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, 2000 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number 33-53132 KENETECH CORPORATION (Exact name of registrant as specified in its charter) Delaware 94-3009803 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 500 Sansome Street, Suite 410 San Francisco, California 94111 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (415) 398-3825 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 On November 10, 2000, there were 31,970,164 shares of the issuer's Common Stock, $.0001 par value, outstanding. 2 PART I - FINANCIAL INFORMATION Item 1. Financial Statements. KENETECH Corporation Consolidated Financial Statements Page Consolidated Statements of Operations for the three and nine months ended September 30, 2000 and 1999 4 Consolidated Balance Sheets, as of September 30, 2000 and December 31, 1999 5 Consolidated Statement of Stockholders' Equity for the nine months ended September 30, 2000 6 Consolidated Statements of Cash Flows for the nine months ended September 30, 2000 and 1999 7 Notes to Consolidated Financial Statements 8-18 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 19-25 Item 3. Quantitative and Qualitative Disclosure about Market Risk 26 Part II - OTHER INFORMATION Item 1. Legal Proceedings. 27 Item 2. Changes in Securities and Use of Proceeds. 27 Item 4. Submissions of Matters to a Vote of Security Holders. 27 Item 6. Exhibits and Reports on Form 8-K. 28 3 PART I - FINANCIAL INFORMATION Item 1. Financial Statements KENETECH CORPORATION -------------------- CONSOLIDATED STATEMENTS OF OPERATIONS for the three and nine months ended September 30, 2000 and 1999 (unaudited, in thousands, except per share amounts) For the three months ended For the nine months ended September 30, September 30, -------------------------- -------------------------- 2000 1999 2000 1999 Revenues: Sale of EcoElectrica Interest ................. $ -- $ 5,000 $ -- $ 5,000 Construction services ......................... -- -- -- 410 Other revenues ................................ 370 679 1,551 2,079 ---------- ---------- ----------- --------- Total revenues .............................. 370 5,679 1,551 7,489 Selling, general and administrative expenses ....................................... 1,192 827 2,591 3,802 ---------- ---------- ----------- --------- Income (Loss) from operations ................... (822) 4,852 (1,040) 3,687 Equity gain of unconsolidated affiliates ........ -- -- -- 27 Gain on disposition of subsidiaries and assets -- 57 -- 4,965 Gain (Loss) on trading debt securities .......... 131 (60) 152 (60) Gain on accounts payable settlement and other income ................................... 1,568 2,934 2,467 3,995 ---------- ---------- ----------- --------- Income before taxes ............................. 877 7,783 1,579 12,614 Income tax benefit .............................. -- 19,573 -- 19,573 ---------- ---------- ----------- --------- Net income ................................ $ 877 $ 27,356 $ 1,579 $ 32,187 ========== ========= =========== ========= Net income per common share: Basic and Diluted $ 0.03 $ 0.65 $ 0.04 $ 0.77 Weighted average number of common shares used in computing per share amounts: Basic and Diluted 32,117 41,934 37,030 41,952 The accompanying notes are an integral part of these consolidated financial statements. 4 KENETECH CORPORATION -------------------- CONSOLIDATED BALANCE SHEETS September 30, 2000 and December 31, 1999 (unaudited, in thousands, except share amounts) ASSETS September 30, December 31, 2000 1999 --------- ----------- Current assets: Cash and cash equivalents ......................... $ 3,514 $ 15,291 Funds in escrow ................................... 125 314 Accounts receivable ............................... 10 110 Trading debt securities ........................... 18,831 31,388 Interest receivable ............................... 347 464 Prepaid expenses .................................. 53 -- Insurance proceeds receivable ..................... 1,500 -- --------- ----------- Total current assets ................................. 24,380 47,567 Project development advances and limited liability joint venture ..................... 12,168 2,451 Investments: Held-to-maturity debt securities .................. 3,500 -- Other investments ................................. 2,190 -- --------- ----------- Total investments ................................ 5,690 -- Property, plant and equipment, net ................... 34 58 Other assets ......................................... 104 21 --------- ----------- Total assets ................................... $ 42,376 $ 50,097 ========= =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable .................................. $ 1,769 $ 937 Accrued liabilities ............................... 2,170 4,580 Current taxes payable ............................. 122 130 Other notes payable ............................... -- 6 Accrued stock repurchase obligation .............. -- 26 --------- ---------- Total current liabilities ....................... 4,061 5,679 Accrued liabilities .................................. 905 1,168 Deferred benefit for deconsolidated subsidiary losses. 10,305 10,305 --------- ---------- Total liabilities ................................ 15,271 17,152 Commitments and contingencies Stockholders' equity: Common stock - 110,000,000 shares authorized, $.0001 par value; 31,970,164 and 41,919,218 issued and outstanding at September 30, 2000, and December 31, 1999, respectively. Repurchased for retirement still outstanding 401,200 at December 31, 1999, subsequently retired on April 14, 2000 .................................... 3 4 Additional paid-in capital ........................ 216,324 223,742 Accumulated deficit ............................... (189,222) (190,801) --------- ---------- Total stockholders' equity ....................... 27,105 32,945 --------- ---------- Total liabilities and stockholders' equity...... $ 42,376 $ 50,097 ========= ========== The accompanying notes are an integral part of these consolidated financial statements. 5 KENETECH CORPORATION -------------------- CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY for the nine months ended September 30, 2000 (unaudited, in thousands, except share amounts) Common Stock Additional Paid-In Accumulated Shares Amount Capital Deficit Total Balance, December 31, 1999 41,919,218 $4 $223,742 $(190,801) $ 32,945 Common stock repurchased for retirement (9,949,054) (1) (7,437) -- (7,438) Compensatory element of warrant issued -- - 19 -- 19 Net income -- - -- 1,579 1,579 ---------- -- -------- --------- --------- Balance, September 30, 2000 31,970,164 $3 $216,324 $(189,222) $ 27,105 ========== == ======== ========= ========= The accompanying notes are an integral part of these consolidated financial statements. 6 KENETECH CORPORATION -------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS for the nine months ended September 30, 2000 and 1999 (unaudited, in thousands) September 30, September 30, 2000 1999 --------- --------- Cash flows from operating activities: Net income ..................................... $ 1,579 $ 32,187 Adjustments to reconcile net income to net cash used in operating activities: Depreciation, amortization and other ........ 24 28 Gain on sale of EcoElectrica Project ........ -- (5,000) Gain on disposition of subsidiaries and assets ................................. -- (4,965) Gain on settlement of accounts payable and other income ........................... -- (3,891) Compensatory element of warrant issued ...... 19 -- Deferred benefit from subsidiary losses ..... -- (19,573) Changes in assets and liabilities: Accounts and interest receivable ........... 217 248 Insurance receivable ....................... (1,500) -- Prepaid expenses ........................... (53) -- Other assets ............................... (83) -- Accounts payable ........................... 832 530 Accrued liabilities ........................ (2,673) (4,558) Current taxes payable ...................... (8) 1,556 Notes payable .............................. (6) -- --------- --------- Net cash used in operating activities ... (1,652) (3,438) Cash flows from investing activities: Capital expenditures ........................ -- (64) Proceeds from sale of EcoElectrica Project .. -- 5,000 Net proceeds on disposition of subsidiaries and assets ................................. -- 3,277 Decrease in funds in escrow restricted for line of credit ......................... 189 142 Gain on trading debt securities ............. 152 -- Proceeds from sales of trading debt securities ............................ 23,132 24,881 Purchase of trading debt securities ......... (10,727) (69,089) Purchase of held-to-maturity debt securities (3,500) -- Other investments ........................... (2,190) -- Project development advances ................ (3,717) (59) Purchase of limited liability joint venture interest ................................... (6,000) -- --------- --------- Net cash used in investing activities ... (2,661) (35,912) Cash flows from financing activities: Payment on other notes payable .............. -- (1,065) Payment of preferred dividend ............... -- (21,408) Increase in stock repurchase payable ........ (26) -- Stock repurchased for retirement ............ (7,438) -- --------- --------- Net cash used in financing activities .... (7,464) (22,473) --------- --------- Decrease in cash and cash equivalents............ (11,777) (61,823) Cash and cash equivalents at beginning of period ........................ 15,291 67,424 --------- --------- Cash and cash equivalents at end of period ... $ 3,514 $ 5,601 ========= ========= The accompanying notes are an integral part of these consolidated financial statements. 