================================================================================
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, 1998
---------------------------------------------
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________________ to ________________
Commission file number 0-15472
----------------------------------------------
ENVIRONMENTAL POWER CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 04-2782065
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
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 13, 1998 11,406,783 shares
The Exhibit Index appears on Page 28.
Total number of pages is 29.
================================================================================
ENVIRONMENTAL POWER CORPORATION
INDEX
PART I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as
of June 30, 1998 (unaudited) and December 31, 1997....................................... 2
Condensed Consolidated Statements of Operations (unaudited) for the Three and Six
Months Ended June 30, 1998 and June 30, 1997............................................ 3
Condensed Consolidated Statements of Cash Flows (unaudited) for the Three and Six
Months Ended June 30, 1998 and June 30, 1997............................................. 4
Notes to Condensed Consolidated Financial Statements..................................... 5-6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations............................................................................... 7-25
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................................. 26-27
Item 4. Submission of Matters to a Vote of Security Holders........................... 28
Item 6. Exhibits and Reports on Form 8-K.............................................. 28
Signatures .............................................................................. 29
1
PART I. FINANCIAL INFORMATION
-----------------------------
ITEM 1. FINANCIAL STATEMENTS
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
JUNE 30 DECEMBER 31
1998 1997
-------------------- --------------------
ASSETS (UNAUDITED)
CURRENT ASSETS:
Cash and cash equivalents $ 1,039,562 $ 12,092,273
Restricted cash 968,557 486,659
Receivable from utility 4,972,134 6,538,645
Notes receivable 40,720 39,128
Other current assets 803,288 881,938
---------------------- ----------------------
TOTAL CURRENT ASSETS 7,824,261 20,038,643
PROPERTY, PLANT AND EQUIPMENT, NET 114,949 129,936
DEFERRED INCOME TAX ASSET 900,755 817,755
LEASE RIGHTS, NET 2,683,017 2,757,519
RECEIVABLE FROM SALE OF AFFILIATE 938,388 791,512
NOTES RECEIVABLE 2,962,796 2,983,562
ACCRUED POWER GENERATION REVENUES 37,374,444 33,362,389
OTHER ASSETS 654,280 701,437
---------------------- ----------------------
$ 53,452,890 $ 61,582,753
====================== ======================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 5,379,203 $ 6,325,062
Dividends payable on common stock 342,203 10,266,105
Other current liabilities 4,064,450 2,911,666
---------------------- ----------------------
TOTAL CURRENT LIABILITIES 9,785,856 19,502,833
DEFERRED INTEREST REVENUE 367,388 220,514
DEFERRED GAIN, NET 5,551,392 5,705,598
SECURED PROMISSORY NOTES PAYABLE
AND OTHER BORROWINGS 3,479,396 4,673,727
ACCRUED LEASE EXPENSES 37,374,444 33,362,389
MAINTENANCE RESERVE 1,841,325 1,995,818
---------------------- ----------------------
TOTAL LIABILITIES 58,399,801 65,460,879
SHAREHOLDERS' EQUITY
Preferred Stock ($.01 par value; 1,000,000 shares authorized; no shares
issued at June 30, 1998 and December 31, 1997, respectively) -- --
Preferred Stock (no par value, 10 shares authorized; 10 shares
issued at June 30, 1998 and December 31, 1997, respectively) 100 100
Common Stock ($.01 par value; 20,000,000 shares authorized;
12,525,423 shares issued at June 30, 1998 and December 31, 1997,
respectively; 11,406,783 shares outstanding at June 30, 1998 and
December 31, 1997, respectively) 125,254 125,254
Additional paid-in capital 0 0
Accumulated deficit (3,806,263) (2,737,478)
---------------------- ----------------------
(3,680,909) (2,612,124)
Treasury stock (1,118,640 common shares, at cost, as of
June 30, 1998 and December 31, 1997, respectively) (456,271) (456,271)
Notes receivable from officers and board members (809,731) (809,731)
---------------------- ----------------------
TOTAL SHAREHOLDERS' EQUITY (4,946,911) (3,878,126)
---------------------- ----------------------
$ 53,452,890 $ 61,582,753
====================== ======================
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
----------------------------------- ---------------------------------------
1998 1997 1998 1997
---------------- ---------------- ---------------- ------------------
POWER GENERATION REVENUES $ 9,546,950 $ 8,032,094 $ 21,725,437 $ 19,305,394
--------------- ---------------- ---------------- ------------------
COSTS AND EXPENSES:
Operating expenses 4,889,564 4,668,847 9,438,248 9,065,573
Lease expenses 5,683,982 5,773,271 11,721,816 11,479,545
General and administrative expenses 551,513 479,981 1,096,592 1,171,820
Depreciation and amortization 73,049 50,186 146,086 99,988
--------------- --------------- --------------- -----------------
11,198,108 10,972,285 22,402,742 21,816,926
--------------- --------------- --------------- -----------------
OPERATING (LOSS) INCOME (1,651,158) (2,940,191) (677,305) (2,511,532)
OTHER INCOME (EXPENSE):
Interest income 40,199 26,328 93,228 144,473
Interest expense (115,459) (56,476) (234,851) (142,952)
Amortization of deferred gain 77,102 77,103 154,205 154,205
Other income 2,595 -- 2,595 --
--------------- --------------- --------------- -----------------
4,437 46,955 15,177 155,726
--------------- --------------- --------------- -----------------
(LOSS) INCOME BEFORE INCOME TAXES (1,646,721) (2,893,236) (662,128) (2,355,806)
INCOME TAX BENEFIT (EXPENSE) 683,000 1,192,000 279,000 966,000
--------------- --------------- --------------- -----------------
NET (LOSS) INCOME $ (963,721) $ (1,701,236) $ (383,128) $ (1,389,806)
=============== =============== =============== =================
BASIC AND DILUTED EARNINGS PER
COMMON SHARE $ (0.08) $ (0.16) $ (0.03) $ (0.13)
=============== =============== =============== =================
DIVIDENDS PAID OR PAYABLE:
Common shares $ 342,203 $ 332,303 $ 684,407 $ 664,607
Preferred shares 1,250 26,428 2,500 27,678
--------------- --------------- --------------- -----------------
$ 343,453 $ 358,731 $ 686,907 $ 692,285
=============== =============== =============== =================
DIVIDENDS PAID OR PAYABLE PER
COMMON SHARE $ 0.03 $ 0.03 $ 0.06 $ 0.06
=============== =============== =============== =================
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
------------------------
1998 1997
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income $ (383,128) $(1,389,806)
Adjustments to reconcile net (loss) income to net cash
provided by operating activities:
Depreciation and amortization 146,086 99,988
Deferred income taxes (83,000) (983,000)
Amortization of deferred gain (154,206) (154,205)
Accrued power generation revenues (4,012,055) (4,450,971)
Accrued lease expenses 4,012,055 4,450,971
Changes in operating assets and liabilities:
Decrease in receivable from utility 1,566,511 1,344,382
Decrease (increase) in other current assets 78,650 (2,645)
Increase in receivable from sale of affiliate (146,876) (146,474)
(Decrease) increase in accounts payable and
accrued expenses (944,609) 743,400
Increase in deferred interest revenue 146,874 73,236
Increase in long-term liabilities 5,669 5,733
(Decrease) increase in maintenance reserve (154,493) 463,200
------------ -----------
Net cash provided by operating activities 77,478 53,809
------------ -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from the collection of notes receivable 19,174 17,704
Increase in restricted cash (481,898) (242,647)
Increase in other assets (4,245) (133,317)
Property, plant and equipment expenditures (5,195) (646,322)
------------ -----------
Net cash used in investing activities (472,164) (1,004,582)
------------ -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividend payments (10,610,809) (691,035)
Net borrowings under working capital loan 552,784 447,043
Borrowings under long-term credit facility --- 389,155
Repayment of secured promissory notes payable and
other borrowings (600,000) ---
------------ -----------
Net cash (used in) provided by financing activities (10,658,025) 145,163
------------ -----------
(DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (11,052,711) (805,610)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 12,092,273 1,178,524
------------ -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 1,039,562 $ 372,914
============ ===========
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 (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 six months ended June 30, 1998 are not necessarily indicative of results
to be expected for the year ending December 31, 1998. 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, 1997.
