UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark one)
[x] QUARTERLY REPORT UNDER SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended June 30, 2001
---------------------------------------------
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission file number 0-15472
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Environmental Power Corporation
(Exact name of registrant as specified in its charter)
Delaware 04-2782065
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
500 Market Street, Suite 1-E, Portsmouth, New Hampshire 03801
(Address of principal executive offices)
(Zip code)
(603) 431-1780
Registrant's telephone number, including area code
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes[x] No[_]
Number of shares of Common Stock outstanding
at August 10, 2001 16,928,332 shares
The Exhibit Index appears on Page 36.
Total number of pages is 38.
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ENVIRONMENTAL POWER CORPORATION
INDEX
PART I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as
of June 30, 2001 (unaudited) and December 31, 2000................ 2
Condensed Consolidated Statements of Operations (unaudited) for
the Three and Six Months Ended June 30, 2001 and June 30, 2000.... 3
Condensed Consolidated Statements of Cash Flows (unaudited) for
the Six Months Ended June 30, 2001 and June 30, 2000.............. 4
Notes to Condensed Consolidated Financial Statements.............. 5-7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................... 8-35
Item 3. Quantitative and Qualitative Disclosures About Market
Risk.............................................................. 35
PART II. OTHER INFORMATION
Item 1. Legal Proceedings........................................ 36
Item 4. Submission of Matters to a Vote of Security Holders...... 36
Item 6. Exhibits and Reports on Form 8-K......................... 36-38
Signatures........................................................ 38
1
PART I. FINANCIAL INFORMATION
------------------------------
ITEM 1. FINANCIAL STATEMENTS
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
JUNE 30 DECEMBER 31
2001 2000
----------------- ----------------
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 624,420 $ 307,666
Restricted cash 1,213,864 587,476
Receivable from utility 6,101,323 7,336,408
Other current assets 1,479,106 760,980
---------------- ---------------
TOTAL CURRENT ASSETS 9,418,713 8,992,530
PROPERTY, PLANT AND EQUIPMENT, NET 478,226 558,015
DEFERRED INCOME TAX ASSET 657,193 755,193
LEASE RIGHTS, NET 2,236,005 2,310,507
ACCRUED POWER GENERATION REVENUES 59,918,565 56,188,143
OTHER ASSETS 666,671 479,786
---------------- ---------------
TOTAL ASSETS $ 73,375,373 $ 69,284,174
================ ===============
LIABILITIES AND SHAREHOLDERS' DEFICIT
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 8,727,170 $ 6,952,054
Dividends payable on common stock --- 171,102
Other current liabilities 1,479,235 3,045,787
---------------- ---------------
TOTAL CURRENT LIABILITIES 10,206,405 10,168,943
DEFERRED GAIN, NET 4,626,160 4,780,365
SECURED PROMISSORY NOTES PAYABLE
AND OTHER BORROWINGS 2,025,863 2,116,309
ACCRUED LEASE EXPENSES 59,918,565 56,188,143
---------------- ---------------
TOTAL LIABILITIES 76,776,993 73,253,760
---------------- ---------------
SHAREHOLDERS' DEFICIT:
Preferred Stock ($.01 par value; 1,000,000 shares authorized; no shares
issued) --- ---
Preferred Stock (no par value, 10 shares authorized; 10 shares
issued at June 30, 2001 and December 31, 2000, respectively) 100 100
Common Stock ($.01 par value; 20,000,000 shares authorized;
12,525,423 shares issued at June 30, 2001 and
December 31, 2000, respectively; 11,406,783 shares outstanding
at June 30, 2001 and December 31, 2000, respectively) 125,254 125,254
Accumulated deficit (2,424,755) (3,192,721)
---------------- ---------------
(2,299,401) (3,067,367)
Treasury stock (1,118,640 common shares, at cost, as of
June 30, 2001 and December 31, 2000, respectively) (456,271) (456,271)
Notes receivable from officers and board members (645,948) (445,948)
---------------- ---------------
TOTAL SHAREHOLDERS' DEFICIT (3,401,620) (3,969,586)
---------------- ---------------
TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIT $ 73,375,373 $ 69,284,174
================ ===============
See Notes to Condensed Consolidated Financial Statements.
2
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS ENDED JUNE 30 SIX MONTHS ENDED JUNE 30
2001 2000 2001 2000
------------ ------------- ------------ ------------
<s>
POWER GENERATION REVENUES $ 12,096,878 $ 11,317,167 $ 25,579,769 $ 28,085,722
------------ ------------- ------------ ------------
COSTS AND EXPENSES:
Operating expenses 7,529,833 6,805,246 12,487,073 12,044,751
Lease expenses 5,859,101 6,386,892 11,874,123 14,038,290
General and administrative expenses 802,751 941,812 1,488,480 1,606,609
Depreciation and amortization 86,564 105,396 173,111 210,782
------------ ------------- ------------ ------------
14,278,249 14,239,346 26,022,787 27,900,432
------------ ------------- ------------ ------------
OPERATING INCOME (LOSS) (2,181,371) (2,922,179) (443,018) 185,290
------------ ------------- ------------ ------------
OTHER INCOME (EXPENSE), NET:
Interest income 22,960 39,703 41,744 673,725
Interest expense (33,124) (66,132) (102,427) (158,136)
Other income 1,677,962 --- 1,677,962 0
Sale of NOx emission credits --- 1,161,888 --- 1,161,888
Amortization of deferred gain 77,102 77,103 154,205 154,205
------------ ------------- ------------ ------------
1,744,900 1,212,562 1,771,484 1,831,682
------------ ------------- ------------ ------------
INCOME (LOSS) BEFORE INCOME TAXES (436,471) (1,709,617) 1,328,466 2,016,972
INCOME TAX BENEFIT (EXPENSE) 219,000 752,000 (558,000) (888,000)
------------ ------------- ------------ ------------
NET INCOME (LOSS) $ (217,471) $ (957,617) $ 770,466 $ 1,128,972
============ ============= ============ ============
BASIC AND DILUTED EARNINGS (LOSS) PER
COMMON SHARE $ (0.02) $ (0.08) $ 0.07 $ 0.10
============ ============= ============ ============
DIVIDENDS:
Common shares $ --- $ 171,102 $ --- $ 342,204
Preferred shares 1,250 1,250 2,500 2,500
------------ ------------- ------------ ------------
$ 1,250 $ 172,352 $ 2,500 $ 344,704
============ ============= ============ ============
DIVIDENDS PER COMMON SHARE $ 0.000 $ 0.015 $ 0.000 $ 0.030
============ ============= ============ ============
See Notes to Condensed Consolidated Financial Statements
3
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
SIX MONTHS ENDED JUNE 30
2001 2000
--------------- ---------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 770,466 $ 1,128,972
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 173,111 210,782
Deferred income taxes 98,000 7,000
Amortization of deferred gain (154,205) (154,205)
Accrued power generation revenues (3,730,422) (3,518,004)
Accrued lease expenses 3,730,422 3,518,004
Changes in operating assets and liabilities:
Decrease (increase) in receivable from utility 1,235,085 (2,101,486)
Increase in other current assets (718,126) (6,997)
Increase in other assets (5,003) (6,638)
Increase in accounts payable and accrued expenses 1,775,116 3,195,547
Increase in long-term liabilities --- 5,700
Decrease in long-term debt to supplier (96,274) (93,250)
--------------- ---------------
Net cash provided by operating activities 3,078,170 2,185,425
--------------- ---------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Increase in restricted cash (626,388) (441,325)
Acquisition related expenditures (199,702) ---
Property, plant and equipment expenditures (1,000) (300)
--------------- ---------------
Net cash used in investing activities (827,090) (441,625)
--------------- ---------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividend payments (173,602) (344,704)
Net repayments of working capital loan (1,523,641) (80,796)
Advances on notes receivable from officers (200,000) ---
Repayment of secured promissory notes payable and
other borrowings (37,083) (600,000)
--------------- ---------------
Net cash used in financing activities (1,934,326) (1,025,500)
--------------- ---------------
INCREASE IN CASH AND CASH EQUIVALENTS 316,754 718,300
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 307,666 306,188
--------------- ---------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 624,420 $ 1,024,488
=============== ===============
See Notes to Condensed Consolidated Financial Statements.
4
ENVIRONMENTAL POWER CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE A -- BASIS OF PRESENTATION
- -------------------------------
The accompanying unaudited condensed consolidated financial statements of
Environmental Power Corporation ("EPC") and its subsidiaries (collectively the
"Company") have been prepared in accordance with the instructions to Form 10-Q
and do not include all of the information and footnotes required by generally
accepted accounting principles for annual financial statements. In the opinion
of management, all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation have been included. The results of
operations for the three and six months ended June 30, 2001 are not necessarily
indicative of results to be expected for the year ending December 31, 2001. For
further information, refer to the consolidated financial statements and
footnotes included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2000.
NOTE B - RECENT ACCOUNTING PRONOUNCEMENTS
- -----------------------------------------
In June 2001, the Financial Accounting Standards Board ("FASB") issued two new
pronouncements: Statement of Financial Accounting Standards ("SFAS") No. 141,
Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets.
SFAS 141 is effective as follows: 1) use of the pooling-of-interest method is
prohibited for business combinations initiated after June 30, 2001; and 2) the
provisions of SFAS 141 also apply to all business combinations accounted for by
the purchase method that are completed after June 30, 2001 (that is, the date
of the acquisition is July 2001 or later). There are also transition provisions
that apply to business combinations completed before July 1, 2001, that were
accounted for by the purchase method. The most significant changes made by SFAS
No. 142 are: 1) goodwill and indefinite-lived intangible assets will be tested
for impairment at least annually; 2) goodwill will no longer be amortized to
income; and 3) the amortization period of intangible assets with finite lives
will no longer be limited to forty years. SFAS 142 is effective for fiscal years
beginning after December 15, 2001 to all goodwill and other intangible assets
recognized in an entity's statement of financial position at that date,
regardless of when those assets were initially recognized. The Company is
currently evaluating the provisions of SFAS 141 and SFAS 142 and has not adopted
such provisions in its June 30, 2001 condensed consolidated financial
statements.
NOTE C -- EARNINGS PER COMMON SHARE
- -----------------------------------
The Company computes its earnings per common share using the treasury stock
method in accordance with SFAS No. 128, "Earnings per Share". The Company
computes basic earnings per share by dividing net income for the period by the
weighted average number of shares of common stock outstanding during the period.
For purposes of calculating diluted earnings per share, the Company considers
its shares issuable in connection with stock options to be dilutive common stock
equivalents when the exercise price is less than the average market price of the
Company's common stock for the period. The Company excludes antidilutive common
stock equivalents from the calculation of diluted earnings per share. The
following table outlines the calculation of basic earnings per share and diluted
earnings per share for the three and six months ended June 30, 2001 and 2000.