7 1. General The interim consolidated financial statements presented herein include the accounts of KENETECH Corporation ("KENETECH") and its consolidated subsidiaries (the "Company"), but exclude KENETECH Windpower, Inc. ("KWI"). These interim consolidated financial statements should be read in conjunction with the Company's consolidated financial statements and the notes thereto for the year ended December 31, 1999. These interim consolidated financial statements are unaudited but, in the opinion of management, reflect all adjustments necessary (consisting of items of a normal recurring nature) for a fair presentation of the Company's interim financial position, results of operations and cash flows. Results of operations for interim periods are not necessarily indicative of those for a full year. 2. Significant Accounting Policies Revenues: Revenues are recognized as they are earned. Investments: The Company accounts for investments in marketable equity securities and debt securities in accordance with FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The Company's investment in publicly-traded debt securities are classified as trading securities under FAS No. 115. Accordingly, these investments are stated at their fair value, with any unrealized gains and losses, net of taxes, reported in results of operations. Certain of the Company's investments in non-marketable debt securities are classified as held-to-maturity under FAS No. 115. Accordingly, these investments are carried at cost. Other of the Company's investments in non-marketable equity securities are not subject to FAS No. 115. The Company employs the cost method of accounting for these investments. Depreciation: Depreciation is recorded on a straight-line basis over the estimated useful life of the asset. Income Taxes: The Company accounts for income taxes using the liability method under which deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the consolidated financial statements. Changes in deferred tax assets and liabilities include the impact of any tax rate changes enacted during the year and changes in the valuation allowance. Cash equivalents: Short-term investments purchased with original maturities of three months or less and other instruments which are readily tradeable and without significant interest rate risk are considered cash equivalents. Project development advances and limited liability joint venture: The Company capitalizes amounts funded under various project participation agreements, as described in Note 3, until such time as the funding is repaid. Amounts funded under the limited liability joint venture, as described in Note 3, are accounted for using the equity method. Comprehensive Income: The Company has adopted Financial Accounting Standards Board SFAS No. 130, "Reporting Comprehensive Income," as of January 1, 1998. SFAS No. 130 requires that all items required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. The Company currently has no reportable comprehensive income items. Recent Accounting Pronouncements: In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 - an Amendment of FASB Statement No. 133", and SFAS No. 138, " Accounting for Certain Derivative Instruments and Certain Hedging Activities - an Amendment of FASB Statement No. 133", which establishes accounting and reporting standards for derivative instruments and hedging activities. The terms of SFAS No. 133 and SFAS No. 138 are effective as of the beginning of the first quarter of the fiscal year beginning after June 15, 2000. The Company is determining the effect of SFAS Nos. 133, 137 and 138 on its financial instruments. 8 In December 1999, the SEC issued Staff Accounting Bulletin (SAB) No. 101. The SAB summarized certain of the SEC Staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. The Company believes it conforms to the guidance contained in the bulletin. 3. Business Activities The Company continues its involvement in project development activities. The Company is currently participating with other parties in developing two electric generating facilities and one oriented strand-board facility. OSB Chateaugay In July 1999, the Company entered into a funding and participation agreement with OSB Chateaugay, LLC ("OSB"). The funding will be used by OSB to pursue the development of an oriented strand-board project in Chateaugay, New York (the "OSB Project"). In addition to development services, the Company agreed to fund up to $1.25 million. The OSB Project is expected to produce up to 475 million square feet of strand-board per year. Construction is anticipated to commence in 2001. In exchange for the services and funding, the Company will receive participation distributions. The funding is to be repaid upon the completion of certain development milestones as specified in the funding and participation agreement. Repayment of the funding is to occur before any participation distributions. Repayment of the funding and participation distributions are both dependent upon the ultimate success of the OSB Project. The Company has advanced $844,000 as of September 30, 2000. As of November 10, 2000, the Company has funded an additional $55,000 on the OSB Project, bringing the total amount funded to $899,000. Astoria In October 1999, the Company entered into funding and participation agreements with Astoria Energy, LLC ("Astoria") to provide funding under a note agreement of up to $3 million for the development of a 1,000 megawatt independent power plant (the "Astoria Project") to be located in Astoria, Queens, New York. The Astoria Project is currently under development and is expected to commence construction in the second half of 2001. In exchange for the services and funding, the Company will receive, in addition to repayment of the note evidencing the funding, certain participation distributions. The note is secured by all property and assets of Astoria. On March 14, 2000, the note was amended to change the due date of the original note to December 15, 2000, and provide for interest at 20% on the balance outstanding beginning on April 15, 2000. On March 14, 2000, the Company also committed to fund an additional $2 million toward the development of the Astoria Project in the form of a second note. The second note is due and payable on December 15, 2000, and carries interest at 20% on the balance outstanding. In conjunction with the acquisition of a 20% membership interest in Steinway Creek Electric Generating Company LLC, discussed below, the Company agreed to postpone the due dates of both notes. The due dates of the aforesaid notes were changed to March 15, 2001, or, depending upon the status of the project's funding, June 30, 2003. The notes' maturity dates are accelerated upon certain project financing milestones being attained. Recovery of the notes, interest on the notes, and participation distributions are all dependent upon the ultimate success of the Astoria Project. Accordingly, interest income and participation distributions will be recognized upon the completion of certain project milestones. As of September 30, 2000, the Company has advanced $4,974,000 on the Astoria Project, consisting of $3,000,000 on the original note and $1,974,000 on the second note. 9 On August 10, 2000, the Company agreed to invest $6 million for a twenty-percent membership interest in Steinway Creek Electric Generating Company LLC ("Steinway"), a Delaware limited liability company. Steinway directly owns 100% of Astoria Project Partners LLC, which in turn owns 100% of Astoria. The Company funded the $6 million initial obligation on August 15, 2000. The Company has the obligation to fund a further $2 million in exchange for an additional ten-percent interest in Steinway, depending upon the status of the project's funding as of December 1, 2000. Because Astoria is currently negotiating additional development financing with a third party, it is unlikely that the Company will fund the additional $2 million. The Company accounts for the interest using APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. Under the equity method, the Company has recorded its initial investment in Steinway at cost. The carrying amount is adjusted for the Company's share of Steinway's income or loss, of which there has been none to date. The Company is required under the equity method of accounting to reduce the carrying amount of the investment by equity distributions received from Steinway. The Company believes that as of September 30, 2000, there is no difference between the carrying amount and the amount of underlying equity in net assets of Steinway. Whinash In February 2000, the Company agreed to fund up to $600,000 for the development of a wind-powered electrical generating facility to be located in Whinash, Cumbria, England. The project is a 50 megawatt facility. In exchange for the funding, the Company will receive certain participation distributions upon the sale or financial closing of the Whinash project. As of September 30, 2000, the Company had funded $350,000. Other Information On October 25, 2000, the Company entered into an agreement and plan of merger with KC Holding Corporation and KC Merger Corp. Under the terms of the merger agreement, KC Merger Corp. has commenced a cash tender offer for all of the issued and outstanding shares of common stock, $.0001 par value (the "Common Stock"), of the Company at a price of $1.04 per share. Following the successful completion of the tender offer, KC Merger Corp. will merge with and into the Company and the Company will become a wholly owned subsidiary of KC Holding Corporation. In the merger, the remaining stockholders of the Company will be entitled to receive the per share consideration paid in the tender offer. KC Holding Corporation is a subsidiary of ValueAct Capital Partners, L.P., and KC Merger Corp. is a subsidiary of KC Holding Corporation. Mark D. Lerdal, Chairman of the Board, Chief Executive Officer and President of KENETECH, has agreed with KC Holding Corporation and KC Merger Corp. not to tender any of the shares of Common Stock held by him. Mr. Lerdal has agreed with KC Holding Corporation to contribute his shares of Common Stock to KC Holding Corporation in exchange for shares of capital stock of KC Holding Corporation. The Board of Directors of the Company, based on the recommendation of a Special Committee consisting of independent members of the Board of Directors, has approved the tender offer and the merger and recommended that stockholders accept the offer. The tender offer is conditioned upon, among other things, the tender of 85% of the outstanding shares of Common Stock (excluding those shares held by Mr. Lerdal), determined on a fully diluted basis. It is anticipated that the transaction will be completed by the end of 2000. Notwithstanding its recommendation and consistent with the terms of the merger agreement, the Special Committee of the Board of Directors requested that the Special Committee's financial advisor, Houlihan Lokey Howard & Zukin Financial Advisors, Inc., be available to receive unsolicited inquiries from any other parties interested in the possible acquisition of the Company. If the Special Committee or the Company's Board of Directors, after consultation with its independent legal counsel, determines that taking such actions is appropriate in light of its fiduciary duties to the Company's stockholders under applicable law, the Company may provide information to and engage in discussions and negotiations with such other parties and take appropriate actions in connection with any such indicated interest. 10 As of September 30, 2000, the Company had incurred expenses of $464,000 for legal and financial advisory services related to the agreement and plan of merger, and expects that merger-related expenses will total approximately $1,500,000. Upon consummation of the merger, the Company's outstanding stock options and warrant will be cancelled and converted into the right to receive cash equal to the excess of the price per share paid in the tender offer over the exercise price multiplied by the total number of shares subject to the options and warrant, payable upon the effective date of the merger. 