NOTE B -- NEW ACCOUNTING STANDARD
- ---------------------------------
Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income". SFAS
No. 130 addresses the reporting and display of comprehensive income and its
components. SFAS No 130 divides comprehensive income into two categories which
are "net income" and "other comprehensive income". The category known as "other
comprehensive income" refers to all changes in stockholders' equity during a
period except changes resulting from net income or loss, investments by
stockholders and distributions to stockholders. There were no items of other
comprehensive income, as defined by SFAS No. 130, to report during the six
months ended June 30, 1998 and June 30, 1997.
NOTE C -- EARNINGS PER COMMON SHARE
- -----------------------------------
The Company computes its earnings (loss) per common share using the
treasury stock method in accordance with SFAS No. 128, "Earnings per Share".
The Company computes basic earnings (loss) per share by dividing net income
(loss) for the period by the weighted average number of shares of common stock
outstanding during the period. For purposes of calculating diluted earnings
(loss) 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 following tables outline the calculation of basic earnings (loss) per share
and diluted earnings (loss) per share for the three and six months ended June
30, 1998 and 1997.
5
LOSS SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNTS
------------------ -------------------- ---------------
THREE MONTHS ENDED JUNE 30, 1998:
- ---------------------------------
Loss available to shareholders $ (963,721) 11,406,783 $(.08)
Effect of dividends to preferred stockholders (1,250)
------------------ -------------------- ---------------
Basic EPS - loss available to common shareholders (964,971) 11,406,783 (.08)
Effect of dilutive securities:
Assumed exercise of dilutive stock options 28,360
------------------ -------------------- ---------------
Diluted EPS - loss available to common shareholders $ (964,971) 11,435,143 $(.08)
================== ==================== ===============
THREE MONTHS ENDED JUNE 30, 1997:
- ---------------------------------
Loss available to shareholders $(1,701,236) 11,076,783 $(.15)
Effect of dividends to preferred stockholders (26,428)
------------------ -------------------- ---------------
Basic EPS - loss available to common shareholders (1,727,664) 11,076,783 (.16)
Effect of dilutive securities:
Assumed exercise of dilutive stock options 110,836
------------------ -------------------- ---------------
Diluted EPS - loss available to common shareholders $(1,727,664) 11,187,619 $(.15)
================== ==================== ===============
LOSS SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNTS
------------------ -------------------- ---------------
SIX MONTHS ENDED JUNE 30, 1998:
- -------------------------------
Loss available to shareholders $ (383,128) 11,406,783 $(.03)
Effect of dividends to preferred stockholders (2,500)
------------------ -------------------- ---------------
Basic EPS - loss available to common shareholders (385,628) 11,406,783 (.03)
Effect of dilutive securities:
Assumed exercise of dilutive stock options 22,594
------------------ -------------------- ---------------
Diluted EPS - loss available to common shareholders $ (385,628) 11,429,377 $(.03)
================== ==================== ===============
SIX MONTHS ENDED JUNE 30, 1997:
- -------------------------------
Loss available to shareholders $(1,389,806) 11,076,783 $(.13)
Effect of dividends to preferred stockholders (27,678)
------------------ -------------------- ---------------
Basic EPS - loss available to common shareholders (1,417,484) 11,076,783 (.13)
Effect of dilutive securities:
Assumed exercise of dilutive stock options 127,522
------------------ -------------------- ---------------
Diluted EPS - loss available to common shareholders $(1,417,484) 11,204,305 $(.13)
================== ==================== ===============
6
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. Until
December 31, 1994 the Company also held varying ownership interests (100% to
approximately 40%) in and oversaw the operation of an approximately 51 Mw (net)
waste coal-fired electric generating facility (the "Sunnyside Project") located
in Utah. Until December 5, 1997, the Company had one additional project (the
"Milesburg Project") which had been in the development stage since 1987 and
involved in significant contract litigation since the early stages of its
development activities. On August 26, 1997, the Company entered into a Buy-Out
Agreement with the utility which had contracted to purchase electricity from the
Milesburg Project. Under the terms of the Buy-Out Agreement, the Company sold
substantially all of the assets of the Milesburg project to this utility on
December 5, 1997 and terminated the ongoing litigation. As such, the Company's
power generation revenues, operating expenses and lease expenses during 1997 and
1998 pertain solely to the Scrubgrass Project. 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, 1998 ("1998") to the three and six months ended June 30, 1997 ("1997").
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 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".
RESULTS OF OPERATIONS
Power generation revenues for the three and six months ended June 30, 1998
amounted to $9,546,950 and $21,725,437, respectively, as compared to $8,032,094
and $19,305,394 for the three and six months ended June 30, 1997, respectively.
The overall increase in power generation revenues during 1998 is primarily
attributable to a 5% increase in certain rates billed to the utility under the
terms of the power purchase agreement and an increase in the capacity rate
billed during the three and six months ended June 30, 1998 when compared to the
same periods in 1997. During the three and six months ended June 30, 1998, the
Scrubgrass Project operated at 69.6% and 83.3% of its capacity as compared to
56.4% and 73.4% for the same periods in 1997. The following factors contributed
principally to the differences in the Scrubgrass Project's capacity factors
billed for 1998 by comparison to 1997. First, the Scrubgrass project had its
annual maintenance outage during the second quarters in
7
1998 and 1997. During the 1998 outage, the Scrubgrass plant was inoperative for
approximately 14 days to perform scheduled maintenance procedures whereas the
1997 maintenance outage was extended from 12 days to approximately 37 days to
perform more extensive repairs to the Scrubgrass generator. Second, the
Scrubgrass plant was also inoperative for approximately 6 days during the first
quarter of 1997 to consider matters related to the generator. Third, in the
second quarter of 1998, the Scrubgrass project incurred several unscheduled
shutdowns to respond to equipment malfunctions which necessitated that the
Scrubgrass plant be inoperative for an aggregate of approximately 11 days
outside of the scheduled outage timeframe. As discussed in the section "Certain
Factors That May Impact Future Results-Scheduled and Unscheduled Shutdowns",
unscheduled shutdowns occur from time to time during the ordinary course of
business and are not unusual. However, unscheduled shutdowns typically occur
sporadically throughout the year so the effect on the Company's operations is
not as apparent as when several happen in one quarter which is the case here.
The aforementioned increase in 1998 power generation revenues was offset in part
by a decrease in the revenue recorded as a result of the straight-line
accounting treatment of certain revenues under the power purchase agreement
which amounted to $2,006,028 and $4,012,055 for the three and six months ended
June 30, 1998, respectively, as compared to $2,222,514 and $4,450,971 for the
three and six months ended June 30, 1997, respectively.
Operating expenses for the three and six months ended June 30, 1998
amounted to $4,889,564 and $9,438,248, respectively, as compared to $4,668,847
and $9,065,573 for the three and six months ended June 30, 1997, respectively.