5
NOTE C -- EARNINGS PER COMMON SHARE (CONTINUED)
- -----------------------------------------------
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNTS
------------------ -------------------- ---------------
Three Months Ended June 30, 2001:
- ---------------------------------
Loss attributable to shareholders $ (217,471) 11,406,783 $ (.02)
Effect of dividends to preferred stockholders (1,250)
------------------ -------------------- ---------------
Basic EPS - Loss attributable to common shareholders (218,721) 11,406,783 (.02)
Effect of dilutive securities:
Assumed exercise of dilutive stock options 28,047
------------------ -------------------- ---------------
Diluted EPS - Loss attributable to common shareholders $ (218,721) 11,434,830 $ (.02)
================== ==================== ===============
Three Months Ended June 30, 2000:
- ---------------------------------
Loss attributable to shareholders $ (957,617) 11,406,783 $ (.08)
Effect of dividends to preferred stockholders (1,250)
------------------ -------------------- ---------------
Basic EPS - Loss attributable to common shareholders (958,867) 11,406,783 (.08)
Effect of dilutive securities:
Assumed exercise of dilutive stock options 1,087
------------------ -------------------- ---------------
Diluted EPS - Loss attributable to common shareholders $ (958,867) 11,407,870 $ (.08)
================== ==================== ===============
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNTS
--------------- ----------------- ------------
Six Months Ended June 30, 2001:
- -------------------------------
Income attributable to shareholders $ 770,466 11,406,783 $ .07
Effect of dividends to preferred stockholders (2,500)
--------------- ------------- --------
Basic EPS - Income attributable to common shareholders 767,966 11,406,783 .07
Effect of dilutive securities:
Assumed exercise of dilutive stock options 14,627
--------------- ------------- --------
Diluted EPS - Income attributable to common shareholders $ 767,966 11,421,410 $ .07
=============== ============= ========
Six Months Ended June 30, 2000:
- -------------------------------
Income attributable to shareholders $ 1,128,972 11,406,783 $ .10
Effect of dividends to preferred stockholders (2,500)
--------------- ------------- --------
Basic EPS - Income attributable to common shareholders 1,126,472 11,406,783 .10
Effect of dilutive securities:
Assumed exercise of dilutive stock options 815
--------------- ------------- --------
Diluted EPS - Income attributable to common shareholders $ 1,126,472 11,407,598 $ .10
=============== ============= ========
NOTE D - SUBSEQUENT EVENT
- -------------------------
On July 23, 2001, the Company acquired approximately 87.7% of the outstanding
common stock of Microgy Cogeneration Systems Inc., a privately held Colorado
Corporation ("Microgy"), in exchange for securities of the Company pursuant to a
Share Exchange Agreement (the "Exchange Agreement") dated as of June 20, 2001
among the Company, Microgy and the Principal Microgy Shareholders, as defined
therein. Under the terms of the Exchange Agreement, the Company issued an
aggregate of 5,521,549 shares of the Company's common stock, $.01 par value
("Common Stock") and 197,760.7 shares of the Company's newly designated Series B
Convertible Preferred Stock, $.01 par value (the "Preferred Stock"), to the
Principal Microgy
6
NOTE D - SUBSEQUENT EVENT (CONTINUED)
Shareholders in exchange for 15,919,147 shares of Microgy common stock. Each
share of Preferred Stock, which votes with the Common Stock on an as converted
basis, will automatically be converted into ten shares of Common Stock upon an
increase in the authorized common stock to an amount sufficient to allow
conversion of the Preferred Stock. The exchange ratio ("Exchange Ratio") used
was 0.3468495 shares of Common Stock and 0.0124228 shares of Preferred Stock for
each share of Microgy common stock. Under the terms of the Exchange Agreement,
the Company agreed to offer the remaining shareholders of Microgy (who own an
aggregate of 2,230,126 shares of Microgy common stock, warrants to purchase
885,000 shares of Microgy common stock and options to purchase 290,000 shares of
Microgy common stock) an opportunity to exchange their Microgy securities for
EPC securities based on the Exchange Ratio. On July 23, 2001, one of the
Principal Microgy Shareholders also exchanged a warrant to purchase 800,000
shares of Microgy common stock for a warrant to purchase securities of the
Company based on the Exchange Ratio. The exercise price for the warrant to
purchase securities of the Company exceeded the estimated market value of the
Company's common stock on the date of the exchange. For further information
about this transaction, refer to the Company's Report on Form 8-K which was
filed on August 7, 2001 and amended on August 14, 2001.
Had Microgy's results of operations been included in the Company's consolidated
statement of operations, the Company would have reported the following pro forma
financial information:
Six Months Ended Six Months Ended
June 30, 2001 June 30, 2000
---------------------- --------------------------
Power generation revenues $25,579,769 $28,085,722
Net income 156,610 613,410
Basic earnings per common share .01 .04
Diluted earnings per common share .01 .03
7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Overview of the Company
The Company owns a 22 year leasehold interest in an approximately 83 Mw (net)
waste coal-fired electric generating facility (the "Scrubgrass Project") located
in Pennsylvania, the lease for which commenced on June 30, 1994. The Company's
leasehold interest in the Scrubgrass Project is held by EPC's subsidiary,
Buzzard Power Corporation ("Buzzard"). Buzzard leases the Scrubgrass Project
from Scrubgrass Generating Company L.P. (the "Lessor"). Buzzard has a Management
Services Agreement (the "MSA") with PG&E National Energy Group Company ("NEG" or
the "Manager") to manage the Scrubgrass Project and a 15-year Operations and
Maintenance Agreement (the "O&M") with PG&E Operating Services Company (the
"Operator") to operate the Scrubgrass Project. Buzzard sells electric output to
Pennsylvania Electric Company ("PENELEC") pursuant to a 25 year power purchase
agreement (the "PPA") which expires in 2018.
On July 23, 2001, the Company purchased an 87.7% controlling interest in Microgy
Cogeneration Systems, Inc., a privately held Colorado corporation ("Microgy").
Microgy intends to develop, finance, own and operate project facilities which
utilize environmentally friendly technologies that focus primarily on production
of energy from animal and organic wastes (bio-energy), creation of fuels from
renewable bio sources (bio-fuels) and the creation of cogeneration projects
(alternative energy) which have potential distributed power applications.
Microgy intends to develop and license from others proprietary technologies that
focus on renewable, clean, cost effective energy and fuels.
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations compares the Company's results of operations for the three
and six months ended June 30, 2001 with the results of operations for the three
and six months ended June 30, 2000. Historical results and trends which might
appear should not be taken as indicative of future operations.
Cautionary Statement
This Quarterly Report on Form 10-Q contains "forward-looking statements", as
defined by the Private Securities Litigation Reform Act of 1995, in order to
provide investors with prospective information about the Company. For this
purpose, any statements which are not statements of historical fact may be
deemed to be forward-looking statements. Without limiting the foregoing, the
words "believes", "anticipates", "plans", "expects" and similar expressions are
intended to identify forward-looking statements. There are a number of
important factors which could cause the Company's actual results and events to
differ materially from those indicated by the forward looking statements. These
factors include, without limitation, those set forth below under the caption "--
Certain Factors That May Affect Future Results".
8
RESULTS OF OPERATIONS
Net income for the six months ended June 30, 2001 amounted to $770,466 (7 cents
per share) as compared to net income of $1,128,972 (10 cents per share) for the
six months ended June 30, 2000. The decrease in net results during the six
months ended June 30, 2001 is primarily attributable to a decrease in power
generation revenues, a decrease in interest income, the absence of revenues from
sales of NOx emission credits, and an increase in operating expenses. The effect
of these changes was offset in part by an increase in other income and decreases
in lease expenses, income tax expense and general and administrative expenses.
Net loss for the three months ended June 30, 2001 amounted to $217,471 (2 cents
per share) as compared to a net loss of $957,617 (8 cents per share) for the
three months ended June 30, 2000. The improvement in net results during the
three months ended June 30, 2001 is primarily attributable to an increase in
power generation revenues, an increase in other income, a decrease in lease
expense and a decrease in general and administrative expenses. The effect of
these changes was offset in part by an increase in operating expenses, a
decrease in the income tax benefit and the absence of revenues from sales of NOx
emission credits. The reasons for these changes in the Company's net results are
discussed in more detail in the following sections.
Power Generation Revenues
- -------------------------
Power generation revenues for the six months ended June 30, 2001 amounted to
$25,579,769 as compared to $28,085,722 for the same period in 2000. The decrease
in power generation revenues during the six months ended June 30, 2001 is
primarily attributable to the absence of revenues of approximately $3,687,000
from the settlement agreement with PENELEC. This decrease was offset in part by
a 5% increase in certain rates billed to PENELEC under the terms of the PPA and
an increase in the revenue recorded as a result of the straight-line accounting
treatment of certain revenues under the PPA which amounted to $3,730,422 and
$3,518,004 for the six months ended June 30, 2001 and 2000, respectively. The
Scrubgrass Project, which operated at 86.9% of its capacity for the six months
ended June 30, 2001 as compared to 86.3% for the same period in 2000, had
comparable power generation during each six month period.
Power generation revenues for the three months ended June 30, 2001 amounted to
$12,096,878 as compared to $11,317,167 for the same period in 2000. The increase
in power generation revenues during the three months ended June 30, 2001 is
primarily attributable to an improvement in the capacity billed to the utility,
the 5% increase in certain rates billed to PENELEC under the terms of the PPA,
and an increase in the revenue recorded as a result of the straight-line
accounting treatment of certain revenues under the PPA which amounted to
$1,865,214 and $1,759,005 for the three months ended June 30, 2001 and 2000,
respectively. The Scrubgrass Project operated at 80.1% of its capacity during
the three months ended June 30, 2001 as compared to 78.7% of its capacity for
the same period in 2000. The second quarter capacity rates were primarily
affected by the following two factors. First, the Scrubgrass project had its
planned annual maintenance outages during the second quarters in both 2001 and
2000. During the 2001 and 2000 planned annual maintenance outages, the
Scrubgrass plant was inoperative for approximately 17 days and 16 days,
respectively, to perform scheduled maintenance procedures. Second, the
Scrubgrass Project incurred unscheduled shutdowns to respond to equipment
malfunctions and utility curtailments which necessitated that the Scrubgrass
9
plant be inoperative for an aggregate of approximately 1 day and 3 days outside
of the scheduled outage timeframes during the second quarters of 2001 and 2000,
respectively.
Operating Expenses
- ------------------
Operating expenses for the three and six months ended June 30, 2001 amounted to
$7,529,833 and $12,487,073, respectively, as compared to $6,805,246 and
$12,044,751 for the three and six months ended June 30, 2000, respectively. The
increase in operating expenses during the three and six months ended June 30,
2001 is primarily attributable to the following reasons. First, the Company had
higher fuel costs primarily from cost escalations in certain fuel supply
agreements, changes in fuel mix, increases in average diesel fuel costs and fuel
excavator expenses. Second, pursuant to the terms of the O&M, the Operator
passed along increases in its labor and related costs and operator fees to the
Company. Third, planned maintenance expenses increased primarily because of
differences in the scope of procedures performed during the 2001 and 2000 annual
maintenance outages. These increases were offset in part by the following
decreases in operating expenses during the three and six months ended June 30,
2001. First, facility enhancement and routine maintenance expenses decreased
due to differences in the nature of work performed during the first six months
of 2001 and 2000. Second, due to the absence of certain hauling fees incurred
during the first half of 2000, the Company had a decrease in its ash handling
expenses.
Lease Expenses
- ---------------
Lease expenses for the three and six months ended June 30, 2001 amounted to
$5,859,101 and $11,874,123, respectively, as compared to $6,386,892 and
$14,038,290 for the three and six months ended June 30, 2000, respectively. The
decrease in lease expenses during the three and six months ended June 30, 2001
is primarily attributable to the following reasons. First, the Lessor's loan
costs, which are passed along to the Company as a lease expense, decreased due
to reductions in the following three items: 1) average variable interest rates;
2) outstanding principal balances on term loans; and 3) principal payments for
the term loans. Second, the Company incurred scheduled decreases in base equity
rents paid to the Lessor. Third, the additional rents paid to the Lessor, which
amount to 50 percent of the net cash flows from the Scrubgrass Project, were
lower during the three and six months ended June 30, 2001 primarily due to the
absence of revenues and interest income from the PENELEC settlement and the
absence of income from the sale of NOx emission credits. This overall decrease
in lease expenses was offset in part by the following increases in lease
expenses during the three and six months ended June 30, 2001. First, due to the
recent refinancing of the Lessor's letter of credit, the Company had an increase
in the Lessor's letter of credit fees which were passed through in its facility
lease expenses. Second, the Company had an increase in lease expenses recorded
as a result of the straight-line accounting treatment of certain lease expenses
under the Scrubgrass lease which amounted to $1,865,214 and $3,730,422 for the
three and six months ended June 30, 2001, respectively, as compared to
$1,759,005 and $3,518,004 for the three and six months ended June 30, 2000,
respectively.
