996. As of the end of September
1997, on a cumulative basis the Company has recognized in its income
statement the full amount of NOL benefit that the Company expects to
utilize on future income tax returns. Additional amounts of NOL
benefit which may be recognized in the future in the Company's income
statement are at present indeterminate due to the interplay of open
tax years for which tax assessments may be made and varying expiration
dates of federal and state NOL carryforwards.
A Reversal of Loss Provision in the amount of $8.5 million was
recorded in the third quarter of 1996. The reversal of loss provision
relates to the satisfaction by the Company's former investment
subsidiaries of approximately $8.5 million of short-term debt
obligations through the assignment of certain finance receivables held
by such investment subsidiaries. Results for the first nine months of
1997 include a Reversal of Loss provision in the amount of $10.2
million recorded in the second quarter of 1997 to reflect the
dissolution of certain subsidiaries which formed part of the Company's
former investment operations.
See Note 4 of Notes to Condensed Consolidated Financial Statements,
Consolidated Subsidiaries.
INTEREST EXPENSE
Interest expense on long-term debt increased in the third quarter
and first nine months of 1997 relative to the same periods in 1996 due
to the refinancing of certain variable and fixed rate debt obligations
with unsecured fixed rate debt obligations, having later maturity
dates, at higher interest rates (see Financing Developments--
Sale of New Bonds, below), as well as higher average interest rates
on the Company's variable debt obligations. The weighted average
interest rate on the Company's variable rate debt obligations was 3.7%
for the first nine months of 1997 compared to 3.5% for the same period
in 1996.
Other Interest Expense was lower in the third quarter and first
nine months of 1997 compared with the same periods in 1996 due to $1.9
million in interest expense incurred in the third quarter of 1996
related to the 1996 contested sales tax assessment of $7.3 million.
EVENTS AFFECTING FUTURE RESULTS OF UTILITY OPERATIONS
NTUA WHOLESALE POWER CONTRACT
On June 26, 1997, the Company signed an agreement to extend and
restructure its current wholesale power sale agreement with the Navajo
Tribal Utility Authority (NTUA). NTUA has purchased approximately 60
MW of power annually since 1993. Under the terms of the Amended and
Restated Power Supply Agreement, firm capacity sales will be provided
in two phases. The first phase runs through May 31, 1999, the
original termination date under the replaced agreement. The second
phase will extend through December 31, 2009. During phase one, the
Company will continue to serve NTUA's full power requirements in
excess of energy and capacity from NTUA's hydroelectric resource. The
new contract also provides NTUA the opportunity and ability to serve
new industrial loads through purchases in the wholesale marketplace.
Phase two of the agreement calls for NTUA to continue purchasing firm
power from the Company, while becoming a partial requirements customer
with a variety of options to serve its remaining needs. The Company
will provide 40 MW of firm power to NTUA in the summer months and 50
MW of firm power in the winter months.
The Company's annual revenues from wholesale sales to NTUA under
the previous terms of the sales agreement were approximately $16.5
million per year. In phase one of the restructured agreement, the
Company's annual revenues from sales to NTUA are estimated to be
approximately $15 million per year. In the first year of phase two,
revenues from sales to NTUA are estimated to range from $9 million to
$16 million.
The new agreement was approved by the FERC on August 20, 1997.
Under the new agreement, the Company will provide generation service
pursuant to the Power Supply Agreement, while providing the
transmission and ancillary services necessary to actually deliver
power pursuant to separate network service and operating agreements in
accordance with the requirements of FERC Order 888.
SPRINGERVILLE COAL SUPPLY CONTRACT
On June 27, 1997, the Company signed an agreement with Peabody
Coalsales to terminate the then existing coal supply contract for the
Springerville Generating Station, and enter into a new contract with
the same supplier. A $50 million termination fee was incurred by the
Company, payable in three installments: $30 million paid on June 30,
1997, $10 million paid on September 30, 1997, and $10 million due
March 31, 1998. The new contract contains more favorable terms to the
Company than the previous contract for certain volume, incremental
volume, base price, incremental price and price adjustment mechanism
requirements. The Company estimates that savings under the new
contract will be approximately $10 million per year initially and will
increase thereafter, resulting in approximately $97.5 million of
savings on a present value basis over the life of the contract.