The overall increase in 1998 is primarily attributable to the following five
reasons. First, the Company incurred higher fuel costs and higher operator fees
in 1998 as a result of cost escalations in certain operating and supply
agreements. Second, the Company incurred higher fuel expenses because it
achieved a higher capacity rate during 1998 and realized lower average heat
rates from fuel consumption in 1998 by comparison to 1997. Third, because the
Company is projecting higher overall operating performance during 1998, the
Company is accruing higher year-end operator bonuses during 1998 than were
recorded in 1997. Fourth, although overall maintenance expenses were higher in
1997 as discussed below, the Company did incur certain additional maintenance
expenses in 1998 by comparison to 1997 to make the necessary repairs related to
the 1998 equipment malfunctions that occurred during the three months ended June
30, 1998. Finally, due to salary increases and increases in the number of
personnel at the Scrubgrass project, the Company incurred higher labor and
related costs in 1998. However, the aforementioned increases in 1998 operating
expenses were offset in part because certain operating expenses were higher
during 1997 by comparison to 1998 primarily for the following reasons. First,
because of extensive repairs made during the 1997 extended outage, the Company
incurred additional maintenance expenses in 1997 by comparison to 1998. Second,
as a result of enhancements made during 1997 to the fuel processing system at
the Scrubgrass Project, the Company realized a savings in certain routine
maintenance expenses during 1998. Finally, the Company entered into
modifications to the financing contract with the manufacturer of the Scrubgrass
generator which reduced certain long-term liabilities and operating expenses
during the first quarter in 1998. See a further discussion of these
modifications under the caption "-Liquidity and Capital Resources -- 1998
Outlook".
Lease expense for the three and six months ended June 30, 1998 amounted to
$5,683,982 and $11,721,816, respectively, as compared to $5,773,271 and
$11,479,545 for the three and six months ended June 30, 1997, respectively. The
overall increase in lease expense during 1998 is primarily due
8
to an increase in equity rents paid to the Lessor and higher scheduled principal
payments on the Lessor's term loans which were passed through to the Company in
its lease expense. The increase in equity rents was primarily attributable to an
increase in the scheduled base rent payments and higher additional rents paid
based on the improved performance of the Scrubgrass plant in 1998. The
comparative increases in equity rents occurred at a higher rate during the first
quarter of 1998 which is the primary reason for the decrease in lease expense
during the three months ended June 30, 1998 by comparison to the three months
ended June 30, 1997. The aforementioned increase in 1998 lease expense was
offset in part by a decrease in the lease expense recorded as a result of the
straight-line accounting treatment of certain lease expenses under the
Scrubgrass lease which amounted to $2,006,028 and $4,012,055 for the three and
six months ended June 30, 1998, respectively, as compared to $2,222,514 and
$4,450,971 for the three and six months ended June 30, 1997, respectively.
General and administrative expenses for the three and six months ended June
30, 1998 amounted to $551,513 and $1,096,592, respectively, as compared to
$479,981 and $1,171,820 for the three and six months ended June 30, 1997,
respectively. The overall decrease in general and administrative expenses
during the 1998 six month period is primarily attributable to the following four
factors. First, the Company incurred significant legal expenses in 1997 to
review documents in the discovery phase of the Sunnyside project litigation
which expenses were incurred to a much lesser extent during 1998. Second, the
management fees for the Scrubgrass Project were lower in 1998 because the
Company had incurred significant management fees to address the Scrubgrass
generator matter and to consider other contract related matters during the six
months ended June 30, 1997, which matters either did not recur or recurred to a
lesser extent in 1998. Third, the Company restructured its insurance programs
at its corporate office and at the Scrubgrass Project in April 1997 which
resulted in lower insurance premiums for 1998 by comparison to 1997. Lastly,
the Company reduced the amount of certain professional fees during 1998 as
compared to 1997 because it used such professional services to a lesser extent
during 1998. However, the aforementioned decreases in 1998 general and
administrative expenses were offset in part because certain general and
administrative expenses were higher during 1998 by comparison to 1997 primarily
for the following two reasons. First, certain labor and overhead expenses,
which were capitalized in 1997 as a result of development activities for the
Milesburg project, were redirected to operating activities during 1998. Second,
the Scrubgrass project received a sales tax refund during the three months ended
June 30, 1997 which reduced general and administrative expenses by comparison to
the same period in 1998. Since the aforementioned differences between expenses
incurred during 1998 and 1997 did not occur at an equal rate during the first
and second quarters, general and adminstrative expenses increased during the
three months ended June 30, 1998 by comparison to the same period in 1997, but
decreased for the entire 1998 period by comparison to 1997.
Depreciation and amortization for the three and six months ended June 30,
1998 amounted to $73,049 and $146,086, respectively, as compared to $50,186 and
$99,988 for the three and six months ended June 30, 1997, respectively. The
1998 increase is primarily attributable to 1997 additions to leasehold
improvements and deferred financing costs for the Scrubgrass Project which were
not amortized during the three and six months ended June 30, 1997.
9
Interest income for the three and six months ended June 30, 1998 amounted
to $40,199 and $93,228, respectively, as compared to $26,328 and $144,473 for
the three and six months ended June 30, 1997, respectively. The overall
decrease in interest income for the six months ended June 30, 1998 by comparison
to the same period in 1997 is primarily attributable to less interest recognized
on the Company's notes receivable related to the sale of its interest in the
Sunnyside Project. Beginning in April 1997, as discussed in previous filings,
the Company has deferred the interest income on the notes receivable related to
the sale of its interest in the Sunnyside Project until the litigation with the
purchasers is resolved (See "Part II - Item 1. Legal Proceedings" and "-
Certain Factors That May Impact Future Results-Legal Proceedings"). The
aforementioned decrease in interest income during 1998 was offset in part by
higher interest earnings in 1998 on the Company's cash reserves which increased
as a result of cash received in December 1997 from the sale of the Milesburg
project. Interest income for the three months ended June 30, 1998 increased by
comparison to the same period in 1997 principally because of the improvement in
the Company's cash reserves during 1998. The interest related to the Sunnyside
Project did not effect the second quarter comparison because such interest was
being deferred during both the second quarters in 1998 and 1997.
Interest expense for the three and six months ended June 30, 1998 amounted
to $115,459 and $234,851, respectively, as compared to $56,476 and $142,952 for
the three and six months ended June 30, 1997, respectively. Interest expense
increased in 1998 primarily because of additional long-term debt for the
Scrubgrass Project which was incurred during the second quarter of 1997 to
finance a cash deficiency which occurred shortly after the 1997 extended
maintenance outage. The additional long-term debt consists of a $3 million term
credit facility which is discussed further in the section "--Liquidity and
Capital Resources - Financing Activities" and installment debt which financed
the generator repair that is discussed further in the section "--Liquidity and
Capital Resources -- 1998 Outlook". The aforementioned increases in 1998
interest expense were offset in part by a decrease in interest incurred on the
Scrubgrass Project working capital loan during 1998 by comparison to 1997. The
interest on working capital loan decreased primarily due to lower average
outstanding borrowings during 1998.
Income tax benefit for the three and six months ended June 30, 1998
amounted to $683,000 and $279,000, respectively as compared to an income tax
benefit of $1,192,000 and $966,000 for the three and six months ended June 30,
1997, respectively. The income tax benefit during 1998 decreased by comparison
to 1997 primarily because the Company's loss before taxes was lower in 1998. The
effective tax rates for 1998 and 1997 are expected to be comparable and may vary
within 1% depending on the apportionment of income between state taxing
jurisdictions.
Net loss for the three and six months ended June 30, 1998 amounted to
$963,721 and $383,128, respectively, as compared to net loss of $1,701,236 and
$1,389,806 for the three and six months ended June 30, 1997, respectively. The
overall decrease in the 1998 net loss is largely attributable to the increase in
power generation revenues and the decrease in general and administrative
expenses. The overall decrease in the net loss was offset in part by the
increases in operating expenses, lease expenses and interest expense, and
decrease in interest income. The changes in these components of the net loss
were discussed more fully in the previous narrative under "Results of
Operations".