10
General and Administrative Expenses
- -----------------------------------
General and administrative expenses for the three and six months ended June 30,
2001 amounted to $802,751 and $1,488,480, respectively, as compared to $941,812
and $1,606,609 for the three and six months ended June 30, 2000, respectively.
The decreases in general and administrative expenses during the three and six
months ended June 30, 2001 were primarily attributable to a decrease in legal
expenses from the settlement of the Sunnyside litigation and a decrease in
Scrubgrass management expenses. Scrubgrass had incurred significant professional
fees, travel expenses and labor related costs during the three and six months
ended June 30, 2000 to address certain non-recurring business matters including
the settlement with PENELEC and the replacement of the letter of credit. These
decreases were offset in part by increases in Scrubgrass insurance expense and
corporate pension expense during the three and six months ended June 30, 2001.
Interest Income
- ---------------
Interest income for the three and six months ended June 30, 2001 amounted to
$22,960 and $41,744, respectively, as compared to $39,703 and $673,725 for the
three and six months ended June 30, 2000, respectively. The decrease during the
six months ended June 30, 2001 is mostly attributable to the absence of
approximately $608,000 of interest income from the settlement agreement with
PENELEC. The decrease during the three and six months ended June 30, 2001 was
also attributable to lower average interest rates for investments and reductions
in the outstanding balances of notes receivable from officers.
Interest Expense
- ----------------
Interest expense for the three and six months ended June 30, 2001 amounted to
$33,124 and $102,427, respectively, as compared to $66,132 and $158,136 for the
three and six months ended June 30, 2000, respectively. The decrease during the
three and six months ended June 30, 2001 is primarily attributable to the
following three factors: 1) lower average variable interest rates; 2) lower
average outstanding balances under Buzzard's working capital and term loans; and
3) the absence of the 1997 term credit facility which was fully paid in 2000.
Other Income
- ------------
Other income amounted to $1,677,962 for each of the three and six months ended
June 30, 2001. As discussed under "Financing Activities - Sunnyside Project
Obligations", the Company reported the settlement proceeds of $1,500,000 and
contingent liability release of $177,962 related to the Sunnyside Project as
other income during the second quarter of 2001.
Income Tax Expense
- ------------------
Income tax expense amounted to $558,000 and $888,000 for the six months ended
June 30, 2001 and 2000, respectively, and income tax benefit amounted to
$219,000 and $752,000 for the three months ended June 30, 2001 and 2000,
respectively. The decrease in income tax expense for the six months ended June
30, 2001 is primarily attributable to a decrease in earnings before taxes and a
decrease in
11
the expected effective income tax rate. The decrease in income tax benefit for
the three months ended June 30, 2001 is primarily attributable to a decrease in
loss before taxes, which decrease was offset in part by an increase in the
expected effective income tax rate. The effective income tax rate for year ended
December 31, 2001 ("Fiscal 2001") is currently projected to be approximately 42%
which is lower than the actual tax rate of approximately 47% incurred during the
year ended December 31, 2000 ("Fiscal 2000"). Due to revenues from the PENELEC
settlement and sales of NOx Credits, the Company's taxable earnings were
significantly concentrated in Pennsylvania during Fiscal 2000, which state
carries the highest effective tax rate for the Company. The Company does not
presently expect its taxable earnings will be so highly concentrated in
Pennsylvania during Fiscal 2001. During the second quarter of 2001, the Company
revised its estimated effective tax rate for Fiscal 2001 from 44% to 42%. Due to
a net loss, the effective tax rate for the second quarter of 2001 increased to
approximately 50% in order to revise the effective tax rate to 42% for the six
months ended June 30, 2001.
Fiscal 2001 Outlook
The Company offers the following prospective information concerning its results
of operations for Fiscal 2001 which are being compared to the historical results
of operations for Fiscal 2000:
Power generation revenues - Power generation revenues are expected to
decrease in Fiscal 2001 primarily due to the absence of revenues from the
PENELEC settlement. This decrease would be offset in part by a 5% increase in
certain contracted rates under the PPA and an increase in the revenue
recorded as a result of the straight-line accounting treatment of certain
revenues under the PPA.
Operating expenses - Operating expenses are expected to increase in Fiscal
2001 from a 4% average escalation in rates for fuel supply agreements,
increases in diesel fuel costs, a 5% escalation in rates for Operator fees,
changes in the scope of planned maintenance procedures, escalating costs for
NOx emission reduction chemicals, and anticipated increases in the Operator's
labor and related costs. These increases are expected to be offset in part
by decreases in facility enhancement and ash handling expenses.
Lease expenses - Lease expenses are expected to decrease in Fiscal 2001 for
the following reasons. First, the Company expects that reductions in
principal balances on Lessor's term loans and lower interest rates on the
Lessor's tax-exempt bonds and term loans will decrease the Lessor's loan
interest costs that are expected to be passed through to the Company in its
facility lease expenses. Second, the Company expects to have scheduled
decreases in base equity rents during Fiscal 2001. Third, due to projected
decreases in available cash flows from the Scrubgrass Project, which included
significant non-recurring revenues and interest income during Fiscal 2000,
the Company expects its additional rent paid to the Lessor, which amounts to
50 percent of the net cash flows from the Scrubgrass Project, would decrease
in Fiscal 2001. These decreases are expected to be offset in part by
increases in the Lessor's letter of credit fees and term loan payments which
would be passed through to the Company in its facility lease expenses.
12
General and administrative expenses - General and administrative expenses are
expected to significantly increase during Fiscal 2001 for the following
reasons. First, the Company acquired Microgy on July 23, 2001 and is
expected to incur this subsidiary's general and administrative expenses for
the remainder of Fiscal 2001. Second, the Company expects to incur
significant expenses pertaining to the Microgy acquisition for post-
acquisition integration, business development, and strategic planning.
Third, the Company expects to incur increases in Scrubgrass insurance expense
and corporate pension expense. These increases are expected to be offset in
part by the following decreases in general and administrative expenses during
Fiscal 2001. First, the Company paid significant bonuses to two executive
officers during Fiscal 2000 and presently expects that aggregate executive
compensation to these executive officers would decrease in Fiscal 2001.
Second, the Company incurred significant Scrubgrass Project management
expenses during Fiscal 2000 to address non-recurring business matters
including the PENELEC settlement and the replacement of the letter of credit.
Third, due to the settlement of the Sunnyside Project litigation, the Company
expects to realize a reduction in professional fees for legal proceedings.
Depreciation and amortization - Depreciation and amortization is expected to
increase during Fiscal 2001 primarily as a result of the acquisition of
Microgy on July 23, 2001. The Company acquired fixed assets and intellectual
property from Microgy which is expected to incur depreciation and
amortization for the remainder of Fiscal 2001.
Other income - Other income is expected to decrease slightly in Fiscal 2001
primarily due to the absence of interest income from the PENELEC settlement
and the absence of income from sales of NOx Credits. This decrease is
expected to be substantially offset by the income from the settlement of the
Sunnyside litigation. As discussed under "Cash Flow Outlook", the Company
expects to be awarded additional NOx Credits in late 2001 or early 2002 and
may be able to sell a portion of these NOx Credits. Should the anticipated
NOx Credits be awarded in Fiscal 2001, the Company may report income from
sales of NOx Credits during Fiscal 2001.
Income tax expense - Income tax expense is expected to significantly decrease
in light of anticipated decreases in income before income taxes and the
effective tax rate.
RECENTLY ISSUED ACCOUNTING STANDARDS
There are two recently issued accounting standards which are required to be
adopted in the future which are included in Note B to the Condensed Consolidated
Financial Statements.
13
LIQUIDITY AND CAPITAL RESOURCES
Operating Activities
The Company had cash provided by operating activities of $3,078,170 and
$2,185,425 during the six months ended June 30, 2001 and 2000, respectively.
During these periods, the Company's only sources of cash from operating
activities were operating profits from the Scrubgrass Project, proceeds from the
settlement of the Sunnyside litigation, proceeds from sales of NOx Credits and
investment earnings.
The Company's net income during the six months ended June 30, 2001 and 2000
contributed a significant portion of the cash provided by operations. The
following adjustments, which did not impact the Company's cash flows, need to be
considered in order to reconcile the Company's net income during the six months
ended June 30, 2001 to its net cash provided by operating activities.
Depreciation and amortization - During the six months ended June 30, 2001, the
Company recognized depreciation and amortization for its lease rights of
$74,502, deferred financing costs of $17,820, machinery and equipment
modifications of $76,554 and equipment and furniture of $4,235.
Deferred gain, net - The Company's deferred gain, net, amounted to $4,626,160 as
of June 30, 2001 as compared to $4,780,365 as of December 31, 2000. The decline
is due to the amortization of the deferred gain related to the Scrubgrass
Project, which is being amortized on a straight-line basis over 22 years.
The Company also offers the following information to discuss changes in its
operating assets and liabilities which most notably impacted its cash position
during the six months ended June 30, 2001:
Receivable from utility - The Company's receivable from utility relates to the
Scrubgrass Project and amounted to $6,101,323 as of June 30, 2001 as compared to
$7,336,408 as of December 31, 2000. The decrease in the receivable from utility
as of June 30, 2001 is primarily attributable to the scheduled annual outage
during the second quarter of 2001, which reduced power generation revenues
during this quarter by comparison to the fourth quarter of 2000. This decrease
was offset in part by a 5% increase during 2001 of certain contracted rates
under the PPA. Power generation revenues are discussed further under "Results
of Operatons".
Other current assets - The Company's other current assets amounted to $1,479,106
as of June 30, 2001 as compared to $760,980 as of December 31, 2000. The
increase in other current assets is primarily attributable to higher on-hand
quantities of limestone inventory and a seasonal increase in prepaid insurance.
During January 2001, the Company purchased a significant amount of limestone
inventory in advance of its consumption requirements to obtain favorable
pricing.
Accounts payable and accrued expenses - The Company's accounts payable and
accrued expenses amounted to $8,727,170 as of June 30, 2001 as compared to
$6,952,054 as of December 31, 2000. The increase in accounts payable and
accrued expenses is primarily attributable to the following reasons. First, due
to its annual maintenance outage, the Company has seasonal increases in
operating
14
expenses during the second quarter of each year. As of June 30, 2001, the
Company had approximately $2.8 million of annual outage costs in its accounts
payable and accrued expenses which were offset in part by reduced variable costs
from not operating the facility. Second, the Company had accruals for base
equity rent and additional rent as of June 30, 2001, for which similar accruals
did not exist as of December 31, 2000. Third, as discussed under Results of
Operations, the Company had increases in certain operating expenses during 2001
which led to increases in accounts payable and accrued expenses as of June 30,
2001. The aforementioned increases were offset in part by the following
decreases in accounts payable and accrued expenses. First, the Company has
certain costs which are paid annually during the first quarter and accrued
monthly during the calendar year. For such costs, the Company's accrued expenses
as of June 30, 2001 included only six months of expense as compared to 12 months
of expense as of December 31, 2000. Second, corporate taxes payable decreased
from $743,208 as of December 31, 2000 to $504,768 as of June 30, 2001. The
decrease in corporate taxes payable was primarily attributable to seasonal
reductions in taxable earnings and the use of available safe harbors to defer
the payment of certain Pennsylvania taxes for Fiscal 2000 to April 2001. Third,
the Company had a higher accrual as of December 31, 2000 for the Lessor's
scheduled principal payments which are passed through to the Company as a lease
expense than as of June 30, 2001.