The Springerville Generating Station consists of two 380 MW coal
fired generating units which account for 38% of the Company's total
net generating capability. The previous coal supply contract covered
the useful lives of Springerville Units 1 and 2 and contained a
bilateral option to renegotiate the contract price and escalation
procedures in 2009 and at intervals of every five years thereafter,
with various adjustment clauses which would affect the future cost of
delivered coal. The new coal contract has an initial term of 13
years, beginning July 1, 1997, and ending June 30, 2010, with an
option to extend for ten years thereafter. During the extension term,
the coal supplier has the right of first refusal to match competing
offers for a portion of Springerville coal requirements.
On July 29, 1997, the ACC issued an interim accounting order
allowing the Company to defer the $50 million termination fee as a
regulatory asset until the ACC decides whether the termination fee
should be recovered through retail rates. The interim accounting
order also allows the Company to begin amortizing the termination fee
to fuel expense over the 13 year initial term of the agreement. See
Note 3 of Notes to Condensed Consolidated Financial Statements,
Springerville Coal Contract.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
The Company expects to generate sufficient cash flows during 1997
to fund its continuing operating activities and construction
expenditures. However, the Company's projected cash flows are subject
to variation due to changes in wholesale revenues, changes in short-
term interest rates, and other factors. For example, an increase in
short-term interest rates of 100 basis points (1%) would result in an
approximate $6 million increase in annual interest payments. If cash
flows were to fall short of expectations, the Company would rely on
existing cash balances, borrowings under the Renewable Term Loan and,
if necessary, borrowings under the Revolving Credit.
At November 5, 1997, there was no outstanding balance due under
the Renewable Term Loan, and to date, no amount has been borrowed
under the Revolving Credit. The Renewable Term Loan commitment
decreased from $156 million at March 31, 1997 to $134 million at June
30, 1997, and to $127.5 million at September 30, 1997. The commitment
was reduced by $16 million at April 29, 1997 in accordance with the
terms of the MRA provisions regarding the optional prepayment of debt
obligations, which encompassed the April 1997 refinancing of $31.4
million of floating rate IDBs (see Financing Developments below).
Mandatory quarterly commitment reductions of $6.7 million each were
effective as of June 30, 1997 and September 30, 1997 in accordance
with the terms of the MRA, whereby the commitment is scheduled to
decrease by approximately 5% per quarter during 1997 and by 10% per
quarter in 1998 and 1999. The Revolving Credit commitment remained at
$50 million as of November 5, 1997.
The Company's cash and cash equivalents balance at November 5,
1997 was approximately $137 million. Cash balances are invested in
investment grade money-market securities with an emphasis on
preserving the principal amounts invested.
CASH FLOWS
The Company's cash and cash equivalents increased by $21.8
million or 22%, from the September 30, 1996 ending balance to the
September 30, 1997 balance of $119.8 million. This increase was due
to the receipt of net cash flows from operating activities in excess
of the net cash flows required for investing and financing activities
for the twelve month period ended September 30, 1997.
Net cash flows from operating activities decreased in aggregate
by $26.9 million in the first nine months of 1997 compared with the
same period in 1996. This decrease was due to the $40.0 million in
contract termination fees paid to a major coal supplier in the second
and third quarters of 1997 (see Springerville Coal Supply Contract above).
Excluding this contract termination fee, net cash flows from operating
activities increased by $13.1 million, or 13.2%, in the first nine months
of 1997 compared with the same period in 1996. This increase was due
primarily to an increase in cash receipts from retail and wholesale
customers and a $13.5 million reduction in wages paid (net of amounts
capitalized), compared with the same period in 1996. The reduction in
wages paid reflected payments made to employees under the VSP in 1996.
These increases to net cash flows were partially offset by higher fuel and
purchased power costs, an $11.9 million increase in payment of other
operations and maintenance costs in the first nine months of 1997, and
the receipt of $4.1 million in cash related to the sale of emission
allowances in the first quarter of 1996.