10
Outlook for the Remainder of 1998
With a view towards the remainder of 1998, the Company currently expects to
achieve earnings on an annual basis as a result of profits from Scrubgrass
project operations and management of corporate general and administrative
expenses. The Company offers the following prospective information concerning
significant components of its 1998 Consolidated Statement of Operations which
are being compared to historical results of operations in 1997:
Power generation revenues - Power generation revenues are expected to increase
in 1998 as a result of a 5% increase in certain contracted rates under the
Scrubgrass power purchase agreement and improvements in the expected annual
capacity rate for 1998. The Scrubgrass capacity rate, which was significantly
effected by the extended maintenance outage in 1997, is expected to improve in
1998 primarily because maintenance shutdowns are presently expected to occur to
a lesser extent during 1998. Although, such increases in 1998 power generation
revenues are expected to be offset in part by a decrease in the revenue
recorded as a result of the straight-line accounting treatment of certain
revenues under the power purchase agreement. A favorable resolution of the
Company's legal action against Pennsylvania Electric Company could also have a
favorable impact upon power generation revenues. See "Part II - Item 1. Legal
Proceedings" and "-Certain Factors That May Impact Future Results-Legal
Proceedings" for a further discussion of the legal action against Pennsylvania
Electric Company.
Operating expenses - Operating expenses are expected to increase in 1998 as a
result of an approximate 3% increase in certain contracted rates under fuel
supply agreements, a 5% increase in certain contracted rates under the
operations and maintenance agreement and anticipated increases in personnel
costs at the Scrubgrass plant. In addition, largely because the Company is
anticipating that maintenance shutdowns will occur to a lesser extent during
1998, operating expenses are expected to further increase as a result of
additional fuel consumption and higher operator bonuses which are primarily
based on Scrubgrass operating profits. However, absent an extended outage in
1998, the Company would expect to incur lower maintenance expenses in 1998.
However, after performing certain machinery and equipment inspections during
the 1998 outage, the Company is now expecting to accelerate certain estimated
timeframes for completing maintenance in future years. The changes in these
estimates are expected to increase maintenance reserves for the remainder of
1998 which would partially offset the savings in maintenance expense which
would otherwise have been realized from the absence of an extended outage in
1998. The Company also expects that certain improvements made in 1997 to its
fuel handling systems may offset a portion of the increases in fuel costs and
result in decreases in maintenance expenses during 1998.
Lease expenses - Lease expenses are expected to increase as a result of higher
scheduled principal payments on the Lessor's term loans which will increase the
Lessor's loan costs that are expected to be passed through to the Company in
its facility lease expenses. In addition, the Company expects to incur
scheduled increases in equity rents for the Scrubgrass Project in 1998.
However, largely due to required repayments of $1.2 million on the Company's $3
million credit facility, the Company expects that there would be less cash
available from the Scrubgrass Project during 1998. As such, the scheduled
increases in the aforementioned lease expenses are expected to
11
be partially offset by a reduction in the additional rent paid to the Lessor
which amounts to 50 percent of the net cash flows from the Scrubgrass Project
(See the further discussion under "--Liquidity and Capital Resources - 1998
Outlook"). The aforementioned increases in 1998 lease expense are also expected
to be offset in part by a decrease in the lease expense recorded as a result of
the straight-line accounting treatment of certain lease expenses under the
Scrubgrass lease.
General and administrative expenses - General and administrative expenses are
expected to increase in 1998 primarily because certain labor and overhead
expenses, which were capitalized in 1997 as a result of development activities
for the Milesburg project, will be redirected to operating activities during
1998. However, such increase is expected to be largely offset by decreases in
professional fees, management fees and insurance expenses during 1998.
Other revenue - In 1997, the Company enjoyed the benefit of certain non-
recurring revenues which included the gain on the sale of the Milesburg
project, the reversal of the provision for non-recovery of Milesburg project
development costs, interest earnings from proceeds on the sale of the Milesburg
project and revenue recorded as a result of the release of certain Milesburg
obligations which were payable only upon the occurrence of events related to
project development. The Company does not expect these items to recur in 1998.
RECENTLY ISSUED ACCOUNTING STANDARDS
See Note B to the Condensed Consolidated Financial Statements for a
discussion of accounting standards which the Company has adopted effective
January 1, 1998. There were no recently issued accounting standards since the
Company filed its Annual Report on Form 10-K for the year ended December 31,
1997 which would have any impact on the Company's financial statements.
LIQUIDITY AND CAPITAL RESOURCES
Operating Activities
Cash provided by operating activities amounted to $77,478 and $53,809 for
the six months ended June 30, 1998 and 1997, respectively. During 1998 and 1997,
the Company's only sources of cash from operating activities were operating
profits from the Scrubgrass Project and investment earnings from cash reserves.
The Company offers the following information to discuss the changes in operating
assets and liabilities which most notably impacted its cash position during the
six months ended June 30, 1998:
Receivable from utility - The Company's receivable from utility relates to the
Scrubgrass Project and amounted to $4,972,134 as of June 30, 1998 as compared
to $6,538,645 as of December 31, 1997. The decrease in receivable from utility
as of June 30, 1998 is primarily attributable to a decrease in revenues during
May 1998 and June 1998 as a result of the 1998 planned maintenance outage and
several unscheduled shutdowns. However, the aforementioned decrease was offset
in part by a 5% increase in certain rates billed to the utility in 1998 under
the terms of the Scrubgrass power purchase agreement.
12
Other current assets - The Company's other current assets amounted to $803,288
as of June 30, 1998 as compared to $881,938 as of December 31, 1997. The
overall decrease is largely attributable to a reduction in fuel inventory
levels which were higher than usual at December 31, 1997 because the Company
had advance purchased certain inventory during 1997 to obtain favorable
pricing. The aforementioned decrease was substantially offset by an increase
in prepaid insurance because the Company made a large prepayment when it
renewed its insurance policies during the second quarter.
Deferred income tax asset - The Company's deferred income tax asset amounted to
$900,755 as of June 30, 1998 as compared to $817,755 as of December 31, 1997.
The increase is largely attributable to the the recorded tax benefits of the
net loss for the six months ended June 30, 1998. The Company expects that it
will realize the recorded tax benefits of the net loss for the six months ended
June 30, 1998 because the Company expects that this net loss will be completely
offset by profitable operating results for the remainder of 1998.
Accounts payable and accrued expenses - The Company's accounts payable and
accrued expenses amounted to $5,379,203 as of June 30, 1998 as compared to
$6,325,062 as of December 31, 1997. The overall decrease is largely attibutable
to the following two factors. First, the Company had significant accruals for
corporate income taxes and additional rent as of December 31, 1997 which either
did not exist or existed to a lesser extent as of June 30, 1998. Second, due
to the decrease in the capacity rate during the second quarter of 1998, the
liabilities for certain variable expenses existed to a lesser extent as of June
30, 1998 when compared to December 31, 1997. The aforementioned decreases in
accounts payable and accrued expenses were offset in part by the following two
factors. First, the Company incurred significant maintenance expenses for
scheduled and unscheduled outages which occurred during the second quarter of
1998 that increased its accounts payable and accrued expenses as of June 30,
1998 when compared to December 31, 1997. Second, similar to the comparison of
expenses between the second quarter of 1998 and 1997 discussed in the section
"Results of Operations", certain of the Company's expenses during the second
quarter of 1998 also increased by comparison to the fourth quarter of 1997
which resulted in higher accounts payable and accrued expenses balances as of
June 30, 1998 by comparison to December 31, 1997.
Deferred gain, net - The Company's deferred gain, net amounted to $5,551,392 as
of June 30, 1998 as compared to $5,705,598 as of December 31, 1997. 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.
Receivable from sale of affiliate and deferred interest revenue - The Company's
receivable from sale of affiliate amounted to $938,388 as of June 30, 1998 as
compared to $791,512 as of December 31, 1997. The increase is attributable to
interest payable by the purchasers of the Sunnyside project during the six
months ended June 30, 1998. The Company's deferred interest revenue amounted
to $367,388 as of June 30, 1998 as compared to $220,514 as of December 31,
1997. The increase is attributable to interest payable by the purchasers of
the Sunnyside project during the six months ended June 30, 1998, but deferred
for financial reporting purposes. Beginning in April 1997, the Company has
deferred the interest income on the notes receivable related to the sale of its
interest in the Sunnyside Project until the litigation with the purchasers is
resolved (See the further discussion under "--Results of Operations" and "Part
II - Item 1. Legal Proceedings").