Long -term debt to supplier - The Company financed the 1997 rewind of the
Scrubgrass generator with an installment note from the generator manufacturer
which had outstanding balances of $94,172 and $190,446 as of June 30, 2001 and
December 31, 2000, respectively. The decrease in 2001 is due to a scheduled
installment payment made during May 2001. The remaining balance is due in May
2002 and is included in other current liabilities on the accompanying balance
sheet as of June 30, 2001.
Investing Activities
The Company used $827,090 and $441,625 in investing activities during the six
months ended June 30, 2001 and 2000, respectively. The Company's investing
activities are concentrated primarily in the following areas:
Restricted cash - The Company is presently required to make scheduled deposits
to a restricted major maintenance fund relating to the Scrubgrass Project to
ensure that funds are available in the future for scheduled major equipment
overhauls. The Company is also allowed to spend restricted cash to fund the
cost of major equipment overhauls subject to certain restrictions. During the
six months ended June 30, 2001 and 2000, the Company made scheduled deposits to
the restricted major maintenance fund of $605,140 and $431,788, respectively.
The remaining increases in restricted cash primarily pertain to earnings on
available restricted cash balances. The Company did not make expenditures for
major equipment overhauls during the six months ended June 30, 2001 and 2000.
Acquisitions - The Company made expenditures of $199,702 during the six months
ended June 30, 2001 for contract negotiations and due diligence activities
related to the acquisition of Microgy. These expenditures were capitalized in
other assets on the accompanying condensed consolidated balance sheet as of June
30, 2001.
15
Property, plant and equipment - The Company purchased office equipment for its
corporate headquarters in the amounts of $1,000 and $300 during the six months
ended June 30, 2001 and 2000, respectively.
Financing Activities
The Company used $1,934,326 and $1,025,500 in financing activities during the
six months ended June 30, 2001 and 2000, respectively. The Company's financing
activities are concentrated primarily in the following areas:
Dividends - The Company has a quarterly dividend program which is subject to
review and consideration by the Board of Directors each quarter. In respect of
this dividend program, the Company paid dividends of $171,102 (1.5 cents per
share) on each of January 10, 2001, April 24, 2000 and January 4, 2000. The
Company also paid dividends to a preferred stockholder of $2,500 during each of
the six months ended June 30, 2001 and 2000. As such, the Company paid total
dividends of $173,602 and $344,704 during the six months ended June 30, 2001 and
2000, respectively. The Company has been reinvesting its available cash in
current business activities and has not declared any dividends during 2001. See
"Cash Flow Outlook" for a further discussion of dividends.
Working Capital Loan - The Company may borrow up to $4 million under a Lessee
Working Capital Loan Agreement with the Lessor for ongoing working capital
requirements of the Scrubgrass Project. The outstanding borrowings under the
Lessee Working Capital Loan Agreement were $1,219,320 and $2,742,961 as of June
30, 2001 and December 31, 2000, respectively. Under the terms of the Lessee
Working Capital Loan Agreement, the Company is required to pay this loan to zero
for a minimum of twenty days during 2001. Since the Company fufilled this
requirement during May 2001, the outstanding borrowings under the Lessee Working
Capital Loan Agreement as of June 30, 2001 were much lower by comparison to
December 31, 2000. The Company expects that the outstanding borrowings under the
Lessee Working Capital Loan Agreement would increase to customary levels when
the accounts payable and accrued expenses as of June 30, 2001 are paid during
the third quarter of 2001.
Notes Receivable from Officers - In December 2000, the Company awarded two
executive officers each a bonus of $250,000 to acknowledge the significant
progress made toward the settlement of the Sunnyside litigation as well as the
increase in their duties to formulate and assess restructuring options, consider
sale and merger proposals, and evaluate prospects for business expansion.
However, due to concerns about the Company's ongoing cash requirements, the
Company requested that these executive officers use substantially all of the
proceeds from these cash bonuses to repay their outstanding loans due to the
Company. The Company agreed, however, to allow these officers to borrow back
sufficient funds to pay their individual tax obligations resulting from these
bonuses subject to the Company's receipt of a settlement payment from the
Sunnyside litigation. In April 2001, the Company received $1,500,000 pursuant to
a settlement of the Sunnyside litigation and the two executive officers each
borrowed back $100,000 from the Company.
16
Term Credit Facility - In June 1997, the Lessor entered into a three year credit
facility with the lenders of the Scrubgrass Project which made $3 million
available to the Scrubgrass Project to cover the cash deficiency which resulted
from the extended annual outage of the Scrubgrass Project and associated costs
and expenses. During the six months ended June 30, 2000, the Company made
aggregate payments of $600,000 to satisfy this obligation by its expiration
date.
Scrubgrass Project Obligations- The Company has a long-term obligation related
to its Scrubgrass Project with scheduled maturities through 2005 and with
outstanding principal balances of $1,151,490 and $1,188,573 as of June 30, 2001
and December 31, 2000, respectively. The Company made principal payments of
$37,083 and $-0- for this obligation during the six months ended June 30, 2001
and 2000, respectively.
Sunnyside Project Obligations - As of June 30, 2001, the Company had contingent
obligations of approximately $1.2 million for the Sunnyside Project which were
payable based on a schedule which was related to the proceeds received from the
collection of the Company's outstanding notes receivable from the sale of the
Sunnyside Project. The Company's notes receivable from the Sunnyside Project
were the subject of a litigation which was recently settled in April 2001. As
part of the Settlement, the Company received $1,500,000 and was formally
released from contingent obligations which amounted to $177,962. Because of the
terms of the Settlement, which terms represented a substantial compromise of its
previous claims against the Plaintiffs, the Company is presently considering its
rights and obligations with respect to the remaining contingent obligations.
Until the Company resolves these remaining issues, the unsettled contingent
obligations will remain recorded on its consolidated balance sheet. The Company
reported the settlement proceeds of $1,500,000 and contingent liability release
of $177,962 as other income during the second quarter of 2001.
Cash Flow Outlook
During Fiscal 2001, the Company expects the principal sources of cash to fund
its business activities will be from available cash balances, investment
earnings, proceeds from the settlement of the Sunnyside litigation, and cash
which may become available from the Scrubgrass Project. As discussed in its
Fiscal 2000 Annual Report on Form 10-K, the Company is not able to receive
distributions from the Scrubgrass Project until all operating expenses, base
lease payments, certain restricted cash deposits and other subordinated payments
of the Scrubgrass Project are satisfied. Nevertheless, the Scrubgrass Project's
cash flows in Fiscal 2001 are expected to be sufficient to satisfy all of these
restrictions and provide the Company with continuing distributions for the
foreseeable future. According to certain agreements, Buzzard is scheduled to
make payments in Fiscal 2001 of $302,826 for debt and $808,936 for deposits to
restricted cash.
As discussed under the caption "Certain Factors That May Affect Future Results--
Environmental Regulation", the Scrubgrass Project needed to achieve certain
seasonal NOx emission levels beginning on May 1, 1999, and will also be required
to achieve reduced emission standards by May 2003. Due to the efficient design
of the Scrubgrass facility, the Scrubgrass Project met the new Fiscal 1999
requirements without any modifications to the Facility. However, the Company
made capital improvements of $811,568 during 1999 to the Facility, which are
expected to enable the Facility to
17
meet the stricter standards in 2003. By making improvements to the Facility
before 2003, the Company anticipated that it would not require a portion of its
future NOx Credits to maintain its compliance with the applicable regulations.
Consequently, the Company sold its anticipated excess NOx Credits and used the
proceeds to finance the capital improvements and generate additional working
capital. The Company expects to comply with all material environmental
regulations for the foreseeable future without any additional material
modifications to the Scrubgrass facility. Furthermore, the Company presently
expects to receive late in Fiscal 2001 or early in Fiscal 2002 its next award of
NOx Credits for the ozone seasons in 2003 through 2007. Similar to prior years,
the Company expects that it may not require a portion of these future NOx
Credits to maintain its compliance with the applicable regulations. Therefore,
the Company would be able to sell its anticipated excess NOx Credits on the open
market and provide additional cash flows to its operations. The Company
presently expects that the market value of its anticipated excess NOx Credits
may be material to its financial position.
Recently, NEG has been in long-term refinancing discussions with the lending
agent for the Scrubgrass Project. Through these discussions, NEG has addressed
or is addressing the following financing requirements for the Scrubgrass
Project:
1) the Lessor's tax-exempt bond letter of credit expired in December 2000 and
needed to be replaced or extended.
2) Buzzard is required to pay the balance of its Lessee Working Capital Loan
to zero for a minimum of 20 days during Fiscal 2001 and Fiscal 2002.
3) Buzzard's Lessee Working Capital Loan commitment expires in December 2002.
4) PENELEC's contracted payment terms will be extended by 20 days beginning in
July 2003, which is expected to create the need for additional working
capital.
In November 2000, NEG replaced the expiring letter of credit with a new letter
of credit expiring on December 31, 2006. Under the terms of the replacement
letter of credit, the Lessor paid an origination fee of $105,000 in Fiscal 2000
and agreed to pay additional fees of approximately $417,000 per year beginning
in Fiscal 2001. Buzzard is required to reimburse the Lessor for these fees
under the terms of the Scrubgrass Project lease.
NEG continues to address the remaining three financing matters with the lending
agent of the Scrubgrass Project. Recently, NEG reached a provisional agreement
with the lending agent which is expected to address all of the remaining
financing matters. Under the terms of this provisional agreement, the available
working capital facility would be increased from $4 million to $10 million
through Fiscal 2005 with annual paydown requirements of $2.5 million in Fiscal
2001 and Fiscal 2002, and $8 million in Fiscal 2003 through Fiscal 2005. After
Fiscal 2005, the available working capital facility and annual paydown
requirements would reduce incrementally until the expiration of the proposed
working capital facility in Fiscal 2008. Due to its credit constraints, the
lending agent is expected to transfer a portion of its existing Scrubgrass
Project loan commitments to another financial institution in order to provide
the proposed working capital facility. At this time, the Company has no reason
to believe that the provisional agreement would not eventually be finalized.
However, present uncertainties in the energy market could cause delays in
locating a suitable financial institution for the lending agent's transferable
loan commitments (See "Certain
18
Factors That May Affect Future Results - Third Party Project Management").
Should there be delays in finalizing the working capital facility, the Company's
distributions from the Scrubgrass Project may be delayed or reduced. As time
passes, there can also be no assurance that the terms of the provisional
agreement would not be amended to reflect changes in market conditions.
As discussed further in Part II - Item 1. Legal Proceedings, the Company had
been seeking financial recoveries for almost five years from the Purchasers of
the Sunnyside Project in a legal proceeding. On April 10, 2001, the Company
received $1,500,000 in full settlement of the legal proceeding. The litigation
settlement enhanced the Company's financial results and cash position in Fiscal
2001.
The Company's corporate structure is very complicated and involves multiple
entities resulting in several layers of tax for the Company and its
shareholders. Prior to 1998, the Company was not adversely affected by this
corporate structure because of the existence of significant net operating loss
carryforwards. However, since utilizing its remaining net operating loss
carryforwards in 1997, the Company's cash position has been materially affected
by ongoing corporate tax payments. Furthermore, due to timing differences
between earnings recognition and cash flow availability at the Scrubgrass
Project, the Company may be taxed on earnings prior to the receipt of
distributions from the Scrubgrass Project. As a result, the Company faces
considerable challenges to predict its available cash resources at any point in
time. To date, the Company has considered numerous tax and restructuring
proposals to reduce the extent of its corporate taxation. The Company has also
implemented some of these proposals and realized some modest reductions in its
overall tax burden. However, due to various limitations, such as restrictive
covenants in project financing arrangements, the Company was not able to pursue
any of the larger tax savings proposals considered to date. While the Company
remains diligent in its pursuit of tax saving strategies, the Company's cash
flows are expected to be affected by substantial corporate tax payments for the
foreseeable future.