4. Net Income Per Share Net income per share amounts for the periods ended September 30, 2000 and 1999 were calculated as follows: Basic and Diluted (in thousands, except per share amounts) Three months Ended Nine months Ended September 30, September 30, September 30, September 30, 2000 1999 2000 1999 --------- --------- --------- --------- Net income $ 877 $ 27,356 $ 1,579 $ 32,187 --------- --------- --------- --------- Net income used in per share calculations $ 877 $ 27,356 $ 1,579 $ 32,187 ========= ========= ========= ========= Weighted average shares used in per share calculations 32,117 41,934 37,030 41,952 ========= ========= ========= ========= Net income per share $ 0.03 $ 0.65 $ 0.04 $ 0.77 ========= ========= ========= ========= Common stock equivalents are not included in weighted average shares used in the per share calculations because they would be anti-dilutive. At September 30, 2000, all of the Company's outstanding stock options were anti-dilutive. 5. Other Income The Company recorded other income of $2,467 thousand for the nine months ended September 30, 2000, primarily due to the reduction in accrued liabilities, related to the favorable resolution of various legal matters, the reversal of construction-related accounts payable upon which the statute of limitations had expired, and gain realized on the sale of demutualized insurance company stock. Also included in other income are proceeds of $1,500,000, net of associated costs of $275,000, received in settlemnt of disputed business interruption insurance coverage on the Hartford Hospital facility, formerly owned by the Company. 6. Investments A. Held-to-maturity debt securities Indosuez Capital Funding VI, Ltd: On September 14, 2000, the Company purchased $2,500,000 of Income Notes of Indosuez Capital Funding VI, Ltd. ("Indosuez"). The Income Notes are non-recourse, junior and subordinated, with a stated maturity of September 14, 2012. Indosuez is a newly-formed company organized under the laws of the Cayman Islands to acquire and manage a diversified portfolio of corporate and other debt obligations. The portfolio consists primarily of U.S. dollar denominated senior secured term loans and high-yield bonds generally rated below investment grade which, at the time of purchase of Indosuez, represent obligations of obligors located in the United States or other non-emerging market countries. The notes are non-marketable and highly illiquid. 11 ServiSense.com: On April 18, 2000, the Company entered into a Bridge Loan and Warrant Agreement with ServiSense.com, Inc. ("ServiSense"), a Delaware corporation, whereby the Company loaned ServiSense $1 million in exchange for a note receivable and a warrant to purchase ServiSense preferred stock. ServiSense is a bundler of core energy and telecommunications products sold to small businesses and residential customers. Its services include local and long distance telephone, natural gas and home heating oil supplied at rates lower than the incumbent's rate. The note, which earned interest at 10% per annum, matured upon the earlier of April 18, 2001, or the date that ServiSense closed an equity financing that yielded at least $5 million in gross proceeds. The note was non-marketable and highly illiquid. On October 31, 2000, ServiSense repaid the note receivable in full. The receipt of principal and interest income will be reflected in the financial statements of the Company as of December 31, 2000. In connection with the note repayment, the Company returned the ServiSense warrants to ServiSense, unexercised. The Company recognizes revenue on the above held-to-maturity debt securities when received. B. Other Investments Francisco Partners: In April 2000, the Company agreed to invest $5 million over the next six years in Francisco Partners, L.P. ("Francisco Partners"), a partnership formed to make private information technology buy-out investments. The Company received limited partnership interests for its investment which aggregate to a less than 0.5% ownership interest in the partnership. The limited partnership interests are highly illiquid and Francisco Partners has a term of at least ten years. The Company uses the cost method of accounting to account for its investment in Francisco Partners. The Company had invested $840,000 as of September 30, 2000. Draper Atlantic Venture Fund II, L.P.: In April 2000, the Company agreed to invest $2,500,000 over the next two years in Draper Atlantic Venture Fund II, L.P. ("Draper Atlantic"), a partnership formed to invest primarily in early-stage information technology companies. The Company received limited partnership interests for its investment which approximate a one percent ownership interest in the partnership. The Company uses the cost method to account for its investment in Draper Atlantic. The limited partnership interests are highly illiquid and Draper Atlantic has a term of at least ten years. The Company had invested $250,000 as of September 30, 2000. Sage Systems, Inc.: On April 14, 2000, the Company invested $500,000 in Sage Systems, Inc. ("Sage"), in exchange for 390,625 shares of Sage's Series A Preferred Stock. Sage is an early stage technology company that possesses networking technology which offers web-based control over everyday devices with a proprietary operating system which operates over existing power lines. The Company's ownership percentage of Sage is approximately seven percent. The Company uses the cost method of accounting with respect to its investment in Sage. There is no public market for the capital stock of Sage. Odin Millennium Partnership, Ltd.: On April 14, 2000, the Company invested $250,000 in Odin Millenium Partnership, Ltd., a Texas limited partnership formed to purchase the FPS Laffit Pincay, a semi-submersible offshore drilling rig. The Company received limited partnership interests for its investment and approximately owns a one and a half percentage interest in the partnership. The Company uses the cost method to account for its investment in the partnership. The limited partnership interests are highly illiquid. The partnership may operate the drilling rig, lease it to a third party, or sell it. GenPhar, Inc.: On June 22, 2000, the Company invested $250,000 in GenPhar, Inc. ("GenPhar") in exchange for 62,500 shares of Series C Preferred Stock. GenPhar is a development stage biopharmaceutical company focusing on viral and oncological diseases with products derived from advanced DNA technology. The Company's ownership percentage of GenPhar is approximately 0.7%. The Company uses the cost method of accounting with respect to its investment in GenPhar. There is no public market for the stock of GenPhar. 12 International Interactive Commerce, Ltd.: On June 29, 2000, the Company invested $100,000 in International Interactive Commerce, Ltd. ("IIC"), in exchange for 33,333 shares of Series B Preferred Stock. IIC is an internet commerce enabling technology company in the development stage. The Company's ownership percentage in IIC is approximately 0.3%. The Company uses the cost method of accounting with respect to its investment in IIC. There is no public market for the stock of IIC. Breitburn working interest: On August 23, 2000, the Company entered into an oil and gas exploration agreement with Breitburn Energy Company LLC ("Breitburn") to explore three prospects in Natrona County, Wyoming. In exchange for committing to fund its share of development and production expenses, the Company received a 12.5% working interest in the prospects. On October 6, 2000, Breitburn decided, as a result of geological and geophysical analysis, to concentrate development efforts on one prospect, known specifically as the Wild Horse Dome Prospect. At September 30, 2000, the Company estimated that its obligation to fund under the contract was $150,000, payable upon demand over the exploration and production phases. The estimated obligation is variable to the extent that the actual costs of production and exploration differ from those forecasted. On September 6, 2000, the Company funded $42,500, representing its share of geological and geophysical costs. The Company accounts for the Breitburn working interest in conformity with Financial Accounting Standard No. 19, Financial Accounting and Reporting by Oil and Gas Producing Companies. Accordingly, the Company's share of geological and geophysical costs have been expensed. Subsequent to September 30, 2000, the Company increased its working interest percentage to 25% in exchange for additional funding commitments. The above investments involve significant investment risk. They are long-term in duration and highly illiquid. There is no assurance that the investments will realize net profits or achieve returns commensurate with the risks associated with such investments, or that the investments will not experience losses, which may be substantial. 7. Income Taxes At September 30, 2000 and December 31, 1999, the Company had substantial net deferred tax assets for which a valuation allowance of an equal amount has been established. The balance of the deferred benefit for deconsolidated subsidiary losses remains unchanged from December 31, 1999, to September 30, 2000, with a balance of $10,305,000 at both periods. 8. Trading Securities Cumulative unrealized losses on trading securities equaled approximately $73,000 at September 30, 2000 and $249,000 at December 31, 1999. The decrease of $176,000 in unrealized losses from December 31, 1999, to September 30, 2000, has been included in earnings during the nine months ended September 30, 2000. The Company recorded a $152,000 gain on trading securities for the nine months ended September 30, 2000, consisting of the above $176,000 unrealized gain less $24,000 in realized losses. The Company uses specific identification to determine the basis used in the computation of gain or loss on the sale of trading securities. 9. Stockholder's Equity Stock Repurchase: In November 1999, the Company's Board of Directors authorized the repurchase of up to 2,000,000 shares of the Company's Common Stock. The repurchase program was to continue until the Company acquired the 2,000,000 shares or until September 30, 2000. The Company, on March 22, 2000, authorized the repurchase of an additional 2,000,000 shares and extended the repurchase period to December 31, 2000. In May 2000, the Company's Board of Directors authorized the repurchase of an additional 5,000,000 shares, bringing the total number of shares authorized for repurchase to 9,000,000. As of September 30, 2000, the Company had reacquired under the program 8,975,734 shares out of the 9,000,000 shares authorized at a cost of $6,878,000 resulting in a decrease of Additional Paid in Capital of $6,877,000 from inception of the program and $6,612,000 during the nine months ended September 30, 2000. As of September 30, 2000, the Company had retired all of the shares repurchased. 