13
Maintenance reserve - The Company records the expense of major equipment
overhauls related to the Scrubgrass Project to a maintenance reserve on a
straight-line basis using management's best estimate of when the Company will
incur future cash outlays for the major equipment overhauls. When the Company
incurs cash outlays for major equipment overhauls, they reduce maintenance
reserves and are funded substantially from scheduled deposits to a restricted
major maintenance fund which have been set aside to ensure that the funds are
available for these maintenance procedures (see further discussion under the
caption "--Investing Activities-Restricted Cash"). The maintenance reserve
decreased to $1,841,325 as of June 30, 1998 from $1,995,818 as of December 31,
1997 primarily due to cash outlays for major equipment overhauls of
approximately $343,000 made during the 1998 Scrubgrass outage and because
certain modifications to the financing contract with the manufacturer of the
Scrubgrass generator reduced long-term liabilities included in the maintenance
reserve. For a further discussion of the modifications to the financing
contract with the manufacturer of the Scrubgrass generator, refer to the
section "--Liquidity and Capital Resources -- 1998 Outlook". However, the
aforementioned decreases were offset in part by scheduled reserves provided for
the ongoing maintenance of the plant.
Investing Activities
The Company used $472,164 and $1,004,582 in investing activities during the
six months ended June 30, 1998 and June 30, 1997, respectively. The Company's
investing activities are concentrated primarily in the following areas:
Notes receivable - The Company presently has notes receivable related to the
1994 sale of the Sunnyside Project and related to fees earned in 1995 for the
Scrubgrass Project. The Company collected $19,174 and $17,704 from notes
receivable related to the Scrubgrass Project during the six months ended June
30, 1998 and June 30, 1997, respectively. The notes receivable related to the
Sunnyside Project, with a principal balance of $2,937,500 and accrued interest
balance of $661,944 as of June 30, 1998, are the subject of a legal proceeding.
See "--Certain Factors That May Impact Future Results-Legal Proceedings" and
"Part II - Item 1. Legal Proceedings" for further information about the notes
receivable related to the Sunnyside Project.
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, 1998 and June 30, 1997, the Company's net deposits to
the restricted major maintenance fund and interest thereon exceeded its
payments for major equipment overhauls by $481,898 and $242,647, respectively.
The Company's expenditures for major equipment overhauls were significantly
higher during the 1997 extended outage by comparison to the 1998 outage. As
such, the net deposits to the restricted major maintenance fund and interest
thereon were much higher during the three months ended June 30, 1998 by
comparison to the same period in 1997.
14
Property plant and equipment - The Company invested $5,195 and $646,322 in
property, plant and equipment expenditures during the six months ended June 30,
1998 and June 30, 1997, respectively. The expenditures in 1997 were primarily
related to development activities for the Company's Milesburg Project which was
sold in 1997 and for which development efforts had increased in 1997 prior to
the sale. The expenditures in 1998 were primarily purchases of computer
equipment for the Company's corporate office.
Financing Activities
The Company utilized $10,658,025 in financing activities during the six
months ended June 30, 1998 and received $145,163 from financing activities
during the six months ended June 30, 1997. 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 declared dividends of 3 cents per share
during each of the quarters in the periods ending June 30, 1998 and June 30,
1997. As of December 31, 1997, the Company had dividends payable for common
stock of $10,266,105 or 90 cents per share (consisting of a 3 cent quarterly
dividend and an 87 cent special dividend out of the proceeds of the Milesburg
buy-out) which were declared on December 10, 1997 and paid on January 7, 1998.
The Company also had dividends payable for common stock as of June 30, 1998 of
$342,203 or 3 cents per share which were declared on June 23, 1998 and paid on
July 10, 1998. As such, dividends paid for common stock amounted to
$10,608,309 and $664,607 during the six months ended June 30, 1998 and June 30,
1997, respectively. During 1997, the Company also commenced the payment of
dividends to its subsidiary's preferred stockholder. The preferred stockholder,
entitled to cumulative dividends of $5,000 per year since December 1991, was
paid its dividends up to date through the first quarter of 1997 with a payment
of $26,428 in April 1997. Beginning during the second quarter of 1997, the
preferred stockholder has been paid its dividends quarterly at a rate of $1,250
per quarter during the month following the end of each quarter. As such,
dividends paid for preferred stock amounted to $2,500 and $26,428 during the
six months ended June 30, 1998 and June 30, 1997, respectively and dividends
payable for preferred stock amounted to $1,250 and $1,250 as of June 30, 1998
and June 30, 1997, respectively.
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. During the six months ended June 30,
1998, the Company increased its outstanding borrowings under the Lessee Working
Capital Loan Agreement from $2,311,666 as of December 31, 1997 to $2,864,450 as
of June 30, 1998. The increase in the working capital loan as of June 30, 1998
was primarily used to cover the cash deficiency which resulted from reduced
revenues during the second quarter (See further discussion under the section "
--Operating Activities - Accounts Payable and Accrued Expenses"). This
increase in the working capital loan tends to be seasonal and occur shortly
after the scheduled maintenance outage each year.
15
Term Credit Facility - In June 1997, the Lessor entered into a three year
credit facility with the lenders of the Scrubgrass Project to make additional
funds available to the Scrubgrass Project to cover the cash deficiency which
resulted from the extended annual outage to repair the generator and associated
costs and expenses. The maximum allowable borrowings under this credit
facility were $3,000,000 through July 1, 1998 at which time the maximum
allowable borrowings were reduced to $2,400,000. Beginning on January 4,
1999, the maximum allowable borrowings will continue to reduce in $600,000
increments every six months through July 3, 2000 when the credit facility will
be payable in full. As of December 31, 1997, the outstanding borrowings under
this credit facility, which were advanced to the Company by the Lessor,
amounted to $3,000,000. During the six months ended June 30, 1998, the Company
paid down this obligation by $600,000 in order to reduce this obligation to the
maximum allowable borrowing amount of $2,400,000 which became effective on July
1, 1998. The current portion of this obligation, which amounted to $1,200,000
as of June 30, 1998, is included in other current liabilities.
Notes payable - In addition to the term credit facility described previously,
the Company has other long-term obligations related to its Sunnyside Project
and Scrubgrass Project in the amounts of $1,011,585 and $1,267,811,
respectively as of June 30, 1998. The Sunnyside Project long-term obligations
are payable based on a schedule which relates directly to the amount of
proceeds received from the collection of the outstanding notes receivable from
the sale of the Company's interest in the Sunnyside Project, which notes are
currently the subject of a legal proceeding (See "--Certain Factors That May
Impact Future Results-Legal Proceedings" and "Part II - Item 1. Legal
Proceedings"). The next installment for the Scrubgrass Project long-term
obligation amounts to $39,585 and is payable later in 1998.
1998 Outlook
During 1998, the Company expects that its principal sources of cash to fund
its business activities will be from available cash balances, investment
earnings and cash which may become available from the Scrubgrass Project. As
discussed more fully in the Company's 1997 Annual Report on Form 10-K, the
Company is not able to receive cash from the Scrubgrass Project until all
operating expenses, base lease payments (which include the Lessor's debt
service), certain maintenance reserve payments and other subordinated payments
of the Scrubgrass Project are first satisfied.
As discussed under the caption "-Results of Operations - 1998 Outlook", the
Company expects that the Scrubgrass Project will be profitable in 1998 and will
generate cash flows from its operating activities. However, the Company
anticipates that a significant portion of the expected cash flows in 1998 will
be utilized for debt and maintenance reserve repayments. According to the terms
of certain Scrubgrass Project obligations, the Company will be required to pay
down the $3 million term credit facility to $1,800,000 by January 4, 1999 and
make an installment payment later in 1998 of $39,585 under the $1.3 million
Scrubgrass Project note. Furthermore, the Company is expecting to make deposits
to the major maintenance reserve fund which are in excess of normal requirements
aggregating $248,795 during 1998 to replenish restricted cash balances which
were used to finance expenditures for major cash overheauls during previous
outages. However, as discussed more fully in the Company's 1997 Annual Report on
Form 10-K,
16
the Company is required to pay the Lessor, in addition to a specified base rent,
an additional rent of 50 percent of the net cash flows it receives from the
Scrubgrass Project. Therefore, the Company would expect to realize a savings in
its additional rent expense to the extent of 50 percent of any required debt and
maintenance reserve repayments. As such, the Company expects that the cash flows
which may become available in 1998 from the Scrubgrass Project would only be
reduced by 50 percent of any required debt and maintenance reserve repayments.