As discussed in its previous filings, the Company had been simultaneously
evaluating several options for the future of its business to enhance shareholder
value. These options included a possible sale of EPC or its assets, merger with
another entity, or re-emergence into the development market. On July 23, 2001,
the Company acquired an 87.7% controlling interest in Microgy and intends to
pursue acquisition of Microgy's remaining shares. Microgy is a development
stage company which intends to develop renewable and distributed energy projects
using licensed technologies. While the Company believes this investment holds
considerable potential for the future, Microgy will require continued investment
by the Company both to maintain its administration and overhead as well as to
pursue development of energy generating facilities utilizing one or more of its
licensed technologies. The Company's management has been exploring financing
alternatives and expects to seek additional investments from equity, debt, and
project financing sources. However, there can be no assurance that these
investments and financings can be obtained by the Company on reasonable terms or
in desired amounts. If unsuccessful in its pursuit of these additional
resources, the Company could become constrained by the lack of readily available
funds and would be required to dedicate all or nearly all of its current
resources and the future cash flows from the Scrubgrass Project to meet its
obligations, including those related to the Microgy acquisition.
19
On April 2, 2001, the Board decided not to declare a dividend for the first
quarter of 2001 and has continued that policy to date. The Company believes
that the Board is likely to continue to reinvest available cash resources in
current business activities and not declare dividends for the foreseeable
future. The payment of any future dividends will depend on the Board of
Directors' evaluation, made on a quarterly basis, based on its dividend policy
and the Company's then current and projected operating performance and capital
requirements.
The Company believes that the Scrubgrass Project would continue to achieve
earnings and cash flows from its operations on an annual basis for the
foreseeable future. The PPA has contracted rate escalations which, assuming the
Scrubgrass Project meets its targeted capacity rates, would ensure a material
increase in revenues each year over a long-term period. As discussed above, the
Company also believes that the Scrubgrass Project would be able to generate
additional cash flows from the sale of anticipated excess NOx Credits in the
near future. Notwithstanding, the Company will continue to be affected by its
obligations for corporate taxes, restricted cash deposits, working capital, and
expenditures incurred in pursuit of the Microgy business plan. Nevertheless, the
Company believes that the cash flows which may become available from the
Scrubgrass Project, together with existing cash reserves, would be sufficient to
fund the Company's present business activities on a long-term basis.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
In recent years, the Company's business had consisted of a single operating
project and a corporate office and the Company had presented its business risks
in that manner. On July 23, 2001, the Company acquired an 87.7% controlling
interest in Microgy, a development stage company, which intends to pursue, among
other things, the development of renewable and distributed energy projects.
While the Company's historical financial statements through June 30, 2001 do not
yet reflect this acquisition, the Company's future business risks will be
materially affected by this recent acquisition. Therefore, during this
transition period, the Company has presented separately its historical business
risks and Microgy's business risks to allow readers to better understand the
changes in the Company's future business from the acquisition.
The following important factors, among others, could cause actual results to
differ materially from those indicated by forward-looking statements made in
this Quarterly Report on Form 10-Q.
RISK FACTORS FOR THE COMPANY'S HISTORICAL BUSINESS
- --------------------------------------------------
OWNERSHIP OF SINGLE OPERATING ASSET
The Company owns a 22 year leasehold interest in the Scrubgrass Project, an
approximate 83 Mw (net) waste coal-fired electric generating facility located in
Pennsylvania, the lease for which commenced on June 30, 1994. Presently, all
the Company's operating revenues are attributable to power generation from the
Scrubgrass Project. Accordingly, the Company's operations are largely dependent
upon the successful and continued operation of the Scrubgrass Project. In
20
particular, if the Scrubgrass Project experiences unscheduled shutdowns of
significant duration, the Company's results of operations will be materially
adversely affected.
DEPENDENCE UPON KEY EMPLOYEES
The success of the Company is largely dependent upon a staff of three full-time
executive officers and a full-time office administrator. The loss of any of the
Company's executive officers could adversely effect the Company's operations.
THIRD PARTY PROJECT MANAGEMENT
The Company has a management services agreement with NEG to manage the
Scrubgrass Project and a 15-year operations and maintenance agreement with PG&E
Operating Services to operate the facility. Under the terms of these
agreements, there are provisions which limit the Company's participation in the
management and operation of the Scrubgrass Project, and provisions which provide
for recourse against NEG and the Operator for unsatisfactory performance.
However, the Company does not exercise control over the operation or management
of the Scrubgrass Project. As such, decisions may be made affecting the
Scrubgrass Project, notwithstanding the Company's opposition, which may have an
adverse effect on the Company.
As discussed in the Company's Annual Report on Form 10-K, NEG, PG&E Operating
Services, and certain partners of the Lessor are indirectly owned, through
subsidiaries, by PG&E Corporation ("PG&E"). As a result of an energy crisis in
California, PG&E had been experiencing financial difficulties which are
primarily related to the regulated business activities of its subsidiary,
Pacific Gas and Electric Company. Pacific Gas and Electric Company recently
filed for protection from its creditors under United States bankruptcy laws.
The Manager has advised the Company that NEG, PG&E Operating Services, and the
partners of the Lessor are separate businesses which are legally protected from
the creditors of PG&E and Pacific Gas and Electric Company. The Manager has
also advised the Company that PG&E is presently solvent after a recent financial
reorganization. Furthermore, the Scrubgrass Project is financed with secured
debt obligations which are also legally protected from the creditors of PG&E and
Pacific Gas and Electric Company. As such, the Company does not expect that it
should be directly impacted by possible financial difficulties of PG&E in the
future. Notwithstanding the foregoing, the Company cannot predict whether the
uncertainty related to these recent events would affect the perceived
creditworthiness of the Scrubgrass Project.
SCHEDULED AND UNSCHEDULED SHUTDOWNS
The Scrubgrass Project from time to time experiences both scheduled and
unscheduled shutdowns. Periodically, the Scrubgrass Project incurs scheduled
shutdowns in order to perform maintenance procedures to equipment that cannot be
performed while the equipment is operating. Occasionally, the Scrubgrass Project
may also incur unscheduled shutdowns or may be required to operate at reduced
capacity levels following the detection of equipment malfunctions, or following
minimum generation orders received by the utility. During periods when the
Scrubgrass Project is shutdown or operating at reduced capacity levels, the
Company may incur losses due to
21
the loss of its operating revenues and/or due to additional costs which may be
required to complete any maintenance procedures.
DEVELOPMENT UNCERTAINTIES
The Company has been evaluating development opportunities and whether its re-
emergence into the development market could enhance shareholder value. In this
regard, the Company recently completed its acquisition of Microgy and expects to
begin developing renewable and distributed energy projects using licensed
technologies. There can be no assurance that the Company will be able to obtain
all of the necessary site agreements, fuel supply contracts, design/build
agreements, power sales contracts, licenses, environmental and other permits,
local government approvals or financing commitments required for the successful
completion of development projects. The Company's failure to accomplish any of
these steps could materially increase the cost or prevent the successful
completion of development projects, or cause the Company to abandon a
development project and incur the loss of its investment to date, which could
materially impact the Company's business and results of operations.
FINANCIAL RESULTS
To date the Company has incurred substantial losses, largely due to its
development activities, which have resulted in an accumulated deficit of
$2,424,755 as of June 30, 2001. While the Company was profitable from operating
activities for the last four years, the Company incurred a net loss from the
operation of the Scrubgrass Project during 1997 due to an unforeseen repair to
the generator at the Scrubgrass facility. The Company also had an overall net
loss during 1998 largely due to the write-off of the Sunnyside project
receivables. Financial results can be affected by numerous factors, including
without limitation general economic conditions, cyclic industry conditions, the
amount and rate of growth of expenses, transportation and quality of raw
materials, inflation, levels of energy rates, uncertainties relating to
government and regulatory policies, the legal environment and volatile and
unpredictable developments like the generator repair. The Company believes it
is well positioned to handle such matters as they may arise during the course of
its future business activities. However, there can be no assurance that the
Company will be profitable in the future.
POTENTIAL LIABILITY, DAMAGES AND INSURANCE
The Company's power generation activities involve significant risks to the
Company for environmental damage, equipment damage and failures, personal injury
and fines and costs imposed by regulatory agencies. In the event a liability
claim is made against the Company, or if there is an extended outage or
equipment failure or damage at the Company's power plant for which it is
inadequately insured or subject to a coverage exclusion, and the Company is
unable to defend such claim successfully or obtain indemnification or warranty
recoveries, there may be a material adverse effect on the Company.
22
CIRCULATING FLUIDIZED BED TECHNOLOGY
The Company's Scrubgrass Project employs circulating fluidized bed technology to
produce electricity. Certain aspects of this technology, as well as the
conversion of waste products into electricity, are relatively new areas being
explored by the alternative energy market in the last 20 years. Accordingly,
this technology carries greater risk than more established methods of power
generation such as hydropower. As such, the long-term costs and implications of
maintaining this technology have not been established by historical industry
data.
CUSTOMER CONCENTRATION
The Company's power generation revenues are earned under a long-term power
purchase agreement with one customer, Pennsylvania Electric Company. The
Company expects that the concentration of its revenues with this customer will
continue for the foreseeable future.
INTEREST RATES
Buzzard, as a lease cost of the Scrubgrass facility, is required to fund the
Lessor's debt service which consists of variable rate and fixed rate debt
obligations. Buzzard also has a variable rate working capital loan and a
variable rate term loan all of which were advanced from the Lessor under various
Scrubgrass Project agreements. The Company offers the following information
about these debt obligations:
BALANCE AT MATURES
DESCRIPTION OF THE OBLIGATION 6/30/01 INTEREST RATE THROUGH
- --------------------------------------------------------------------------------------------------
Lessor's term debt obligations:
Variable rate tax-exempt bonds $135,600,000 Quoted Bond Rates 2012
Swap rate term loan 11,597,665 Swapped LIBOR + 1.250% 2005
Variable rate term loan 9,747,510 LIBOR + 1.250% 2004
Buzzard's term debt obligations:
Variable rate working capital loan 1,219,320 LIBOR + 1.1250% 2002
Variable rate term loan 1,151,490 LIBOR + 1.250% 2004
The Lessor's debt obligations and Buzzard's debt obligation incur interest at
either quoted rates or variable rates which are based on the London Interbank
Offering Rate ("LIBOR"). On December 22, 1995, the Lessor entered into an
interest rate swap arrangement which fixed the LIBOR component for the life of
its swap rate term loan at 6.4225%. As a result, the interest rate for the swap
rate term loan was fixed at 7.5475% (LIBOR + 1.125%) through December 31, 2000
and 7.6725% (LIBOR + 1.25%) for the remaining term of the obligation. As such,
except for the Lessor's swap rate term loan, the Company will be required to
fund debt service consisting of rates which will vary with market conditions.
Presently, the Company is not able to predict how future interest rates will
affect its debt or lease obligations. Should market interest rates rise
significantly, the Company's operating results may be significantly impacted.
Notwithstanding, the Company believes the Lessor has good relationships with the
project lenders who would continue to support lending terms which would not have
a material
23
adverse affect on the operating results of the Scrubgrass Project. However,
there can be no assurance that the Lessor could renegotiate its credit
facilities under terms which would ensure continuing profitable operating
results of the Scrubgrass Project. See Notes H, I and L of the Consolidated
Financial Statements included in the Company's Fiscal 2000 Annual Report on Form
10-K for further information about the Company's debt and lease obligations.