13 In May and June 2000, the Company's Board of Directors authorized the repurchase of 973,320 shares directly from stockholders at a cost of $825,000, resulting in a decrease of Additional Paid in Capital of $825,000 for the nine months ended September 30, 2000. As of September 30, 2000, all of the shares purchased directly had been retired. Warrants: In connection with a consulting agreement with Terrasearch, Inc., the Company issued a warrant to purchase up to 500,000 shares of Common Stock of the Company at an exercise price of $1.00 per share. The warrant becomes exercisable on January 1, 2002 and expires on December 31, 2005. Upon consummation of the merger, as described in Note 3, the warrant will convert into the right to receive cash equal to the difference between the price per share paid in the tender offer and the exercise price, multiplied by the total number of shares subject to the warrant, payable upon the effective date of the merger. 10. Preferred Stock Rights On May 4, 1999, the Board of Directors of the Company declared a dividend of one preferred share purchase right (a "Right") for each outstanding share of common stock, par value $.0001 per share, of the Company (the "Common Stock"). The dividend was paid on May 13, 1999 to the stockholders of record on May 5, 1999 (the "Record Date"). Each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of Series A Junior Participating Preferred Stock, par value $.01 per share, of the Company (the "Preferred Stock") at a price of $10 per one one-thousandth of a share of Preferred Stock (the "Purchase Price"), subject to adjustment. The Rights are not exercisable until the earlier to occur of (i) 10 days following a public announcement that a person or group of affiliated or associated persons (with certain exceptions, an "Acquiring Person") has acquired beneficial ownership of 15% or more of the outstanding shares of Common Stock or (ii) 10 business days (or such later date as may be determined by action of the Board of Directors prior to such time as any person or group of affiliated persons becomes an Acquiring Person) following the commencement of, or announcement of an intention to make, a tender offer or exchange offer the consummation of which would result in the beneficial ownership by a person or group of 15% or more of the outstanding shares of Common Stock (the earlier of such dates being called the "Distribution Date"). The Rights will expire on May 4, 2009 (the "Final Expiration Date"), unless the Final Expiration Date is advanced or extended or unless the Rights are earlier redeemed or exchanged by the Company, in each case as described below. Shares of Preferred Stock purchasable upon exercise of the Rights will not be redeemable. Each share of Preferred Stock will be entitled, when, as and if declared, to a minimum preferential quarterly dividend payment of the greater of (a) $10 per share, or (b) an amount equal to 1,000 times the dividend declared per share of Common Stock. In the event of liquidation, dissolution or winding up of the Company, the holders of the Preferred Stock will be entitled to a minimum preferential payment of the greater of (a) $10 per share (plus any accrued but unpaid dividends), or (b) an amount equal to 1,000 times the payment made per share of Common Stock. Each share of Preferred Stock will have 1,000 votes, voting together with the Common Stock. Finally, in the event of any merger, consolidation or other transaction in which outstanding shares of Common Stock are converted or exchanged, each share of Preferred Stock will be entitled to receive 1,000 times the amount received per share of Common Stock. These rights are protected by customary antidilution provisions. In the event that any person or group of affiliated or associated persons becomes an Acquiring Person, each holder of a Right, other than Rights beneficially owned by the Acquiring Person (which will thereupon become void), will thereafter have the right to receive upon exercise of a Right that number of shares of Common Stock having a market value of two times the exercise price of the Right. 14 In the event that, after a person or group has become an Acquiring Person, the Company is acquired in a merger or other business combination transaction or 50% or more of its consolidated assets or earning power are sold, proper provisions will be made so that each holder of a Right (other than Rights beneficially owned by an Acquiring Person which will have become void) will thereafter have the right to receive upon the exercise of a Right that number of shares of common stock of the person with whom the Company has engaged in the foregoing transaction (or its parent) that at the time of such transaction have a market value of two times the exercise price of the Right. At any time after any person or group becomes an Acquiring Person and prior to the earlier of one of the events described in the previous paragraph or the acquisition by such Acquiring Person of 50% or more of the outstanding shares of Common Stock, the Board of Directors of the Company may exchange the Rights (other than Rights owned by such Acquiring Person which will have become void), in whole or in part, for shares of Common Stock or Preferred Stock (or a series of the Company's preferred stock having equivalent rights, preferences and privileges), at an exchange ratio of one share of Common Stock, or a fractional share of Preferred Stock (or other preferred stock) equivalent in value thereto, per Right. At any time prior to the time an Acquiring Person becomes such, the Board of Directors of the Company may redeem the Rights in whole, but not in part, at a price of $.01 per Right (the "Redemption Price") payable, at the option of the Company, in cash, shares of Common Stock or such other form of consideration as the Board of Directors of the Company shall determine. The redemption of the Rights may be made effective at such time, on such basis and with such conditions as the Board of Directors in its sole discretion may establish. Immediately upon any redemption of the Rights, the right to exercise the Rights will terminate and the only right of the holders of Rights will be to receive the Redemption Price. Until a Right is exercised or exchanged, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends. In connection with the approval of the Merger Agreement, as described in Note 3, the Company modified the terms of the Rights Agreement. Pursuant to the Rights Agreement Amendment, dated and effective October 25, 2000, neither the execution of the Merger Agreement or the various actions contemplated by and described in the Merger Agreement will trigger the distribution or exercisability of the Rights. Furthermore, the Rights Agreement will terminate immediately prior to the closing of the cash tender offer. 11. Commitments and Contingencies As described in Note 3, the Company has committed to fund approximately $12.9 million to various development projects, of which approximately $12.2 million had been funded by November 10, 2000. An additional $2,000,000 contribution to Steinway is contingent upon certain events, as described in Note 3. As described in Note 6, the Company has committed to several long-term investments, which require $12.3 million in cash to be invested. As of November 10, 2000, approximately $5.7 million had been invested. Litigation Delaware Stockholders' Class Action and Derivative Litigation: On February 2, 2000, plaintiffs Robert L. Kohls and Louise A. Kohls filed two actions in the Court of Chancery of the State of Delaware In and For New Castle County, against the Company, Angus M. Duthie, Mark D. Lerdal, Gerald R. Alderson and Charles Christenson. Plaintiffs filed amended complaints on February 23, 2000. Plaintiffs allege that they were beneficial owners of Preferred Redeemable Increased Dividend Equity Securities, 8-1/4% PRIDES, Convertible Preferred Stock, par value $0.01 per share (the "PRIDES") of the Company, that mandatorily converted, on May 14, 1998, into common stock, par value $0.0001 per share ("Common Stock"), of the Company. 15 The first action was purportedly brought as a class action on behalf of the named plaintiffs and all other persons who owned the PRIDES as of May 13, 1998. Plaintiffs alleged, among other things, that defendants breached the terms of the Company's Certificate of Designations, Preferences, Rights and Limitations (the "Certificate of Designations") under which the PRIDES were issued and breached their fiduciary duty to protect the interests of the holders of the PRIDES prior to the PRIDES mandatory conversion. Plaintiffs sought, among other things, (i) certification of the action as a class action, (ii) a declaration that the holders of PRIDES were entitled to be paid a liquidation preference of up to $1,012.50 per share of PRIDES, and (iii) a judgment that the defendants were liable to the PRIDES holders in an amount up to $1,012.50 per share. The Delaware Court of Chancery dismissed the class action by opinion dated July 26, 2000, and order dated August 4, 2000. The plaintiffs filed a notice of appeal on August 31, 2000. On November 6, 2000, the Company and the other defendants filed a motion to affirm the Court of Chancery's judgment. The Company intends, and has been informed that the individual defendants intend, to continue to defend this action vigorously. The second action is purportedly brought as a derivative action on behalf of the Company. Plaintiffs generally allege that the purchase of the Company's Common Stock by defendant Mark D. Lerdal in December 1997 was a corporate opportunity and that such Common Stock should have been instead purchased by the Company. Plaintiffs are seeking, among other things, (i) a declaration that the purchase of the Common Stock by defendant Lerdal constituted the taking of a corporate opportunity and is null and void, (ii) an order requiring defendant Lerdal to transfer the Common Stock to the Company for the consideration he paid, and (iii) to the extent the Common Stock may not be transferred to the Company, damages for the fair value of the Common Stock. On July 26, 2000, the Delaware Court of Chancery denied defendants' motion to dismiss the derivative action. On August 7, 2000, defendants filed an application seeking certification of an interlocutory appeal to the Delaware Supreme Court of the Court's opinion denying their motion to dismiss. The interlocutory appeal and a motion to stay the proceedings pending the potential appeal were denied. The parties are proceeding with discovery and trial is scheduled to commence in April 2001. If the merger, as described in Note 3, is consummated, the plaintiffs in this action may lose standing to pursue the action. However, stockholders would still be entitled to have the cause of action evaluated in an appraisal action to determine the fair value of their shares of Common Stock. Moreover, the cause of action itself would not be extinguished. On November 9, 2000, the plaintiffs moved to file a second amended and supplemental complaint (the "Second Amended Complaint") in the action pending in the Court of Chancery of the State of Delaware in and for New Castle County (the "Chancery Court") styled Kohls v. Duthie, et al. (the "Action"). The Second Amended Complaint names Gerald R. Morgan, Jr., Michael D. Winn and the Company as additional defendants. The Company previously was a nominal defendant. The first cause of action of the Second Amended Complaint sets forth all of the allegations and seeks all of the relief set forth in the Plaintiffs' first amended complaint described above. The first cause of action of the Second Amended Complaint is purportedly brought as a derivative action on behalf of the Company. The second cause of action of the Second Amended Complaint seeks to enjoin preliminarily and permanently the agreement and plan of merger among the Company, KC Merger Corp. and KC Holding Corporation (the "Merger Agreement") as further described in Note 3. 