As discussed in a previous filing, the Company improved its financial
position by revising the terms of its installment contract to finance the 1997
repair of the Scrubgrass generator. Under the terms of the revised agreement
with the manufacturer of the Scrubgrass generator ("GEC"), as payment in full
for their recent work performed during the 1998 outage and for the five
remaining installments of $110,000 and $75,000 bonus owed under the original
contract, the Company will pay GEC a total of $450,000 over a four year period.
The revised agreement provides that $50,000 was payable upon the completion of
their work during the scheduled 1998 plant outage and that $100,000 is payable
upon each of the first four anniversaries of the first payment thereof. As of
June 30, 1998, the Company has recorded in its Consolidated Balance Sheet the
first installment of $50,000 in its accounts payable and accrued expenses and
the present value of the remaining four installments, discounted at the
Scrubgrass Project's incremental borrowing rate (6.75%), which amounted to
approximately $344,000, in its maintenance reserve. The $56,000 balance of the
$450,000 revised generator rewind cost is being recognized as interest expense
over the remaining four year term of the financing contract with GEC. During
the first quarter in 1998, the Company recognized, through a reduction of its
operating expenses, the reduction of the present value of the future
installments due to GEC, which reduction amounted to approximately $169,000 as
of December 31, 1997. The Company has also recognized interest expense of
approximately $14,000 during the six months ended June 30, 1998 under the
revised agreement with GEC.
The Company continues to address the issue of Year 2000 compliance. During
the year ended December 31, 1996, the Company replaced all of the hardware and
software at its corporate office with products which are Year 2000 compliant.
The Company has reviewed all of the hardware and software at the Scrubgrass
facility for Year 2000 compliance and, where necessary, is either upgrading or
replacing this software in accordance with a schedule which would ensure Year
2000 compliance prior to the year 2000. The Company presently does not expect
that any future expenditures for hardware and software upgrades or replacements
at the Scrubgrass facility related to Year 2000 compliance would have a material
impact on the Company's results of operations or financial position. The
Company continues to consider whether there are issues with Year 2000 compliance
at its customer, or any of its vendors, which could adversely affect its
operations. In this regard, the Company has presently developed a list of
vendors for which compliance letters will be sent to ensure such vendors have
systems which are Year 2000 compliant. Presently, pending feedback from its
customer and vendors, the Company's management is unable to assess whether there
would be any impact on its operations if its customer, or any of its vendors,
fail to ensure that their computer systems are Year 2000 compliant.
17
The Company is optimistic about the future performance of the Scrubgrass
Project which is currently expected to achieve earnings on an annual basis for
the foreseeable future. Notwithstanding, the Scrubgrass Project will obviously
bear the burden of repaying the debt obligations relating to the extended outage
of the Scrubgrass Project in the near term. Nevertheless, the Company believes
that the cash flows which may become available from the Scrubgrass Project,
together with cash reserves which the Company estimates were approximately
$700,000 at June 30, 1998, would be sufficient to fund the Company's business
activities on a long-term basis. However, the payment of any future dividends
will depend on the Board of Directors' evaluation, made on a quarterly basis,
based on the Company's then current and projected operating performance and
capital requirements. See "--Certain Factors That May Affect Future Results"
below.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
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.
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
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 four full-
time employees and one part-time employee, including three executive officers.
The loss of any of these employees could adversely effect the Company's
operations.
Third Party Project Management
The Company has entered into a management services agreement with U.S. Gen
to manage the Scrubgrass Project and a 15-year operations and maintenance
agreement with U.S. 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 the manager and 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.
18
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 the loss of its operating revenues and/or due to
additional costs which may be required to complete any maintenance procedures.
It is not possible for the Company to predict the frequency of future
unscheduled shutdowns or to predict the extent of maintenance which may be
required during shutdowns related to equipment maintenance.
Legal Proceedings
As discussed under the caption "Part II. Item 1.-Legal Proceedings", the
Company is involved in a legal proceeding with the purchasers of the Company's
interest in the Sunnyside Project which was sold in 1994. Pending the
resolution of the legal proceeding, the purchasers have withheld scheduled
payments of principal and interest due on the promissory notes since June 1996,
which amounted to $2,937,500 and $661,944, respectively as of June 30, 1998. In
addition, the Company recorded in 1994 a receivable related to a purchase price
adjustment, as provided for in the Purchase and Sale Agreement, of approximately
$1.1 million, of which $708,000 was received in April 1995. The balance of
purchase price adjustment is also being disputed in the legal proceeding with
the purchasers. Although the Company's available cash and cash provided by
operating activities has been sufficient to fund the Company's investing and
financing activities, the withholding of scheduled principal and interest
payments has adversely affected the Company's cash flow. At this time, while
management believes the Company's position in this litigation is meritorious,
the Company cannot predict whether it will prevail in the litigation and to what
extent it will incur professional fees to defend its position in the litigation.
An unfavorable resolution and/or extensive professional fees to defend the
litigation could adversely affect the Company's results of operations.
As discussed under the caption "Part II. Item 1.-Legal Proceedings", the
Company is also a plaintiff in a legal proceeding with Pennsylvania Electric
Company ("PENELEC"), the utilty which purchases electricity from the Scrubgrass
facility. In this legal proceeding, among other complaints, the Company alleged
that PENELEC has breached the power purchase agreement by failing to pay
contract rates for energy produced by the Scrubgrass facility in excess of 80 MW
in any hour. At this time, while management believes the Company's position in
this litigation is meritorious, the Company cannot predict whether it will
prevail in the litigation and receive contract rates for energy produced by the
Scrubgrass facility in excess of 80 MW in any hour.
Financial Results
19
To date the Company has incurred substantial losses, primarily due to its
development activities, which have resulted in an accumulated deficit of
$3,806,263 as of June 30, 1998. While the Company was profitable overall during
1997, the Company incurred a loss from the operation of the Scrubgrass Project
during 1997 due to an unforeseen repair to the generator at the Scrubgrass
facility. While the Company continues to expect to be profitable for 1998, the
Company's 1998 results to date have been adversely affected by several
unscheduled shutdowns during the second quarter resulting from equipment
malfunctions. Financial results can be affected by numerous factors, including
without limitation general economic conditions, cyclical 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 the occurrence of
unpredictable events like the generator repair and the equipment malfunctions.
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.
Development Uncertainties
From time to time, the Company invests its resources to develop power
generating facilities or invest in other projects of a development nature. The
successful development of power generating facilities or similar projects
typically require the Company 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 to complete such projects. However, the failure to
accomplish any of the aforementioned steps could materially increase the cost or
prevent the successful completion of projects under development, or cause the
Company to abandon the pursuit of such development projects and incur the loss
of its investment to date, which could materially impact the Company's business
and results of operations. As of June 30, 1998, the Company has no projects
which are in the development stage.
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.
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 ten years.