FUEL QUALITY
The Company obtains waste coal primarily from coal mining companies on a long-
term basis because waste coal is plentiful and generally creates environmental
hazards, such as acid drainage, when not disposed of properly. The waste coal
is burned in the Scrubgrass facility using a circulating fluidized bed
combustion system. During the circulating fluidized bed combustion process, the
waste coal is treated with other substances such as limestone. Depending on the
quality of the waste coal, the facility operator may need to add additional
waste coal or other substances to create the appropriate balance of substances
which would result in the best fuel or sorbent consistency for power generation
and compliance with air quality standards. Therefore, the cost of generating
power is directly impacted by the quality of the waste coal which supplies the
Scrubgrass power generation facility. The facility operator maintains certain
controls over obtaining higher quality waste coal. However certain conditions,
such as poor weather, can create situations where the facility operator has less
control over the quality of the waste coal. The Company cannot predict the
extent to which poor fuel quality may impact its future operating results.
COMPETITION
The Company, through a subsidiary, generates electricity using waste coal, an
alternative energy source, all of which electricity is sold at rates established
under a long-term power purchase agreement with PENELEC, a division of GPU. This
power purchase agreement has been approved by the Pennsylvania Public Utility
Commission. Other than the risk that PENELEC would assert a position and achieve
judicial determination that it has a right to renegotiate the terms of the power
purchase agreement (see "Energy Regulation"), the sale of power from our
existing facility is not subject to competition during the term of the power
purchase agreement. However, since the Company's contracted rates in the later
years of the agreement are determined with reference to then existing market
conditions, the rate at which such power is sold is influenced by competitive
power rates in the region. Therefore, low wholesale energy rates during the
later years of the power purchase agreement would negatively impact the
Company's profitability and could affect its financial position.
Further, expansion of our business through acquisition and/or development of
additional facilities, such as the recent acquisition of Microgy, would be
affected by competition from various sources. The principal sources of
competition in this market include traditional regulated utilities who have
excess capacity, unregulated subsidiaries of regulated utilities, energy brokers
and traders, energy service companies in the development and operation of
energy-producing projects as well as the marketers of electric energy, equipment
suppliers and other non-utility generators like the Company. The electric
industry is also characterized by rapid changes in regulations which the
24
Company expects could continue to increase competition. For instance, as
discussed under "Energy Markets", the electric industry has been previously
affected by legislation such as PURPA and the Energy Act which have encouraged
companies other than utilities to enter the electric power business by reducing
regulatory constraints and increasing access to markets. More recently, as
discussed under "Energy Regulation", there has been legislation in numerous
states deregulating aspects of the electric business and encouraging a highly
competitive rate environment. Furthermore, initiatives to repeal or modify
existing regulations could further reduce regulatory restrictions placed on
electricity producers and encourage them to create new sources of electric
power. Any of these regulatory matters, among others, could increase
competition.
The Company's present operations, as well as any possible future expansion in
the industry, are also affected by requirements for compliance with various
local, state and federal environmental laws and regulations (See "Environmental
Regulation"). As such, the Company's operating costs are subject to increases
resulting from expanded environmental regulations. Such increases could
negatively impact profitability from current operations and could affect the
Company's competitive position in pursing further expansion through acquisition
and/or development.
Presently, competition in this industry is substantially based on price, with
competitors striving for lower cost alternatives for providing electricity. The
cost of producing electricity is in large measure influenced by the capital
costs of generating and transmitting facilities as well as the operating costs,
including fuel costs, of such facilities. As natural gas prices have risen and
supplies have tightened, the overall cost advantage of that fuel source has
diminished and consideration is again being given to other conventional and non-
conventional fuel sources. In addition, electricity shortages in certain major
markets, as well as a general increase in demand, have tightened overall
availability of generating capacity which may exert upward pressure on rates.
In previous years, the Company competed in the market to develop power
generation facilities. The primary bases of competition in this market are
price, the ability of the developer to generate high quality opportunities and
to select and acquire environmentally permittable sites in favorable locations
as well as to create attractive and efficient development plans which can be
financed and cost effectively constructed. In most cases, competitive bidding
for a development opportunity is required. In recent years, the Company believed
there were limited opportunities for additional project development in the
United States for projects similar to those previously developed by the Company.
Since there were many companies with substantially greater resources than the
Company competing for these limited development opportunities, the Company
believed it was not in a favorable competitive position. Therefore, the Company
had not been actively pursuing development opportunities in recent years.
However, the Company now believes that current market conditions may be more
favorable for smaller developers. Therefore, the Company recently took steps to
re-emerge into the development market by purchasing an 87.7% controlling
interest in Microgy, which intends to develop, finance, own and operate project
facilities which utilize environmentally friendly technologies that focus
primarily on production of energy from animal and organic wastes (bio-energy),
creation of fuels from renewable bio sources (bio-fuels) and the creation of
cogeneration projects (alternative energy) which have potential distributed
power applications.
25
ENERGY REGULATION
The Company's Scrubgrass facility is subject to certain regulations under
federal and state laws and regulations, and is certified as a QF by the FERC.
Pursuant to PURPA, FERC has promulgated regulations which exempt certain QFs
from the Federal Power Act of 1935, PUHCA, and, except under certain limited
circumstances, state laws regulating the rates charged by electric utilities.
In order to be QFs under PURPA, any facilities which the Company might acquire
or develop will be required to meet certain size, fuel and ownership
requirements and/or co-generate. In addition to the regulation of QFs, PURPA
requires that electric utilities purchase electric energy produced by QFs at
negotiated rates or at a price equal to the incremental or avoided cost that
would have been incurred by the utility if it were to generate the power itself
or purchase it from another source. The Company is not presently subject to
regulation under PUHCA and does not presently intend to engage in any activities
that would cause it to be so regulated.
The nature and impact of potential future changes of laws or regulations on the
Company's projects is unknown at this time. Presently, there are numerous
pending legislative proposals which suggest a comprehensive restructuring of the
electric utility industry. These proposals advocate, among other things, retail
choice for all utility customers, the opportunity for utilities to recover their
prudently incurred stranded costs in varying degrees, and the repeal of both
PURPA and PUHCA. If PURPA is amended or repealed, the statutory requirement that
electric utilities purchase electricity from QFs at full avoided cost could be
repealed or modified. While existing contracts are expected to be honored, the
repeal or modification of these statutory purchase requirements under PURPA in
the future could increase pressure from electric utilities to renegotiate
existing contracts. Should there be changes in statutory purchase requirements
under PURPA, and should these changes result in amendments to the Company's
current power purchase agreement which reduce the contracted rates, the
Company's results of operations and financial position could be negatively
impacted.
State public utility commissions, pursuant to state legislative authority, may
have jurisdiction over how any new federal initiatives are implemented in each
state. The actual scope of jurisdiction over independent power projects by state
public utility regulatory commissions varies from state to state. Presently,
through its power purchase agreement with PENELEC, the Scrubgrass Project is
indirectly affected by state legislation in the Commonwealth of Pennsylvania.
On December 3, 1996, in response to changes in the electric industry, the
Commonwealth of Pennsylvania passed legislation known as the Electricity
Generation Customer Choice and Competition Act (Customer Choice Act) which
became effective on January 1, 1997. The Customer Choice Act provides for the
deregulation of the generation portion of electric business by permitting all
Pennsylvania retail electric customers to choose their electric generation
supplier over a phase-in period which expired December 31, 2000. The Customer
Choice Act required that all electric utilities file restructuring plans with
the PUC. PENELEC filed its proposed restructuring plan during 1997, which was
subsequently litigated by numerous parties, and later settled by an agreement
which was approved by the PUC on October 20, 1998. The settlement
26
agreement set forth a comprehensive plan for restructuring PENELEC's service and
for ensuring there would be competition for electric generation for all of
PENELEC's customers beginning on January 1, 1999. Most pertinently, the
restructuring plan, as approved by the PUC, provided for PENELEC to maintain a
separate non-utility generator cost recovery mechanism for accounting purposes.
Therefore, the restructuring plan is designed, in pertinent part, to enable
PENELEC to recover all of its costs from non-utility generators such as the
Scrubgrass plant and should serve to decrease the pressure on PENELEC to
renegotiate existing power contracts with non-utility generators.
On November 21, 2000, the shareholders of GPU and FirstEnergy Corp. approved a
merger of these two companies. FirstEnergy and GPU have applied for approval of
their merger to Federal Energy Regulatory Commission, New Jersey Board of Public
Utilities, Pennsylvania Public Utility Commission, Nuclear Regulatory
Commission, Federal Communications Commission, Securities and Exchange
Commission, and the Department of Justice under the Hart-Scott-Rodino Act. The
Company has been monitoring these merger activities to determine whether such
activities would have an unfavorable impact on the Scrubgrass Project.
Presently, except as discussed above, neither the Customer Choice Act nor
PENELEC's restructuring plan directly impacts the Company, since the legislation
and restructuring plan pertain to the retail market or new contracts in the
wholesale market. Nevertheless, the Company continues to monitor regulatory
developments in order to evaluate any impact on the Scrubgrass Project and
possible new business opportunities.
ENVIRONMENTAL REGULATION
The Company's projects are subject to various federal, state and local
regulations pertaining to the protection of the environment, primarily in the
areas of water and air pollution. In many cases, these regulations require a
lengthy and complex process of obtaining and maintaining licenses, permits and
approvals from federal, state and local agencies. The Company also has
significant administrative responsibilities to monitor its compliance with the
regulations. As regulations are enacted or adopted in any of these
jurisdictions, the Company cannot predict the effect of compliance therewith on
its business. The Company's failure to comply with all the applicable
requirements could require modifications to operating facilities. During
periods of non-compliance, the Company's operating facilities may be forced to
shutdown until the compliance issues are resolved. The Company is responsible
for ensuring the compliance of its facilities with all the applicable
requirements and, accordingly, attempts to minimize these risks by dealing with
reputable contractors and using appropriate technology to measure compliance
with the applicable standards. The Company believes the Scrubgrass Project, its
only operating project, is currently in compliance with all material applicable
environmental regulations. The Scrubgrass Project most notably has been
affected by the following environmental regulations:
Air Quality - The Scrubgrass Project is subject to air quality regulations
under the Federal Clean Air Act of 1970 (CAA). CAA Title I established
National Ambient Air Quality Standards (NAAQS) for certain pollutants
including ozone, sulfur dioxide, nitrogen dioxide, particulate matter, carbon
monoxide and lead. In particular, CAA Title I established the Northeast
Ozone Transport Region, which includes 12 northeast states and the District
of
27
Columbia, to address the transport of these pollutants which may lead to
the non-attainment of the ozone NAAQS in the Northeast. Ozone control is
facilitated by the control of pollutant precursors, which are nitrogen oxides
(NOx) and volatile organic compounds. Electric generating facilities that
use fossil fuels, including the Scrubgrass facility, are considered major
sources of NOx emissions. In recent years, the Pennsylvania Department of
Environmental Protection (PaDEP) established regulations that required
companies with stationary sources of NOx emissions to establish plans to
reduce their NOx emissions. To administer these regulations, the PaDEP began
allocating Nitrogen Oxide Ozone Transport Region Budget Allowances ("NOx
Credits") to facilities based on numerous factors including the design and
operation of each facility. A market-based trading system was established to
allow companies with excess NOx Credits to trade with companies that required
additional NOx Credits to meet the stricter requirements. More recently, an
Ozone Transport Commission (OTC) established certain inner and outer zones
with seasonal NOx emission reductions that required the Scrubgrass Project to
achieve certain targeted NOx emission levels beginning on May 1, 1999. Under
the OTC's requirements, the Scrubgrass Project will also be required to
achieve reduced emission standards by May 2003. Due to the efficient design
of the Scrubgrass facility, the Scrubgrass Project met the new 1999
requirements without any modifications to the facility. However, the Company
made capital improvements of $811,568 in 1999 to the Scrubgrass facility,
which are expected to enable the Scrubgrass facility to meet the stricter
standards in 2003. The Company expects to meet the NAAQS for sulfur dioxide,
nitrogen dioxide, particulate matter, carbon monoxide and lead for the
foreseeable future without any additional material modifications to the
Scrubgrass facility.