16 As it pertains to the Merger Agreement, the Second Amended Complaint alleges in substance the following: * that the tender offer and the merger are the result of an unfair process, and will constitute an unfair transaction to the KENETECH stockholders; * that Charles Christenson, one of the members of the Special Committee, has, as a defendant in the Action, a personal interest in approving the Merger Agreement because the closing of the merger would eliminate the standing of the Plaintiffs to bring the Action, and therefore the transactions contemplated by the Merger Agreement were not the product of arms-length negotiations, but instead constituted self-dealing; * that because Gerald R. Morgan, Jr., one of the members of the Special Committee, has, as the Chief Operating Officer of an entity in which KENETECH invests, an interest in pleasing Mr. Lerdal, and because the tender offer and the merger provide a unique benefit to Mr. Lerdal in the form of a "roll over" of his investment in KENETECH, the process whereby the tender offer and the merger were agreed to by KENETECH was unfair; * that the per share amount of $1.04 to be paid in the tender offer and merger was the product of an analysis of Houlihan Lokey that failed to consider the value of the Action, failed to investigate the Action by contacting the Plaintiffs, failed to consider that the Action is scheduled to go to trial in April 2001, and failed to evaluate independently the deferred benefit for deconsolidated losses, as a result of which the process whereby the tender offer and the merger were agreed to by the Company was unfair; * that the per share amount of $1.04 fails to properly account for issues relating to the deferred benefit for deconsolidated losses and overhead costs, as a result of which the per share amount is unfair; * that the per share amount of $1.04 is based on Mr. Lerdal owning the shares of the Company's Common Stock that are the subject of the Action, title to which is contested by the Action; as a result of which both the process whereby the tender offer and the merger were agreed to by the Company and the per share amount are unfair; and * that the disclosures surrounding the tender offer and merger contain material misstatements and fail to include information necessary to make the statements not misleading. The Plaintiffs allege that the second cause of action of the Second Amended Complaint, including the above allegations, is maintainable as a class action, and that there are questions of law and fact which are common to the KENETECH stockholders who comprise the class, including: (i) whether the transactions contemplated by the tender offer and the Merger Agreement are the product of a fair process and provide a fair price to the stockholders of KENETECH; and (ii) whether the materials that describe the tender offer and merger contain any misrepresentations or fail to disclose material facts which are necessary for the disclosures that have been made to not be misleading. The Plaintiffs request that the Chancery Court: (i) issue a preliminary injunction enjoining the consummation of the Merger Agreement; (ii) enter a permanent injunction prohibiting the consummation of the Merger Agreement; and (iii) award Plaintiffs their attorneys' fees, costs, and other expenses. Also on November 9, 2000, the Plaintiffs asked the Chancery Court to hold a scheduling conference to determine whether to schedule an expedited hearing on the Plaintiffs' application for a preliminary injunction enjoining the consummation of the Merger Agreement. On November 13, 2000, the Chancery Court held a conference and scheduled a hearing on the Plaintiffs' application for a preliminary injunction for December 5, 2000, at 3:00p.m. The Company intends, and has been informed that the individual defendants intend, to continue to defend this action vigorously. 17 Federal Stockholders' Class Action: On September 28, 1995, a class action complaint was filed against the Company and certain of its officers and directors (namely, Stanley Charren, Maurice E. Miller, Joel M. Canino and Gerald R. Alderson), in the United States District Court for the Northern District of California, alleging federal securities laws violations. On November 2, 1995, a First Amended Complaint was filed naming additional defendants, including underwriters of the Company's securities and certain other officers and directors of the Company (namely, Charles Christenson, Angus M. Duthie, Steven N. Hutchinson, Howard W. Pifer III and Mervin E. Werth). Subsequent to the Court's partial grant of the Company's and the underwriter defendants' motions to dismiss, a Second Amended Complaint was filed on March 29, 1996. The amended complaint alleged claims under sections 11 and 15 of the Securities Act of 1933, and sections 10(b) and 20(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, based on alleged misrepresentations and omissions in the Company's public statements, on behalf of a class consisting of persons who purchased the Company's Common Stock during the period from September 21, 1993 (the date of the Company's initial public offering) through August 8, 1995 and persons who purchased the Company's PRIDES (depository shares) during the period from April 28, 1994 (the public offering date of the PRIDES) through August 8, 1995. The amended complaint alleged that the defendants misrepresented the Company's progress on the development of its latest generation of wind turbines and the Company's future prospects. The amended complaint sought unspecified damages and other relief. The Court certified a plaintiff class consisting of all persons or entities who purchased Common Stock between September 21, 1993 and August 8, 1995 or depositary shares between April 28, 1994 and August 8, 1995, appointed representatives of the certified plaintiff class, appointed counsel for the certified class and certified a plaintiff and defendant underwriter class as to the section 11 claim. On August 9, 1999, the Court granted defendants' motion for summary judgment and ordered that plaintiffs take nothing and that the action be dismissed on the merits. The plaintiffs have appealed the Court's order, and both parties have filed briefs and are waiting for oral argument to be scheduled by the Ninth Circuit of the United States Court of Appeals. The Company intends, and has been informed that the individual defendants intend, to continue to defend this action vigorously. Insurance Litigation: On January 29, 1999, Travelers Insurance Company filed a complaint against KENETECH and CNF Industries, Inc. ("CNF") in the Superior Court, Judicial District of Hartford, Connecticut. The complaint alleged that the defendants failed to pay premiums and other charges for insurance coverage and services. Damages were alleged to be in excess of $1,121,305. On September 20, 2000, the Company entered into a confidential settlement agreement with the plantiff. Under the settlement agreement, the Company paid $875,000 to settle this action on October 3, 2000. Annual Meeting Litigation: On July 30, 1999, Campus, LLC and Joseph A. Wagda filed a complaint against the Company and its directors (namely, Angus M. Duthie, Mark D. Lerdal, Gerald R. Alderson and Charles Christenson) in the Court of Chancery of the State of Delaware In and For New Castle County. The plaintiffs in this action purport to be stockholders of the Company. The complaint alleges, among other things, that plaintiffs were deprived of the opportunity to nominate directors for election at the Company's annual meeting which took place on August 18, 1999. Plaintiffs are seeking, among other things, (i) a declaration that the annual meeting was illegally and inequitably scheduled and that any actions taken at the annual meeting are null and void and (ii) an order requiring the defendants to schedule a meeting, allowing stockholders an opportunity to nominate directors, file solicitation materials with the Securities and Exchange Commission and conduct a proxy solicitation. The litigation had been stayed by agreement of both parties since October 1999. On November 7, 2000, the defendants filed a motion to dismiss the litigation. Other: The Company is also a party to various other legal proceedings normally incident to its historical business activities. The Company intends to continue to defend itself vigorously against these actions. The Company does not believe that the ultimate outcome of the above-described matters will have a material adverse effect on the Company's financial position. Lease Commitments: The Company leases approximately 2,400 square feet of office space in San Francisco, CA. The associated lease commitment is approximately $75,000 annually, expiring on September 30, 2001. 18 12. Subsequent events As more fully described in Note 3, on October 25, 2000, the Company entered into an agreement and plan of merger with KC Holding Corporation and KC Merger Corp. Under the terms of the merger agreement, KC Merger Corp. has commenced a cash tender offer for all of the issued and outstanding shares of the Company's Common Stock at a price of $1.04 per share. Following the successful completion of the tender offer, KC Merger Corp. will merge with and into the Company and the Company will become a wholly owned subsidiary of KC Holding Corporation. In the merger, the remaining stockholders of the Company will be entitled to receive the per share consideration paid in the tender offer. KC Holding Corporation is a subsidiary of ValueAct Capital Partners, L.P., and KC Merger Corp. is a subsidiary of KC Holding Corporation. Mark D. Lerdal, Chairman of the Board, Chief Executive Officer and President of KENETECH, has agreed with KC Holding Corporation and KC Merger Corp. not to tender any of the shares of Common Stock held by him. Mr. Lerdal has agreed with KC Holding Corporation to contribute his shares of Common Stock to KC Holding Corporation in exchange for shares of capital stock of KC Holding Corporation. As of September 30, 2000, the Company had incurred expenses of $464,000 for legal and financial advisory services related to the agreement and plan of merger, and expects that merger-related expenses will total approximately $1,500,000. 