Accordingly, this technology carries greater risk than more established
20
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
The Company's subsidiary, as a lease cost of the Scrubgrass facility, is
required to fund the Lessor's debt service which primarily consists of $135.6
million of variable rate tax-exempt bonds maturing through 2012, a $17.7 million
remaining term loan maturing through 2005, a $10.7 million variable rate term
loan maturing through 2004 and $.5 million in remaining junior subordinated debt
obligations which mature through 2004. The Company's subsidiary is also
required to fund a variable rate working capital loan, a $1.3 million variable
rate term loan maturing through 2004 and $2.4 million in advances from the
Lessor under a variable rate credit agreement executed in June 1997. The Lessor
entered into interest rate swaps which had the effect of fixing the interest
rate on the tax-exempt bonds until May 18, 1996 at approximately 3.72% and
fixing the interest rate over the life of the $17.7 million remaining term loan
at 6.42%. After May 18, 1996, the Company's specified base rent was incurred
based on floating rates on the Lessor's tax-exempt bonds. As such, except for
the Lessor's $17.7 million remaining term loan and $.5 million remaining junior
subordinated debt obligations, 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 lease
expense or debt service. 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 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.
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
21
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 generates electricity using alternative energy sources which is
sold on a wholesale basis under long-term contracts to utilities under rates
established in power purchase agreements and approved by regulatory agencies.
The independent power industry has grown rapidly over the past twenty years.
There are a large number of suppliers in the wholesale market and a surplus of
capacity which has led to intense competition in this market. 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 and the marketing of electric energy,
equipment suppliers and other non-utility generators like the Company.
Competition in this industry is substantially based on price. The electric
industry is also characterized by rapid changes in regulations which the Company
expects could continue to increase competition. For instance, as discussed more
fully in the Company's latest Annual Report on Form 10-K, the electric industry
has been previously affected by legislation such as the Federal Public Utility
Regulatory Policies Act of 1978 ("PURPA") and the Energy Policy Act of 1992
("Energy Act") which have encouraged companies other than utilities to enter the
electric power business by reducing regulatory constraints. More recently, as
discussed under the caption "--Energy Regulation" below, there has been new
state legislation to deregulate the generation component of the electric
business. Furthermore, as discussed under the caption "Energy Regulation",
proposed changes to repeal or modify the Public Utility Holding Company Act of
1935 ("PUHCA") and PURPA could reduce regulatory restrictions placed on electric
utilities and encourage them to seek new sources of electric power. Any of
these regulatory matters, among others, could increase competition for electric
power. Other than the risk that PENELEC will seek to renegotiate the terms of
the Scrubgrass power purchase agreement (see further discussion under the
caption "Energy Regulation"), the Company does not believe it will be
significantly impacted by competition in the wholesale energy market since its
revenues are subject to contracted rates which are substantially fixed for
several years. However, the contracted rates in the later years of the
Scrubgrass power purchase agreement switch to rates which vary more closely with
existing market conditions. Should ensuing competition in the later years of
the Scrubgrass power purchase agreement create downward pressure on wholesale
energy rates, the Company's profitability could be impacted.
The Company also competes in the market to develop power generation
facilities. The primary bases of competition in this market are the quality of
development plans, the ability of the developer to finance and complete the
project and the price. In certain cases, competitive bidding for a development
opportunity is required. Competition for attractive development opportunities
is expected to be intense as there are a number of competitors in the industry
interested in the limited number of such opportunities. Many of the companies
competing in this market have substantially greater resources than the Company.
The Company believes its project development experience and its experience in
22
creating strategic alliances with other development firms with greater financial
and technical resources could enable it to continue to compete effectively in
the development market when opportunities arise. Presently, the Company believes
there are limited opportunities for additional project development in the United
States for projects similar to those previously developed by the Company.
Presently, there is significant merger and consolidation activity occurring
in the electric industry. From time to time, the Company considers sale or
merger strategies and proposals when they appear to present an opportunity to
enhance shareholder value.
Energy Regulation
The Company's projects are subject to regulation under federal and state
energy laws and regulations. The Company's facilities are either self-certified
as a Qualifying Facility under PURPA, or formally certified as a Qualifying
Facility by the Federal Energy Regulatory Commission ("FERC"). Pursuant to
PURPA, FERC has promulgated regulations which exempt certain Qualifying
Facilities from the Federal Power Act of 1920, PUHCA, and, except under certain
limited circumstances, state laws regulating the rates charged by electric
utilities. In order to qualify under PURPA, the Company's facilities must meet
certain size, fuel and ownership requirements and/or co-generate. In addition
to the regulation of Qualifying Facilities, PURPA requires that electric
utilities purchase electric energy produced by qualifying facilities 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 Company believes that changes in PURPA, PUHCA and other related federal
statutes could occur in the next several years. The nature and impact of such
changes on the Company's projects is unknown at this time. Presently, there are
several legislative proposals pending in Congress which propose amendments to
certain regulations promulgated by PURPA. If Congress amends PURPA, the
statutory requirement that electric utilities purchase electricity from
Qualifying Facilities at full avoided cost could be repealed or modified. While
current legislative proposals specify the honoring of existing contracts, the
repeal or modification of these statutory purchase requirements under PURPA in
the future could increase pressure for electric utilities to renegotiate
existing contracts. Should there be changes in statutory purchase requirements
under PURPA, and should these changes result in amendments which reduce the
contracted rates under the Scrubgrass power purchase agreement, 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. Although FERC generally has exclusive jurisdiction over the rates
charged by an independent power project to its wholesale customers, state public
utility commissions have the practical ability to influence the establishment of
such rates by asserting jurisdiction over the purchasing utility's ability to
pass through the resulting cost of purchased power to its retail customers. In
addition, although
23
thought to be unlikely, states may assert jurisdiction over the siting and
construction of independent power projects and, among other things, the issuance
of securities and the sale and transfer of assets. 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 subject to state
legislation in the Commonwealth of Pennsylvania.
In recent years, in response to changes in the electric industry, the
Commonwealth of Pennsylvania has passed new legislation most notably in the area
of deregulating the generation portion of the electric business. On December 3,
1996, the Commonwealth of Pennsylvania passed new 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 permits all
Pennsylvania retail electric customers to choose their electric generation
supplier over a phase-in period which expires December 31, 2000. The Customer
Choice Act has required that all electric utilities file restructuring plans
with the Pennsylvania Public Utility Commission which, among other things,
included unbundled prices for electric generation, transmission and distribution
and a competitive transition charge ("CTC") for the recovery of "stranded costs"
which would be paid by all customers receiving distribution service and certain
customers that increase their own generation of electricity. "Stranded costs"
generally are electric generation-related costs that traditionally would be
recoverable in a regulated environment but may not be recoverable in a
competitive electric generation market.
Presently, none of the new or proposed legislation directly impacts the
Company since the legislation pertains to the retail market or new contracts in
the wholesale market. However, as discussed previously, the Company could be
impacted in the future by, among other things, increases in competition as a
result of deregulation, or increasing pressure on electric utilities to
renegotiate existing power contracts. The Company is actively monitoring these
developments in energy proceedings in order to evaluate the impact on its
projects and also to evaluate new business opportunities created by the
restructuring of the electric industry.
Environmental Regulation
The Company's projects are subject to regulation under federal, state and
local environmental and mining laws and regulations and must also comply with
the applicable federal, state and local laws pertaining to the protection of the
environment, primarily in the areas of water and air pollution. These laws and
regulations in many cases require a lengthy and complex process of obtaining and
maintaining licenses, permits and approvals from federal, state and local
agencies. 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 applicable requirements could result in
delays in proceeding with any projects under development or require
modifications to operating facilities. During periods of non-compliance, the
Company's operating facilities may be forced to shutdown until the non-
compliances are corrected. The Company is responsible for ensuring compliance
of its facilities with all applicable requirements and, accordingly, attempts to
minimize these risks by dealing with
24
reputable contractors and using appropriate technology to measure compliance
with the applicable standards.