Waste Disposal - The Scrubgrass Project must also comply with various
environmental regulations pertaining to the handling and disposal of
hazardous and non-hazardous wastes. The PaDEP establishes classifications for
wastes and requires companies to follow certain handling and disposal
procedures for each waste classification. Currently, the Scrubgrass Project
employs special handling procedures for the transportation of its fuel, which
is classified as a waste, from the waste sites to the Scrubgrass facility.
The fuel is burned in the Scrubgrass facility where it is treated with
various substances such as limestone during the electric generation process.
Ash, which is a byproduct of the electric generation process, is removed from
the Scrubgrass facility and returned to the original waste site which is
reclaimed in part by deposit of the ash along with the soil. Under existing
regulations, ash is not classified as a hazardous waste. However, various
environmental organizations have recently been lobbying for changes to the
applicable regulations for the classification of ash. If there are changes to
the waste classification of ash, the Company's ash disposal costs may
significantly increase which could have material adverse affect on the
Company's results of operations and financial position.
28
RISKS FACTORS RELATING TO MICROGY'S BUSINESS (ACQUIRED ON JULY 23, 2001)
- ------------------------------------------------------------------------
MICROGY HAS EXPERIENCED LOSSES TO DATE AND THE COMPANY ANTICIPATES MICROGY WILL
CONTINUE TO EXPERIENCE LOSSES IN THE FORESEEABLE FUTURE
Microgy has minimal financial operating history and has accumulated losses of
$1,773,222 through June 30, 2001. Microgy expects to continue to experience
losses and accumulate an earnings deficit as it seeks to develop its operations
with limited sales. Microgy expects to incur additional operating deficits as
it seeks to develop its market presence in the bio-energy and distributed
cogeneration power markets, and makes a substantial investment in sales and
marketing, the acquisition of key technology and equipment, management,
technical and administrative resources. Therefore, the Company can provide no
assurance that Microgy will achieve or sustain profitability or a positive cash
flow from its operations.
MICROGY IS A YOUNG COMPANY AND HAS ONLY A LIMITED OPERATING HISTORY WITH WHICH
INVESTORS CAN EVALUATE ITS BUSINESS AND PRODUCTS
Microgy was formed in 1999, and is still in the development stage. As such,
Microgy is subject to many of the risks common to enterprises with a limited
operating history, including potential under-capitalization, limitations with
respect to personnel, financial and other resources and limited customers and
revenues. Microgy's likelihood of success must be considered in light of the
problems, expenses, difficulties, complications and delays frequently
encountered in connection with the development and marketing of large systems.
Furthermore, Microgy became a subsidiary of the Company in July 2001 and the
Company does not have experience developing and marketing products and projects
similar to those of Microgy or in integrating acquired businesses such as
Microgy.
FINANCING RISK; NEED FOR ADDITIONAL CAPITAL
Microgy's future growth is dependant on the availability of capital to finance
product development, to construct projects, to fund marketing efforts and to
provide sufficient working capital on a continuing basis. There can be no
assurance that financing for working capital, project development or other
requirements will be available on acceptable terms, if at all. If Microgy's
plans or assumptions change or are inaccurate, the timing or amount of capital
required may vary substantially.
THE TECHNICAL INFORMATION AND SPECIFICS MICROGY NEEDS TO BUILD ITS INITIAL
BIOENERGY FACILITIES IS PROPRIETARY TO ITS DANISH LICENSOR. MICROGY REQUIRES
TIMELY ACCESS TO THIS INFORMATION IN ORDER TO BUILD ITS PROJECTS AND FOR IT TO
BE SUCCESSFUL.
Microgy's Danish licensor, Danish Biogas Technology, A.S., holds trade secret
and other proprietary information which is important to Microgy in building its
anaerobic digestion bioenergy projects. Notwithstanding the fact that Microgy
has executed trade secret and non-disclosure agreements with them, Microgy has
experienced certain delays in obtaining and completing the information it may
require to successfully process anaerobic digester based
29
products, such as blue prints and detailed designs. Microgy may require
additional information from engineering resources in order for it to maximize
the process efficiencies.
MICROGY FACES COMPETITION FROM LARGE PUBLIC UTILITIES AND ENERGY COMPANIES
Competition in the traditional energy business for electric utilities and oil
companies is well established with many substantial entities having multi-
billion dollar multi-national operations. Competition in the alternative fuels
and renewable energy business is not well established and is now just beginning
to emerge with rapid growth of the industry and advent of many new technologies.
Large companies are entering the renewable power generation field and these
companies are significantly better capitalized than the Company.
MICROGY FACES COMPETITION IN THE BIO-DIGESTER TECHNOLOGY MARKET AND FROM OTHER
AGRICULTURAL WASTE TECHNOLOGIES, SUCH AS INCINERATION AND GASIFICATION
TECHNOLOGIES
There are many companies that offer anaerobic digester technologies ("AD"). AD
technologies have been around for many years with most of the applications
centered on treatment of municipal sewage sludge. Only in recent years has the
AD technology been used to treat high strength organic wastes from animal
manure, food, beverage processing, and meat packing plants. Microgy has
identified as many as 65 companies offering complete systems or components to AD
systems in the U.S. market. These companies may be able to offer a similar or
better AD technology than Microgy and may also have greater financial, marketing
and organizational resources than the Company.
MICROGY FACES COMPETITION IN THE MARKET FOR TURBINES AND MICRO-TURBINE
TECHNOLOGIES
There are a number of larger well-known and better capitalized companies
developing micro-turbine technologies which might compete with Microgy licensed
microturbine technology. Microgy holds a certain license for applications of
microturbine technology which is owned and being developed by Electric Power
International, Inc. ("EPI"), which itself is a small company with limited
resources. Many of these companies with which EPI and Microgy will compete have
spent tens of millions of dollars developing their technologies and products and
have production ready models.
In addition, a number of manufacturers of larger combustion turbines are
developing smaller units in the 250 kW to 1,000 kW range. EPI is still in the
development stage for its microturbine technology and has had no commercial
production.
MICROGY WOULD FACE COMPETITION IN THE BIO-FUELS SERVICES MARKET
Emerging competitors in the bio-fuels market are fairly new entities. Based on
information provided by an industry publication, Microgy has identified five
entities that are in the emerging business of converting organic wastes into
liquid fuels such as ethanol and other products. These companies have a
competitive edge over Microgy in that they are first to market with
30
technologies and projects. These companies are also better financed and they may
be able to offer a more complete system at a lower cost than Microgy's bio-
energy concept.
MICROGY'S TECHNOLOGIES COULD BECOME OBSOLETE
Competitive solutions exist or new technologies may be developed in the future
by competitive firms that could make Microgy's technologies obsolete.
Accordingly, Microgy cannot guarantee that its technologies will ensure a
leadership or competitive position within the marketplace in the future.
MICROGY'S PRODUCTS/SERVICES INVOLVE AN EXTENDED SALES CYCLE
The negotiation of fuel purchase agreements, lease agreements, power sales
agreements and utility service agreements with hosts such as dairy or swine
farmers or customers such as industrial operators, involve a long-term sales
cycle and decision-making process. Microgy estimates that it can take from six
months to a year to obtain decisions and to negotiate and close these complex
agreements. Delays in the customer's decision-making process are outside of
Microgy's control and may have a negative impact on Microgy's receipt of
revenues and sales projections.
MICROGY HAS AN UNPROVEN BUSINESS APPROACH
It is difficult to predict whether Microgy's proprietary technologies or
business approach to the alternative energy and waste management industry will
operate and will produce results as anticipated, be profitable or be readily
accepted by the marketplace. It is hard to estimate whether demand for
Microgy's bio-energy products will materialize at the prices it expects to
charge, or whether satisfactory profit margins will be achieved. If such
pricing levels are not achieved or sustained, or if Microgy's technologies and
business approach to the energy industry do not achieve or sustain broad market
acceptance, Microgy's business operating results and financial condition will be
materially and negatively impacted. Microgy's ability to generate future
revenues will be dependent on a number of factors, many of which are beyond
Microgy's control, including, among other things, the risk factors described
herein.
THE PERFORMANCE OF MICROGY'S ALTERNATIVE ENERGY TECHNOLOGIES IS DEPENDENT ON
CERTAIN WASTE RESOURCES
The performance of Microgy's alternative energy technologies is dependent on the
availability of certain waste resources. To produce the raw energy and
subsequently generate power or fuel is dependent on the long-term availability
of wastes from animal manure, fats/oils/greases, plastics and other organic
material. There can be no assurances that these waste resources in the future
will be available or at a price that make them affordable for Microgy's waste to
energy technologies. Lack of these raw materials would seriously affect
Microgy's ability to generate income, and as a result, Microgy's revenues and
financial condition will be materially and negatively affected.
31
THE COMPANY MAY NOT BE ABLE TO EFFECTIVELY MANAGE MICROGY'S GROWTH
Microgy is currently in the early stages of development of its technologies and
business strategies. This continuing transition will place a significant strain
on the Company's management and personnel resources. The ability to manage the
growth of the Microgy business will require the Company to develop and maintain
new operations, including financial and management information systems, project
operations and management systems, to motivate and manage employees effectively,
and to attract new qualified employees. If the Company's management is unable
to manage such growth effectively, its business, operating results and financial
condition could be materially and adversely affected.
THE COMPANY WILL NEED ADDITIONAL PERSONNEL AND OUTSIDE CONTRACTORS
The Company requires the addition of qualified personnel to support its plans
for technology acquisition, research and development, information systems,
financial and executive management, market penetration, project management, and
expanded operations. If the Company is unable to attract, hire or retain and
fund the costs of the necessary technical, sales, marketing, information
systems, financial and executive personnel, or the Company loses the services of
any member of its current senior management team, it could have a material
adverse effect on the Company's business, operating results and financial
condition. In addition, the Company must hire outside contractors, including
general contractors, site surveying contractors, electrical contractors and
equipment providing contractors, to build Microgy's projects.
DISSOLUTION OF BUSINESS ALLIANCES; INHERENT RISKS IN ALLIANCES
Microgy will rely on a network of various alliances and agreements with other
businesses to provide integrated technology solutions to customers. The
termination of any business alliance or agreement may have a detrimental impact
on the success of a given project and, thereby, negatively impact Microgy's
revenue. In addition, alliances are inherently difficult to manage and often do
not meet the expectations of the partners. Therefore, there can be no assurance
that this part of Microgy's strategy will be effective.
TECHNOLOGY RIGHTS
Microgy relies heavily on strategic relationships, confidentiality agreements,
licensing agreements, and its relationships with inventors and consultants to
maintain the proprietary nature of its base of technologies relating to
currently licensed technologies. To compete effectively, Microgy may have to
defend its rights to intellectual property from time to time. The defense costs
can be significant. As such, Microgy may lack the financial resources to
adequately defend its intellectual property. Microgy and its partners are
assessing the strategic value of filing patents. To date, Microgy has not filed
any patent applications. There can be no assurance that any patent applications
relating to Microgy's existing or future products or technologies will result in
patents being issued, that any issued patents will afford adequate protection to
Microgy or its licensors, or that such patents will not be challenged,
invalidated, infringed, or circumvented. Furthermore,
32
there can be no assurance that others have not developed, or will not develop,
similar products or technologies that will compete with those of Microgy or its
licensors without infringing upon, or which do not infringe upon, Microgy's or
its licensors' intellectual property rights.
Third parties, including potential competitors, may already have filed patent
applications relating to the subject matter of Microgy's licenses. In the event
that any such patents are issued to such parties, such patents may preclude
Microgy and its licensors from obtaining patent protection for their
technologies, products or processes, may hinder or prevent Microgy from
commercializing its products and could require Microgy to enter into licenses
with such parties or cease such activities. There can be no assurance that any
required licenses would be available on acceptable terms, or at all.