Net cash outflows from investing activities decreased in
aggregate by $6.6 million in the first nine months of 1997 compared
with the same period in 1996, due to a reduction in both construction
expenditures and investments and loans to joint ventures.
Net cash outflows from financing activities increased in
aggregate by $3.1 million in the first nine months of 1997 compared
with the same period in 1996.
FINANCING DEVELOPMENTS
SALE OF NEW BONDS
On April 29, 1997, the City of Farmington, New Mexico issued
$80.41 million aggregate principal amount of its 1997 Series A
Pollution Control Revenue Bonds (Tucson Electric Power Company San
Juan Project) for the benefit of the Company. The proceeds from this
issuance were made available to the Company under an installment sale
agreement and were used on June 12, 1997 to redeem all of the City of
Farmington's Series 1973 Pollution Control Revenue bonds (Tucson Gas &
Electric Company San Juan Project), 6.25% due in 2003 ($47.91 million
aggregate principal amount) and all of the City of Farmington's 1977
Series A Collateralized Pollution Control Revenue bonds (Tucson Gas &
Electric Company San Juan Project), 6.10% due 2007 ($32.5 million
aggregate principal amount). The Farmington 1977 Series A bonds were
secured by an equal principal amount of First Mortgage Bonds, which
were cancelled. The new bonds, which are unsecured, bear interest at
a fixed annual rate of 6.95% and mature in October 2020.
On April 29, 1997, the Coconino County, Arizona Pollution Control
Corporation issued $36.7 million aggregate principal amount of its
1997 Series A Pollution Control Revenue Bonds (Tucson Electric Power
Company Navajo Project) for the benefit of the Company. The proceeds
from this issuance were loaned to the Company and were used on June 4,
1997 to (i) redeem all of the 1996 Series A Pollution Control Revenue
Bonds (Tucson Electric Power Company Project), variable rate due 2031
($16.7 million aggregate principal amount) and (ii) fund the
construction of additional pollution abatement facilities at the
Navajo Generating Station. The new bonds, which are unsecured, bear
interest at a fixed annual rate of 7.125% and mature in October 2032.
On April 29, 1997, the Coconino County, Arizona Pollution Control
Corporation also issued $14.7 million aggregate principal amount of
its 1997 Series B Pollution Control Revenue Bonds (Tucson Electric
Power Company Navajo Project) for the benefit of the Company. The
proceeds from this issuance were loaned to the Company and were used
on June 4, 1997 to redeem all of the 1996 Series B Pollution Control
Refunding Revenue Bonds (Tucson Electric Power Company Project),
variable rate due 2031 ($14.7 million aggregate principal amount).
The new bonds, which are unsecured, bear interest at a fixed annual
rate of 7.00% and mature in October 2032.
In addition to the redemption of the Coconino bonds, the letters
of credit which provided credit support, and certain First Mortgage
Bonds, which collateralized the letters of credit, were also
eliminated. Therefore, the aggregate principal amount of Company
debt backed by letters of credit was reduced from $805 million to $774
million and the aggregate principal amount of First Mortgage Bonds
outstanding was reduced by $34.5 million.
On October 1, 1997, the Industrial Development Authority of the
County of Pima, Arizona issued $22.5 million aggregate principal
amount of its 1997 Series A Industrial Development Bonds (Tucson
Electric Power Company Project) for the benefit of the Company. The
proceeds from this issuance have been loaned to the Company and (i)
were used to redeem all of the 1990 Series A Industrial Development
Bonds, variable rate due 2025 ($20 million aggregate principal amount)
on November 5, 1997 and (ii) will finance improvements to the
Company's lower voltage electric transmission and distribution system
in Pima County. The new bonds, which are unsecured, bear interest at
a rate of 6.10% and mature in September 2025.