25
PART II. OTHER INFORMATION
---------------------------
ITEM 1. LEGAL PROCEEDINGS
On October 11, 1995, Scrubgrass Generating Company L.P. (the "Lessor") and
Buzzard Power Corporation (the "Lessee") (collectively the "Plaintiffs") filed a
complaint against Pennsylvania Electric Company ("PENELEC") in the Court of
Common Pleas of Venango County, Pennsylvania (the "Court") seeking damages for
certain alleged breaches of the power purchase agreement entered into between
Scrubgrass Power Corporation, a predecessor to the Plaintiffs, and PENELEC on
August 7, 1987. In its complaint, the Plaintiffs allege that PENELEC has failed
to pay contract rates for energy produced by the Scrubgrass facility in excess
of 80 MW in any hour, that PENELEC has misused certain automatic regulation
equipment and that PENELEC has caused the Plaintiffs to incur losses from its
late payment for energy purchased from the Scrubgrass facility. As a result of
PENELEC's alleged failure to pay contract rates for energy produced by the
Scrubgrass facility in excess of 80 MW in any hour, the Plaintiffs estimate that
as of June 30, 1998, after giving effect to certain payments made by PENELEC
which are discussed below, they have incurred damages of approximately $2.7
million. Should the Plaintiffs prevail in this litigation and be awarded all of
these damages, the Company, as Lessee, would expect to retain 50% of these
damages because of its requirement to pay 50% of any net proceeds retained by
the Scrubgrass Project to the Lessor as additional rent. The Plaintiffs have yet
to quantify their damages from PENELEC's alleged late payments for energy
purchased from the Scrubgrass facility but do not expect that these damages
would be material relative to the other allegations. The Plaintiffs are unable
to quantify the damages they have incurred from PENELEC's alleged misuse of
certain automatic regulation equipment. From October 1995 to September 1996,
this legal proceeding was stayed informally by a letter agreement between the
parties. Pursuant to the letter agreement, PENELEC, which had previously not
made any payments for the energy it received in excess of 80 MW in any hour,
agreed to pay for all energy in excess of 80 MW in any hour, both previously
received and to be received in the future, at a rate equal to 90% of a market
based rate, subject to reimbursement based on the ultimate determination of
PENELEC's responsibility to pay for such energy and the applicable rate
therefor. Through June 30, 1998, the Scrubgrass Project has recognized
cumulative power generation revenues of approximately $1.5 million for energy in
excess of 80 MW in any hour based on the terms established in the letter
agreement. On September 27, 1996, the Plaintiffs provided written notice of
their intention to resume the litigation. Consequently, on October 24, 1996,
PENELEC filed preliminary objections to the complaint to the Court which
principally suggested that the primary jurisdiction for this dispute lies with
the Pennsylvania Public Utility Commission ("PUC"). On November 12, 1996, the
Plaintiffs filed a response to PENELEC's preliminary objections. The Court
heard oral arguments on this matter on January 31, 1997 for which the Court
ultimately decided in favor of the Plaintiffs on September 9, 1997 to deny
PENELEC's motion to transfer the jurisdiction of this dispute to the PUC. On
January 8, 1998, as a result of this ruling by the Court, PENELEC filed its
response to the allegations made in the Plaintiffs' complaint. On February 4,
1998, the Plaintiffs filed a Motion for Partial Judgment on the Pleadings which
was heard by the Court on March 30, 1998. On June 8, 1998, the Venango County
Court of Common Pleas ruled in favor of the Plaintiffs that, under the terms and
conditions of the Scrubgrass power purchase agreement, "PENELEC is required to
purchase all energy produced in good faith, so long as the quantity is not
unreasonably disproportionate to estimate of 80 MW". On July 9, 1998, the
Plaintiffs were notified that PENELEC filed an appeal to the court order.
26
Presently, pending the ultimate determination of its responsibility under the
power purchase agreement, PENELEC continues to pay for energy in excess of 80 MW
at a rate equal to 90% of a market based rate. The Plaintiffs had been in
discussions with PENELEC concerning a proposal made by PENELEC to settle the
litigation. However, because the Plaintiffs and PENELEC could not come to a
mutual agreement on all of the terms of the proposal, PENELEC withdrew its
proposal offer in July 1998.
On May 3, 1996, B&W Sunnyside L.P., NRG Sunnyside Inc., NRG Energy Inc., and
Sunnyside Cogeneration Associates (collectively the "Plaintiffs") filed a
complaint, which was amended on June 27, 1996, against the Company and three of
its wholly-owned subsidiaries (collectively hereafter in this Item 1 "the
Company") in Seventh District Court for Carbon County, State of Utah. The
amended complaint alleges that the Company breached the purchase and sale
agreement by which the Company transferred all of its interest in Sunnyside
Cogeneration Associates, a joint venture which owned and operated a nominal 51
megawatt waste coal fired facility located in Carbon County, Utah. The amended
complaint also alleges that the Company made certain misrepresentations in
connection with the purchase and sale agreement. As a result of the alleged
breaches of contract and misrepresentations, the Plaintiffs allege that they
suffered damages in an unspecified amount that exceed the aggregate outstanding
principal and interest balances due to the Company by B&W Sunnyside L.P. and NRG
Sunnyside, Inc. under certain notes receivable, which amounted to $2,937,500 and
$661,944, respectively at June 30, 1998. In addition to alleging unspecified
damages, the Plaintiffs also request rescission of the purchase and sale
agreement. On July 30, 1996, in response to the Plaintiffs' amended complaint,
the Company filed an answer and counterclaim. In the answer to the amended
complaint, the Company denied all material allegations of the amended complaint
and asserted numerous affirmative defenses. In the counterclaim, the Company
alleges numerous causes of action against the Plaintiffs which include breach of
contract, breach of the promissory notes, intentional, malicious and willful
breach of contract, intentional tort, interference and misrepresentation.
Through the counterclaim, the Company seeks remedies which include: (1)
compensatory, consequential and punitive damages; (2) acceleration and immediate
payment in full of the promissory notes; and (3) injunctions which require the
Plaintiffs to continue making payments under the promissory notes during the
pendency of this action and until the promissory notes are paid in full and
which enjoin the Plaintiffs from continuing certain malicious and intentional
actions that are alleged in the counterclaim, together with interest, reasonable
attorney's fees, costs and other such relief as the court deems proper. On
August 30, 1996, the Plaintiffs filed a reply to the Company's counterclaim in
which they denied all material allegations of the counterclaim and asserted
numerous affirmative defenses. The Company plans to vigorously defend against
the amended complaint and vigorously pursue the causes of action stated in the
counterclaim. On April 15, 1998, the Company filed a Motion for Summary
Judgment with Respect to Claims Regarding the Power Purchase Agreement, seeking
dismissal of a portion of the Plaintiffs' claims. On June 5, 1998, the Company
received the Plaintiffs' response to its Motion for Summary Judgment with
Respect to Claims Regarding the Power Purchase Agreement wherein the Plaintiffs
stated their opposition to such motion. The Company is in the process of
drafting a response to the Plaintiffs' correspondence dated June 5, 1998.
Discovery remains ongoing.
27
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Company's Annual Meeting of Stockholders, held on Tuesday June 23, 1998,
the following actions were submitted to a vote of security holders:
1. The Company elected a Board of Directors to serve for the ensuing year until
their respective successors have been duly elected and qualified. The results
of the voting were as follows:
NUMBER OF SHARES
---------------------
WITHHELD
ELECTED DIRECTOR FOR AUTHORITY
---------------- --- ---------
Joseph E. Cresci 10,802,708 22,200
Donald A. Livingston 10,802,708 22,200
Peter J. Blampied 10,803,108 21,800
Edward B. Koehler 10,803,108 21,800
Robert I. Weisberg 10,803,108 21,800
2. The Company ratified the selection of the firm Deloitte and Touche LLP as
auditors for the Company for the fiscal year ending December 31, 1998. The
results of the voting were as follows:
RESULT NUMBER OF SHARES
------ ----------------
For 10,824,532
Against 376
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 11 - Computation of Earnings Per Share
(b) Reports on Form 8-K - None
28
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ENVIRONMENTAL POWER CORPORATION
August 13, 1998 /s/ William D. Linehan
-------------------------------
William D. Linehan
Treasurer and
Chief Financial Officer
(principal accounting officer
and authorized officer)
29