MICROGY'S SERVICES WILL BE SUBJECT TO NUMEROUS GOVERNMENTAL REGULATIONS
Microgy expects to provide services involving government regulation, which
subjects Microgy to certain regulatory policies and procedures. Many involve
environmental regulations covering air and water quality and related pollution
issues. These regulations are mandated by the United States Environmental
Protection Agency (EPA) and various state and local governments. More
specifically, Microgy's activities in nutrient management related to animal
manure, bio-refineries that convert organic wastes that may be considered toxic
or hazardous, and power production will all come under some form of scrutiny
from these agencies. Microgy's activities related to these regulations will
come under a number of health and safety regulations and OSHA requirements.
Microgy's plans and operations involving these issues could come under stricter
requirements as new laws and environmental standards apply to both air and water
quality. Microgy is also impacted by laws and regulations relating to farms and
zoning, as its anaerobic digester projects are expected to be located on leased
farm property.
Many of Microgy's bio-energy projects may produce power that can be sold to the
electric grid. As such, the sale of this power may come under the regulations
of various state public utility commissions. These commissions set the price
tariffs that such energy can be sold or purchased and they set the design
standards for the interconnection of Microgy's equipment with the electric power
grid. Thereby, most of Microgy's green power projects where electricity is sold
to the grid will come under regulation by these commissions. These regulations
may impede or delay the process of approving and implementing Microgy's
projects. Substantial delays may materially affect Microgy's financial
performance and financial condition. Many state regulatory commissions,
however, have mandated renewable energy portfolio standards which may streamline
approval processes for these types of projects. However, there is no assurance
that renewable energy standards or mandates will continue or be available for
Microgy's projects.
Various state governments and federal energy agencies may also regulate the sale
of alternative fuels such as ethanol, hydrogen or gas/oil. These agencies may
set the price for some or all of the fuel that Microgy plans to produce at bio-
refineries which Microgy may choose to develop. Although economic and tax
incentives exist and are expected to increase in the future, price controls
and/or regulation could negatively affect the economics of Microgy's various
alternative fuels projects.
33
Government regulations can be burdensome and may result in delays and expense to
Microgy. In addition, modifications to regulations could adversely affect the
timing and cost of new products and services Microgy introduces. Failure to
comply with applicable regulatory requirements can result in, among other
things, operating restrictions and fines.
RISK OF SYSTEM FAILURE
Microgy would depend on the efficient and uninterrupted operation of bio-energy
plants and systems, including automation control systems. As Microgy expands
its operations, there will be increased stress placed upon hardware and
information traffic management systems. There can be no assurance that Microgy
will not experience system failures. Any system failure that causes
interruptions in Microgy's operations could have a material adverse effect on
Microgy's business, results of operations and financial condition. In addition,
Microgy's systems and operations are vulnerable to damage or interruption from
fire, flood, power loss, telecommunications failure, break-ins and similar
events. Microgy does not presently have redundant systems or a formal disaster
recovery plan to mitigate the risk of losses that may occur. There can also be
no assurance that any business interruption or property and casualty insurance
that Microgy would carry in the future would be sufficient to compensate it for
any losses that may occur.
SECURITY RISKS TO COMPUTER, INTERNET AND AUTOMATION CONTROL SYSTEMS
Despite Microgy's plans to implement security measures, the networks which will
be used to monitor the facilities Microgy develops may be vulnerable to
unauthorized access, computer viruses and other disruptive problems.
Unauthorized access through the Internet has caused user problems in the past,
and Microgy may in the future experience interruptions in service or breaches
into our business or control systems as a result of the accidental or
intentional actions of Internet users, current and former employees or others.
Unauthorized access could also potentially jeopardize the security of
confidential information stored in Microgy's computer systems and its installed
systems or plants that may result in liability for Microgy. Although Microgy
intends to continue to implement industry-standard security measures, such
measures have been circumvented in the past and there can be no assurance that
measures Microgy would implement will not be circumvented in the future.
Eliminating computer viruses and alleviating other security problems may have a
material adverse effect on Microgy's business, operating results and financial
conditions.
LIABILITY NOT COVERED BY INSURANCE
Although Microgy plans to carry general liability insurance, the insurance may
not cover certain potential claims or may not be adequate to indemnify Microgy
for all liability that may be imposed. Any imposition of liability that is not
covered by insurance or is in excess of insurance coverage could have a material
adverse effect on Microgy's business, operating results, and financial
condition. The Company anticipates Microgy or its subsidiaries will seek
project financing of projects. Such financings typically call for surety
bonding, which will be difficult to
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obtain, given Microgy's current minimal capitalization and operating experience.
Accordingly, obtaining project financing may be difficult, if not impossible.
MICROGY DEPENDS ON A SMALL NUMBER OF KEY EXECUTIVES AND ITS BUSINESS COULD
SUFFER IF THEY WERE TO LEAVE MICROGY
Microgy employs a small group of skilled individuals to accomplish its strategic
business plan. Microgy believes its performance is substantially dependent on
the continued employment and performance of its senior management. None of these
individuals are currently subject to employment agreements or employee non-
compete agreements. If Microgy fails to retain the services of one or more of
these persons, its business could suffer significantly. Microgy does not
maintain key-man insurance on the life of any of its officers at this time.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's most significant market risk exposure is changing interest rates
which may affect its short-term investments, its debt and certain of its lease
expenses. The Company offers the following information about these market risks:
Short-term investments - The Company invests cash balances which are in excess
of its normal operating requirements in short term investments generally with
maturities of three months or less. Because of the short duration of these
investments, the Company does not believe its short-term investments are subject
to material market risk.
Debt - The Company has borrowings which bear interest at variable rates which
are based on the London Interbank Offering Rate (LIBOR). The Company or the
Lessor monitors market conditions for interest rates and, from time to time,
enters into interest rate swaps to manage its interest payments. The interest
rate swaps have the effect of converting the variable rate borrowings to fixed
rate borrowings for specified time periods. For further information on the
Company's interest rate risk, refer to "Item 2. Management's Discussion and
Analysis of Financial Condition and Results of Operations - Certain Factors That
May Impact Future Results -- Interest Rates".
Lease Expense - The Company, as a lease cost of the Scrubgrass facility, is
required to fund the Lessor's debt service which consists of fixed rate
borrowings and borrowings which bear interest at variable rates based on either
quoted bond rates or the London Interbank Offering Rate (LIBOR). The Lessor
monitors market conditions for interest rates and, from time to time, enters
into interest rate swaps to manage the interest payments for the Scrubgrass
facility. The interest rate swaps have the effect of converting the variable
rate borrowings to fixed rate borrowings for specified time periods. For
further information on the Company's interest rate risk, refer to "Item 2.
Management's Discussion and Analysis of Financial Condition and Results of
Operations - Certain Factors That May Impact Future Results -- Interest Rates".
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PART II. OTHER INFORMATION
---------------------------
ITEM 1. LEGAL PROCEEDINGS
On April 10, 2001, Environmental Power Corporation and certain of its wholly-
owned subsidiaries (the "Defendants") received aggregate proceeds of $1,500,000
from B&W Sunnyside, Inc., NRG Sunnyside, Inc. and certain of their affiliates
(the "Plaintiffs") as consideration pursuant to a Binding Settlement Agreement
(the "Settlement") dated April 9, 2001. The Settlement resolved a legal
proceeding between the Plaintiffs and Defendants which had been ongoing since
May 3, 1996. The nature of the legal proceeding and the terms and conditions of
the Settlement were described in previous filings with the Securities and
Exchange Commission.
At the time of making the Settlement, the Defendants had recorded on their
balance sheets aggregate contingent obligations of approximately $1.2 million
due to third party creditors. As part of the Settlement, the Defendants were
formally released from contingent obligations which amounted to $177,962.
Because of the terms of the Settlement, which terms represented a substantial
compromise of their previous claims against the Plaintiffs, the Defendants are
presently considering their rights and obligations with respect to the remaining
contingent obligations. Until the Defendants resolve these remaining issues,
the unsettled contingent obligations will remain recorded on their balance
sheets.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Due to the pending transaction to acquire a controlling interest in Microgy, the
Company postponed its June 26, 2001 annual shareholders' meeting to a later
date, following closing, which will be announced.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
(i) Exhibit 3.02 - Certificate of Designations related to the Company's
newly designated, $.01 par value, Series B Convertible Preferred
Stock. (incorporated by reference to Form 8-K filed on August 7,
2001)
(ii) Exhibit 10.02 - Binding Settlement Agreement dated April 9, 2001
between Sunnyside II, L.P., Sunnyside I, Inc., NRG Energy, Inc.,
Babcock & Wilcox Investment Company, and Sunnyside Cogeneration
Associates (collectively the "Plaintiffs") and Environmental Power
Corporation, Sunnyside Power Corporation, Kaiser Systems, Inc. and
Kaiser Power of Sunnyside, Inc. (collectively the "Defendants")
(incorporated by reference to Form 8-K filed on April 23, 2001)
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(iii) Exhibit 10.03 - Share Exchange Agreement dated June 20, 2001 among
the Company, Microgy and the Principal Microgy Shareholders
(incorporated by reference to Exhibit 2 to Amendment No. 7 to
Schedule 13D filed by Joseph E. Cresci on August 2, 2001 (the
"13D")).
(iv) Exhibit 10.04 - Stockholders' Agreement dated July 23, 2001 among
the Company, the Principal Microgy Shareholders, Joseph E. Cresci
and Donald A. Livingston (incorporated by reference to Exhibit 4 to
the 13D)
(v) Exhibit 10.05 - Registration Rights Agreement dated July 23, 2001
among the Company, the Principal Microgy Shareholders, Joseph E.
Cresci, Donald A. Livingston and future exchanging Microgy security
holders who become a party thereto (incorporated by reference to
Exhibit 5 to the 13D).
(vi) Exhibit 10.06 - Form of Joinder Agreement (incorporated by reference
to Exhibit 6 to the 13D).
(vii) Exhibit 10.07 - Form of Waiver Agreement dated July 23, 2001
executed by certain Microgy Shareholders (incorporated by reference
to Exhibit 3 to the 13D).
(viii) Exhibit 10.08 - Warrant Agreement dated July 23, 2001 between the
Company and Daniel J. Eastman. (incorporated by reference to Exhibit
6 to the Schedule 13D filed by Daniel J. Eastman on August 2, 2001).
(ix) Exhibit 11 - Computation of Earnings Per Share.
(b) Reports on Form 8-K
(i) On April 23, 2001, the Registrant reported the Settlement related to
the Sunnyside Project litigation dated April 9, 2001.
(ii) On May 9, 2001, the Registrant disclosed pursuant to Regulation FD
the Letter to Shareholders dated April 15, 2001 which was included
in its Fiscal 2000 Annual Report to Shareholders.
(iii) On June 21, 2001, the Registrant disclosed pursuant to Regulation FD
the Letter to Shareholders dated June 4, 2001 which was included in
its First Quarter 2001 Quarterly Brochure to Shareholders.
(iv) On June 21, 2001, the Registrant disclosed pursuant to Regulation FD
a press release announcing an agreement for the acquisition of an
80% or greater controlling interest in Microgy subject to the
Registrant's due diligence and approval of its Board of Directors.
The Registrant also disclosed that, due to the pending transaction
to acquire an 80% or greater controlling interest in Microgy, it
postponed its June 26, 2001 shareholders' meeting to a later date,
following closing, which will be announced.
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(v) On August 7, 2001, as amended on August 14, 2001, the Registrant
disclosed the completion on July 23, 2001 of an acquisition of an
87.7% controlling interest in Microgy.
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.
ENVIRONMENTAL POWER CORPORATION
August 14, 2001 /s/ William D. Linehan
-------------------------------
William D. Linehan
Treasurer and
Chief Financial Officer
(principal accounting officer
and authorized officer)
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