19 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. OVERVIEW KENETECH Corporation ("KENETECH") is a Delaware corporation that has historically been involved in the development, construction, and management of independent power projects. The Company continues in project development activities at this time; however, it has ceased its construction and management activities. The Company is currently participating with other parties in developing two electric generating facilities and one oriented strand-board facility. As used in this document, "Company" refers to KENETECH and its wholly-owned subsidiaries (including KENETECH Windpower, Inc. ("KWI") only through May 29, 1996). Merger Agreement On October 25, 2000, the Company entered into an agreement and plan of merger with KC Holding Corporation and KC Merger Corp. Under the terms of the merger agreement, KC Merger Corp. has commenced a cash tender offer for all of the issued and outstanding shares of common stock, $.0001 par value (the "Common Stock"), of the Company at a price of $1.04 per share. Following the successful completion of the shares of Common Stock pursuant to the tender offer, KC Merger Corp. will merge with and into the Company and the Company will become a wholly owned subsidiary of KC Holding Corporation. In the merger, the remaining stockholders of the Company will be entitled to receive the per share consideration paid in the tender offer. KC Holding Corporation is a subsidiary of ValueAct Capital Partners, L.P., and KC Merger Corp. is a subsidiary of KC Holding Corporation. Mark D. Lerdal, Chairman of the Board, Chief Executive Officer and President of KENETECH, has agreed with KC Holding Corporation and KC Merger Corp. not to tender any of the shares of Common Stock held by him. Mr. Lerdal has agreed with KC Holding Corporation to contribute his shares of Common Stock to KC Holding Corporation in exchange for shares of capital stock of KC Holding Corporation. The Board of Directors of the Company, based on the recommendation of a Special Committee consisting of independent members of the Board of Directors, has approved the tender offer and the merger and recommended that stockholders accept the offer. The tender offer is conditioned upon, among other things, the tender of 85% of the outstanding shares of Common Stock (excluding those shares held by Mr. Lerdal), determined on a fully diluted basis. It is anticipated that the transaction will be completed by the end of 2000. Notwithstanding its recommendation and consistent with the terms of the merger agreement, the Special Committee of the Board of Directors requested that the Special Committee's financial advisor, Houlihan Lokey Howard & Zukin Financial Advisors, Inc., be available to receive unsolicited inquiries from any other parties interested in the possible acquisition of the Company. If the Special Committee or the Company's Board of Directors, after consultation with its independent legal counsel, determines that taking such actions is appropriate in light of its fiduciary duties to the Company's stockholders under applicable law, the Company may provide information to and engage in discussions and negotiations with such other parties and take appropriate actions in connection with any such indicated interest. As of September 30, 2000, the Company had incurred expenses of $464,000 for legal and financial advisory services related to the agreement and plan of merger, and expects that merger-related expenses will total approximately $1,500,000. OSB Chateaugay In July 1999, the Company entered into a funding and participation agreement with OSB Chateaugay, LLC ("OSB"). The funding will be used by OSB to pursue the development of an oriented strand-board project in Chateaugay, New York (the "OSB Project"). In addition to development services, the Company agreed to fund up to $1.25 million. The OSB Project is expected to produce up to 475 million square feet of strand-board per year. Construction is anticipated to commence in 2001. In exchange for the services and funding, the Company will receive participation distributions. The funding is to be repaid upon the completion of certain development milestones as specified in the funding and participation agreement. Repayment of the funding is to occur before any participation distributions. Repayment of the funding and participation distributions are both dependent upon the ultimate success of the OSB Project. 20 The Company has advanced $844,000 as of September 30, 2000. As of November 10, 2000, the Company has funded an additional $55,000 on the OSB Project, bringing the total amount funded to $899,000. Astoria In October 1999, the Company entered into funding and participation agreements with Astoria Energy, LLC ("Astoria") to provide funding under a note agreement of up to $3 million for the development of a 1,000 megawatt independent power plant (the "Astoria Project") to be located in Astoria, Queens, New York. The Astoria Project is currently under development and is expected to commence construction in the second half of 2001. In exchange for the services and funding, the Company will receive, in addition to repayment of the note evidencing the funding, certain participation distributions. The note is secured by all property and assets of Astoria. On March 14, 2000, the note was amended to change the due date of the original note to December 15, 2000, and provide for interest at 20% on the balance outstanding beginning on April 15, 2000. On March 14, 2000, the Company also committed to fund an additional $2 million toward the development of the Astoria Project in the form of a second note. The second note is due and payable on December 15, 2000, and carries interest at 20% on the balance outstanding. In conjunction with the acquisition of a 20% membership interest in Steinway Creek Electric Generating Company LLC, discussed below, the Company agreed to postpone the due dates of both notes. The due dates of the aforesaid notes were changed to March 15, 2001, or, depending upon the status of the project's funding, June 30, 2003. The notes' maturity dates are accelerated upon certain project financing milestones being attained. Recovery of the notes, interest on the notes, and participation distributions are all dependent upon the ultimate success of the Astoria Project. Accordingly, interest income and participation distributions will be recognized upon the completion of certain project milestones. As of September 30, 2000, the Company has advanced $4,974,000 on the Astoria Project, consisting of $3,000,000 on the original note and $1,974,000 on the second note. On August 10, 2000, the Company agreed to invest $6 million for a twenty-percent membership interest in Steinway Creek Electric Generating Company LLC ("Steinway"), a Delaware limited liability company. Steinway directly owns 100% of Astoria Project Partners LLC, which in turn owns 100% of Astoria. The Company funded the $6 million initial obligation on August 15, 2000. The Company has the obligation to fund a further $2 million in exchange for an additional ten-percent interest in Steinway, depending upon the status of the project's funding as of December 1, 2000. Because Astoria is currently negotiating additional development financing with a third party, it is unlikely that the Company will fund the additional $2 million. The Company accounts for the interest using APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. Under the equity method, the Company has recorded its initial investment in Steinway at cost. The carrying amount is adjusted for the Company's share of Steinway's income or loss, of which there has been none to date. The Company is required under the equity method of accounting to reduce the carrying amount of the investment by equity distributions received from Steinway. The Company believes that as of September 30, 2000, there is no difference between the carrying amount and the amount of underlying equity in net assets of Steinway. Whinash In February 2000, the Company agreed to fund up to $600,000 for the development of a wind-powered electrical generating facility to be located in Whinash, Cumbria, England. The project is a 50 megawatt facility. In exchange for the funding, the Company will receive certain participation distributions upon the sale or financial closing of the Whinash project. As of September 30, 2000, the Company had funded $350,000. 21 Other Investments A. Held-to-maturity debt securities Indosuez Capital Funding VI, Ltd: On September 14, 2000, the Company purchased $2,500,000 of Income Notes of Indosuez Capital Funding VI, Ltd. ("Indosuez"). The Income Notes are non-recourse, junior and subordinated, with a stated maturity of September 14, 2012. Indosuez is a newly-formed company organized under the laws of the Cayman Islands to acquire and manage a diversified portfolio of corporate and other debt obligations. The portfolio consists primarily of U.S. dollar denominated senior secured term loans and high-yield bonds generally rated below investment grade which, at the time of purchase of Indosuez, represent obligations of obligors located in the United States or other non-emerging market countries. The notes are non-marketable and highly illiquid. ServiSense: On April 18, 2000, the Company entered into a Bridge Loan and Warrant Agreement with ServiSense.com, Inc. ("ServiSense"), a Delaware corporation, whereby the Company loaned ServiSense $1 million in exchange for a note receivable and a warrant to purchase ServiSense preferred stock. ServiSense is a bundler of core energy and telecommunications products sold to small businesses and residential customers. Its services include local and long distance telephone, natural gas and home heating oil supplied at rates lower than the incumbent's rate. The note, which earned interest at 10% per annum, matured upon the earlier of April 18, 2001, or the date that ServiSense closed an equity financing that yielded at least $5 million in gross proceeds. The note was non-marketable and highly illiquid. On October 31, 2000, ServiSense repaid the note receivable in full. The receipt of principal and interest income will