On October 1, 1997, the Industrial Development Authority of Pima
County, Arizona issued $150 million aggregate principal amount of its
1997 Series B Industrial Development Bonds (Tucson Electric Power
Company Project) for the benefit of the Company. The proceeds from
this issuance have been loaned to the Company and will be used on
November 17, 1997 to redeem $150 million aggregate principal amount of
1982 Series A Industrial Development Bonds, variable rate, due 2022.
The new bonds, which are unsecured, bear interest at a rate of 6.00%
and mature in September 2029.
On October 1, 1997, the Industrial Development Authority of Pima
County, Arizona issued $75 million aggregate principal amount of its
1997 Series C Industrial Development Bonds (Tucson Electric Power
Company Project) for the benefit of the Company. The proceeds from
this issuance have been loaned to the Company and will be used on
November 17, 1997 to redeem $75 million aggregate principal amount of
1983 Series A Industrial Development Bonds, variable rate, due 2018.
The new bonds, which are unsecured, bear interest at a rate of 6.00%
and mature in September 2029.
The redeemed Pima bonds are backed by letters of credit under the
MRA. Upon redemption of such Pima bonds, the aggregate principal
amount of Company debt backed by letters of credit will be reduced
from $774 million to $529 million.
FINANCING APPLICATION FILED WITH ACC
On July 11, 1997, the Company filed an application with the ACC
requesting authority to enter into certain financing transactions.
The proposed financing transactions are intended to extend debt
maturities and letter of credit expiration dates, gain additional
financial and operating flexibility through the replacement or
modification of certain credit agreements, reduce exposure to variable
interest rates, reduce dependence on letters of credit and strengthen
the Company's balance sheet by raising additional equity capital. The
application requests authorization for four financings. First, the
Company seeks authority to refinance up to $450 million of existing
tax-exempt variable rate debt obligations currently backed by letters
of credit. These refinancings are expected to be on a fixed rate,
unsecured basis. Second, the Company seeks authority to replace its
current bank credit facilities under the MRA, with one or more new
bank credit facilities. The Company anticipates that the new credit
facilities will be reduced in size (due to the refinancing activity
described above), will have extended maturities or termination dates,
and will contain less restrictive covenants than those contained in
the MRA. Third, the Company requests authority to refinance up to
$184 million in First Mortgage Bonds, scheduled to mature between 1999
and 2003, with the issuance of new securities consisting of debt
and/or equity securities. Fourth, the Company seeks authority to
establish a direct stock purchase plan, which would allow small
investors to purchase shares directly from the Company. Pursuant to
this plan, the Company would issue from time to time up to 1,000,000
shares of Common Stock, without par value.
On August 26, 1997, the ACC approved the section of the financing
application requesting authority to refinance up to $450 million of
existing tax-exempt variable rate debt obligations. This allowed the
Company to proceed with the October 1, 1997 bond sale transactions
outlined above in Financing Developments--Sale of New Bonds. The ACC
is expected to rule on the remaining portions of the financing
application in the fourth quarter of 1997.
Subject to ACC authorization, the Company intends to replace the
current bank credit facilities under the MRA with one or more new bank
credit facilities during the fourth quarter of 1997 and intends to
pursue the negotiation and consummation of the remaining transactions
over the next two years. Even if ACC authorization is granted, there
can be no assurance that any of the contemplated transactions, other
than the October 1, 1997 bond sale transactions, will be consummated
or that the terms of any transactions which are consummated will
result in the realization of the Company's objectives.
The Company expects to incur increased financing costs as a
result of the completion of the proposed financings. The Company
believes, however, that such costs are outweighed by the related
benefits, including the extension of maturities, reduction in
volatility of capital costs, elimination of certain restrictions on
dividends and increases in equity capital.
YEAR 2000 ISSUE
- ---------------
The Company has and will continue to make modifications to its
computer systems and applications to ensure that year 2000
transactions can be processed. The Company currently estimates that
the costs associated with this project are not material to the
Company's operating results.
SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS
- ------------------------------------------
This Quarterly Report on Form 10-Q contains forward-looking
statements as defined by the Private Securities Litigation Reform Act
of 1995. The Company is including the following cautionary statements
to make applicable and take advantage of the safe harbor provisions of
the Private Securities Litigation Reform Act of 1995 for any forward-
looking statements made by, or on behalf, of the Company in this
Quarterly Report on Form 10-Q. Forward-looking statements include
statements concerning plans, objectives, goals, strategies, future
events or performance and underlying assumptions and other statements
which are other than statements of historical facts. Such forward-
looking statements may be identified, without limitation, by the use
of the words "anticipates," "estimates," "expects," "intends,"
"plans," "predicts," "projects," and similar expressions. From time
to time, the Company may publish or otherwise make available forward-
looking statements of this nature. All such forward-looking
statements, whether written or oral, and whether made by or on behalf
of the Company, are expressly qualified by these cautionary statements
and any other cautionary statements which may accompany the forward-
looking statements. In addition, the Company disclaims any obligation
to update any forward-looking statements to reflect events or
circumstances after the date hereof.
Forward-looking statements involve risks and uncertainties which
could cause actual results or outcomes to differ materially from those
expressed in the forward-looking statements. The Company's
expectations, beliefs and projections are expressed in good faith and
are believed by the Company to have a reasonable basis, including
without limitation, management's examination of historical operating
trends, data contained in the Company's records and other data
available from third parties, but there can be no assurance that
management's expectations, beliefs or projections will result or be
achieved or accomplished. In addition to other factors and matters
discussed elsewhere herein, some of the important factors that, in the
view of the Company, could cause actual results to differ materially
from those discussed in the forward-looking statements include the
following:
1. Effects of restructuring initiatives in the electric industry and
other energy-related industries.
2. Changes in economic conditions, demographic patterns and weather
conditions in the Company's retail service area.
3. Changes affecting the Company's cost of providing electrical
service including, but not limited to, changes in fuel costs,
generating unit operating performance, interest rates, tax laws,
environmental laws, and the general rate of inflation.
4. Changes in governmental policies and regulatory actions with
respect to allowed rates of return, financings, rate structures,
and methods of establishing rates.
5. Changes affecting the cost of competing energy alternatives,
including changes in available generating technologies and changes
in the cost of natural gas.
6. Changes in accounting principles or the application of such
principles to the Company.
PART II - OTHER INFORMATION
ITEM 1. -- LEGAL PROCEEDINGS
TAX ASSESSMENTS
See Note 1 of
Notes to Condensed Consolidated Financial Statements,Tax Assessments.
ITEM 6. -- EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
-- See Exhibit Index.
(b) Reports on Form 8-K.
-- The company has not filed any Current Reports on Form 8-K
since filing the Form 10-Q for the Quarter Ending June 30,
1997.
SIGNATURE
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.
TUCSON ELECTRIC POWER COMPANY
------------------------------
(Registrant)
Date: November 10, 1997 Ira R. Adler
------------------------------
Ira R. Adler
Senior Vice President and
Principal Financial Officer
EXHIBIT INDEX
4a - Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and
the Registrant relating to Industrial Development Revenue
Bonds, 1997 Series A (Tucson Electric Power Company Project).
4b - Indenture of Trust, dated as of September 15, 1997, between
The Industrial Development Authority of the County of Pima
and First Trust of New York, National Association,
authorizing Industrial Development Revenue Bonds, 1997 Series
A (Tucson Electric Power Company Project).
4c - Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and
the Registrant relating to Industrial Development Revenue
Bonds, 1997 Series B (Tucson Electric Power Company Project).
4d - Indenture of Trust, dated as of September 15, 1997, between
The Industrial Development Authority of the County of Pima
and First Trust of New York, National Association,
authorizing Industrial Development Revenue Bonds, 1997 Series
B (Tucson Electric Power Company Project).
4e - Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and
the Registrant relating to Industrial Development Revenue
Bonds, 1997 Series C (Tucson Electric Power Company Project).
4f - Indenture of Trust, dated as of September 15, 1997, between
The Industrial Development Authority of the County of Pima
and First Trust of New York, National Association,
authorizing Industrial Development Revenue Bonds, 1997 Series
C (Tucson Electric Power Company Project).
15 - Letter regarding unaudited interim financial information.
27 - Financial Data Schedule.