be reflected in the financial statements of the Company as of December 31, 2000. In connection with the note repayment, the Company returned the ServiSense warrants to ServiSense, unexercised. The Company recognizes revenue on the above held-to-maturity debt securities when received. B. Other Investments Francisco Partners: In April 2000, the Company agreed to invest $5 million over the next six years in Francisco Partners, L.P. ("Francisco Partners"), a partnership formed to make private information technology buy-out investments. The Company received limited partnership interests for its investment which aggregate to a less than 0.5% ownership interest in the partnership. The limited partnership interests are highly illiquid and Francisco Partners has a term of at least ten years. The Company uses the cost method of accounting to account for its investment in Francisco Partners. The Company had invested $840,000 as of September 30, 2000. Draper Atlantic Venture Fund II, L.P.: In April 2000, the Company agreed to invest $2,500,000 over the next two years in Draper Atlantic Venture Fund II, L.P. ("Draper Atlantic"), a partnership formed to invest primarily in early-stage information technology companies. The Company received limited partnership interests for its investment which approximate a one percent ownership interest in the partnership. The Company uses the cost method to account for its investment in Draper Atlantic. The limited partnership interests are highly illiquid and Draper Atlantic has a term of at least ten years. The Company had invested $250,000 as of September 30, 2000. Sage Systems, Inc.: On April 14, 2000, the Company invested $500,000 in Sage Systems, Inc. ("Sage"), in exchange for 390,625 shares of Sage's Series A Preferred Stock. Sage is an early stage technology company that possesses networking technology which offers web-based control over everyday devices with a proprietary operating system which operates over existing power lines. The Company's ownership percentage of Sage is approximately seven percent. The Company uses the cost method of accounting with respect to its investment in Sage. There is no public market for the capital stock of Sage. 22 Odin Millennium Partnership, Ltd.: On April 14, 2000, the Company invested $250,000 in Odin Millenium Partnership, Ltd., a Texas limited partnership formed to purchase the FPS Laffit Pincay, a semi-submersible offshore drilling rig. The Company received limited partnership interests for its investment and approximately owns a one and a half percentage interest in the partnership. The Company uses the cost method to account for its investment in the partnership. The limited partnership interests are highly illiquid. The partnership may operate the drilling rig, lease it to a third party, or sell it. GenPhar, Inc.: On June 22, 2000, the Company invested $250,000 in GenPhar, Inc. ("GenPhar") in exchange for 62,500 shares of Series C Preferred Stock. GenPhar is a development stage biopharmaceutical company focusing on viral and oncological diseases with products derived from advanced DNA technology. The Company's ownership percentage of GenPhar is approximately 0.7%. The Company uses the cost method of accounting with respect to its investment in GenPhar. There is no public market for the stock of GenPhar. International Interactive Commerce, Ltd.: On June 29, 2000, the Company invested $100,000 in International Interactive Commerce, Ltd. ("IIC"), in exchange for 33,333 shares of Series B Preferred Stock. IIC is an internet commerce enabling technology company in the development stage. The Company's ownership percentage in IIC is approximately 0.3%. The Company uses the cost method of accounting with respect to its investment in IIC. There is no public market for the stock of IIC. Breitburn working interest: On August 23, 2000, the Company entered into an oil and gas exploration agreement with Breitburn Energy Company LLC ("Breitburn") to explore three prospects in Natrona County, Wyoming. In exchange for committing to fund its share of development and production expenses, the Company received a 12.5% working interest in the prospects. On October 6, 2000, Breitburn decided, as a result of geological and geophysical analysis, to concentrate development efforts on one prospect, known specifically as the Wild Horse Dome Prospect. At September 30, 2000, the Company estimated that its obligation to fund under the contract was $150,000, payable upon demand over the exploration and production phases. The estimated obligation is variable to the extent that the actual costs of production and exploration differ from those forecasted. On September 6, 2000, the Company funded $42,500, representing its share of geological and geophysical costs. The Company accounts for the Breitburn working interest in conformity with Financial Accounting Standard No. 19, Financial Accounting and Reporting by Oil and Gas Producing Companies. Accordingly, the Company's share of geological and geophysical costs have been expensed. Subsequent to September 30, 2000, the Company increased its working interest percentage to 25% in exchange for additional funding commitments. The above investments involve significant investment risk. They are long-term in duration and highly illiquid. There is no assurance that the investments will realize net profits or achieve returns commensurate with the risks associated with such investments, or that the investments will not experience losses, which may be substantial. CAUTIONARY STATEMENT Certain information included in this report contains forward looking statements within the meaning of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. Such forward looking information is based on information available when such statements are made and is subject to risks and uncertainties that could cause actual results to differ materially from those expressed in the statements. 23 Results of Operations --------------------- The Company recognized net income for the third quarter of 2000 of $877 thousand as compared to $27,356 thousand in the third quarter of 1999. On July 27, 1999, KENETECH Energy Systems, Inc., received $5.0 million in cash, upon the successful conversion of the local tax status of EcoElectrica, L.P. No other proceeds will be received from the sale of the Company's indirect interests in EcoElectrica, L.P. The Company recorded other revenue of $370 thousand for the quarter ended September 30, 2000, compared to $679 thousand for the comparable quarter in 1999. Other revenue consists primarily of interest income earned on trading debt securities. The decrease in interest income from the comparable period in 1999 is due to the reduction in funds invested. Selling, general and administrative expenses increased to $1,192 thousand for the quarter ended September 30, 2000, from $827 thousand for the comparable period in 1999. Current period general and administrative expense consists primarily of salary and wages, legal costs associated with litigation, consulting expenses, and costs associated with the agreement and plan of merger. The Company recorded no gain or loss on the disposition of subsidiaries and assets for the quarter ended September 30, 2000, compared to a $57 thousand gain for the comparable quarter in 1999. The $57 thousand gain in 1999 related primarily to the sales of partnership interests. During the quarter ended September 30, 2000, the Company recorded a $131 thousand gain on trading debt securities, compared to a $60 thousand loss for the comparable quarter in 1999. The Company recorded other income of $1,568 thousand for the quarter ended September 30, 2000 compared to $2,919 thousand in this period in 1999. Other income in 2000 relates primarily to the reduction in accrued liabilities related to the favorable resolution of various legal matters and to the receipt of business interruption insurance proceeds in settlement of litigation, net of related expenses. The Company recorded no gain on settlement of accounts payable in the current quarter compared to $15 thousand in 1999. Income taxes: The Company uses the asset and liability approach for financial accounting and reporting for income taxes. The Company reported no income tax expense for the period ended September 30, 2000, due to the expected utilization of deferred tax benefits offset by reduction in valuation reserve. During the quarter ended September 30, 1999, the Company reduced the balance of the deferred benefit for deconsolidated subsidiary losses, resulting in an income tax benefit of $19.6 million. The Company recognized net income for the nine months ended September 30, 2000, of $1,579 thousand, compared to net income of $32,187 thousand for the comparable period in 1999. On July 27, 1999, KENETECH Energy Systems, Inc., received $5.0 million in cash, upon the successful conversion of the local tax status of EcoElectrica, L.P. No other proceeds will be received from the sale of the Company's indirect interests in EcoElectrica, L.P. The Company recorded other revenue of $1,551 thousand for the nine months ended September 30, 2000, compared to $2,079 thousand for the comparable period in 1999. Other revenue consists primarily of interest income earned on trading debt securities. The decrease in interest income from the comparable period in 1999 is due to the reduction in funds invested. Selling, general and administrative expenses decreased to $2,591 thousand for the nine months ended September 30, 2000, from $3,802 thousand for the comparable period in 1999 due principally to reduced personnel expenses related to the payment of severance to several senior level executives in 1999. Current period general and administrative expense consists primarily of salary and wages, legal costs associated with litigation, consulting expenses, and costs associated with the agreement and plan of merger. The Company recorded no gain or loss on the disposition of subsidiaries and assets for the nine months ended September 30, 2000, compared to a $5 million gain for the comparable period in 1999. The $5 million gain in 1999 represents primarily the gain on the disposition of the Chateaugay Project and a Dutch limited partnership. 24 During the nine months ended September 30, 2000, the Company recorded a $152 thousand gain on trading debt securities, compared to a $60 thousand loss for the comparable period in 1999. The Company recorded other income of $2,467 thousand for the nine months ended September 30, 2000, compared to $3,052 thousand in this period in 1999. Other income in 2000 relates primarily to the reduction in accrued liabilities related to the favorable resolution of various legal matters, the reversal of construction-related accounts payable upon which the statute of limitations had expired, gain realized on the sale of the demutualized insurance company stock, and the receipt of business interruption insurance proceeds in settlement of litigation, net of related expenses. The Company recognized no gain on settlement of accounts payable in the nine-month period ended September 30, 2000, compared to $943 thousand in 1999. Income taxes: The Company uses the asset and liability approach for financial accounting and reporting for income taxes. The Company reported no income tax expense for the period ended September 30, 2000 due to the expected utilization of deferred tax benefits offset by reduction in valuation reserve. During the nine months ended September 30, 1999, the Company reduced the balance of the deferred benefit for deconsolidated subsidiary losses, resulting in an income tax benefit of $19.6 million. Liquidity and Capital Resources ------------------------------- Operating activities During the first nine months of 2000, operating activities used cash of approximately $1,652 principally due to the payment of general and administrative expenses. Investing activities During the first nine months of 2000, investment activities used cash of approximately $2,261, consisting primarily of the purchase of nonmarketable investments of $5,690, the funding of $3,717 in project development costs, the purchase for $6,000 of the limited liability joint venture interest, the purchase of trading debt securities of $10,727, offset by proceeds from the sale of trading debt securities of $23,132. Financing activities During the first nine months of 2000, the Company used cash of approximately $7,464 in repurchasing its Common Stock. Status Given the current operations and strategy of the Company, its cash balances are adequate for the foreseeable future. As of November 10, 2000, the Company had approximately $700 thousand remaining to be funded under its project development funding commitments and approximately $6.6 million remaining under its investment funding commitments. An additional $2,000,000 contribution to Steinway is contingent upon certain events. Effect of Recent Accounting Pronouncements Recent Accounting Pronouncements: In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 - an Amendment of FASB Statement No. 133", and SFAS No. 138, " Accounting for Certain Derivative Instruments and Certain Hedging Activities - an Amendment of FASB Statement No. 133", which establishes accounting and reporting standards for derivative instruments and hedging activities. The terms of SFAS No. 133 and SFAS No. 138 are effective as of the beginning of the first quarter of the fiscal year beginning after June 15, 2000. The Company is determining the effect of SFAS Nos. 133, 137 and 138 on its financial instruments. In December 1999, the SEC issued Staff Accounting Bulletin (SAB) No. 101. The SAB summarized certain of the SEC Staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. The Company believes it conforms to the guidance contained in the bulletin. 25 Item 3. Quantitative and Qualitative Disclosure about Market Risk Market Risk - Trading Securities As of September 30, 2000, the Company's exposure to market risk associated with instruments entered into for trading purposes is principally confined to its investment in trading debt securities, which are subject primarily to interest rate risk. The Company's investment in trading debt securities is a material component of the Company's total assets; therefore, market risk exposure should be considered to be material. The Company manages its interest rate risk through specific investment criteria designed to minimize such risk. The Company also employs discretionary selling practices aimed at minimizing realized market losses. The Company could foreseeably hold its investment in trading debt securities until the investments' maturity, thereby effectively eliminating associated interest rate risk. The majority of the Company's investment in trading debt securities that is subject to interest rate risk matures within three years. The potential gain or loss in fair value to the Company's investment in trading debt securities resulting from selected hypothetical increases in interest rates is expressed in the following sensitivity analysis. Change in market interest rates ------------------------------- Current 10% 20% ------------------------------------- (in thousands) Fair value of trading debt securities $ 18,831 $ 18,729 $ 18,628 Decrease from current fair value -- $ (102) $ (203) The sensitivity analysis above, known as a stress test in the banking industry, models the change in fair value based upon specific changes in the prime interest rate. The Company has no material market risk relating to foreign exchange rate risk or commodity price risk. Market Risk - Non-Trading Securities As of September 30, 2000, market risk associated with instruments entered into for other than trading purposes, namely the Company's investments in held-to-maturity debt securities and other investments, is not material. The Company's held-to-maturity debt securities and other investments are non-marketable and non-tradeable. Many of the Company's held-to-maturity debt securities and other investments represent investments in development-stage entities. The fair value of such investments may suffer adverse consequences should the investee entities fail to develop successfully. With respect to both investments entered into for trading purposes and instruments entered into for purposes other than trading, the Company is exposed to risk of classification as an investment company under the Investment Company Act of 1940. Some of the Company's investments may constitute investment securities under the 1940 Act. A company may be deemed to be an investment company if it owns investment securities with a value exceeding forty percent of its total assets, subject to certain exclusions. Investment companies are subject, in general, to registration under, and compliance with, the 1940 Act. If the Company was deemed to be an investment company under the 1940 Act, the Company would be prohibited from engaging in business or issuing securities as it has in the past, and might be subject to civil and criminal penalties for noncompliance. Additionally, certain of the Company's contracts might be voidable, and a court-appointed receiver could take control of the Company and liquidate its business. Although the Company's investments currently comprise less than forty percent of its total assets, fluctuations in the value of these securities or in other of the Company's assets may cause the limitation to be exceeded. To avoid exceeding the limitation, the Company may dispose of assets, realizing losses as a consequence, or may purchase additional non-investment assets. If the Company sells investment securities, it may sell them sooner than it otherwise would, perhaps at depressed prices or on unfavorable terms. Some investments may not be sold due to restrictions on transfer or non-marketability. Moreover, the Company may incur substantial tax liabilities upon any sale. 26 Part II OTHER INFORMATION Item 1. Legal Proceedings. See discussion under Note 11 of Item 1 incorporated herein by reference. Item 2. Changes in Securities and Use of Proceeds. On August 24, 2000, the Company amended its Restated Certificate of Incorporation to eliminate the Company's Series U Preferred Stock. No shares of the Series U Preferred Stock have ever been issued by the Company. Item 4. Submission of Matters to a Vote of Security Holders. (a) The 2000 Annual Meeting of Stockholders of the Company was held August 23, 2000. (b) The meeting involved the election of two Class I Directors to hold office for three-year terms. Charles Christenson and Michael D. Winn were duly nominated and seconded as the nominees for the Class I Directors with a term expiring on the date of the Annual Stockholder Meeting in 2003. Gerald R. Morgan, Jr.'s and Mark D. Lerdal's terms of office continued after such meeting until the date of the Annual Stockholder Meeting in 2001 and 2002, respectively. (c) The matters voted upon at the meeting, and vote tabulations for each matter, were as follows: (1) Election of Directors: Charles Christenson In Favor 28,395,214 Against 0 Withheld 328,598 Abstentions 0 Broker Non-Voters 0 Michael D. Winn. In Favor 28,393,415 Against 0 Withheld 330,397 Abstentions 0 Broker Non-Voters 0 (2) Approval of Amendment of the Company's Restated Certificate of Incorporation to Eliminate the Company's Series U Preferred Stock. In Favor 17,322,855 Against 303,778 Abstentions 32,778 Broker Non-Voters 11,064,401 (3) Approval of Amendment of the Company's Restated Certificate of Incorporation to Effect a One-For-Ten Reverse Stock Split of the Issued and Outstanding Shares of the Company's Common Stock. In Favor 28,421,396 Against 257,828 Abstentions 44,588 Broker Non-Voters 0 27 (4) Approval of Amendment of the Company's Restated Certificate of Incorporation to Decrease the Number of Authorized Shares of the Company's Common Stock from 110,000,000 to 11,000,000 and Decrease the Number of Authorized Shares of the Company's Preferred Stock From 10,000,000 to 1,000,000. In Favor 17,373,123 Against 239,180 Abstentions 47,108 Broker Non-Voters 11,064,401 (5) Ratification of the selection of KPMG LLP as the independent auditors of the Company for its fiscal year ending December 31, 2000. In Favor 28,389,941 Against 265,392 Abstentions 68,479 Broker Non-Voters 0 (d) Not applicable. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits 3 Restated Certificate of Incorporation. 27 Financial Data Schedule. (b) Reports on Form 8-K The Company filed a Report on Form 8-K, on October 26, 2000, reporting under Item 5, the execution of the agreement and plan of merger described in Part I, Item 1, Note 3. 28 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KENETECH Corporation By: Date: November 14, 2000 Mark D. Lerdal President, Chief Executive Officer and Principal Accounting Officer Date: November 14, 2000 By: Andrew M. Langtry Corporate Controller and Chief Accounting Officer 29 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KENETECH Corporation By: /s/ Mark D. Lerdal Date: November 14, 2000 Mark D. Lerdal President, Chief Executive Officer and Principal Accounting Officer Date: November 14, 2000 By: /s/ Andrew M. Langtry Andrew M. Langtry Corporate Controller and Chief Accounting Officer 30 EXHIBIT INDEX The following constitute the exhibits to the Quarterly Report on Form 10-Q of the Company for the period ended September 30, 2000: Sequential Exhibit Page Number Exhibit Number 3 Restated Certificate of Incorporation 33 27 Financial Data Schedule 63 99.1 Notice of Motion and Motion for Leave -- to File Second Amended and Supplemental Complaint in the action styled Kohls vs. Duthie, et. al.* * Incorporated by reference to Amendment No. 1 to Schedule 14D-9, filed with the Securities and Exchange Commission by Registrant on November 14, 2000. 31