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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 March 31, 1999
-------------------------------------------------
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
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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 May 11, 1999 11,406,783 shares
The Exhibit Index appears on Page 29.
Total number of pages is 30.
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ENVIRONMENTAL POWER CORPORATION
INDEX
PART I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as
of March 31, 1999 (unaudited) and December 31, 1998............................................... 2
Condensed Consolidated Statements of Operations (unaudited)
for the Three Months Ended March 31, 1999
and March 31, 1998................................................................................ 3
Condensed Consolidated Statements of Cash Flows (unaudited) for the
Three Months Ended March 31, 1999
and March 31, 1998................................................................................ 4
Notes to Condensed Consolidated Financial Statements.............................................. 5-6
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations..................................................................................... 7-26
Item 3. Quantitative and Qualitative Disclosures About Market Risk............................... 26
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.................................................................... 27-29
Item 6. Exhibits and Reports on Form 8-K..................................................... 29
Signatures .................................................................................... 30
1
PART I. FINANCIAL INFORMATION
-----------------------------
ITEM 1. FINANCIAL STATEMENTS
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
March 31 December 31
1999 1998
----------------- -----------------
ASSETS (Unaudited)
CURRENT ASSETS:
Cash and cash equivalents $ 538,868 $ 362,416
Restricted cash 1,619,903 797,922
Receivable from utility 3,619,108 6,598,864
Notes receivable 32,310 42,376
Other current assets 702,795 821,462
----------------- -----------------
TOTAL CURRENT ASSETS 6,512,984 8,623,040
PROPERTY, PLANT AND EQUIPMENT, NET 122,056 94,755
DEFERRED INCOME TAX ASSET 1,808,561 1,826,561
LEASE RIGHTS, NET 2,571,264 2,608,515
NOTES RECEIVABLE --- 3,686
ACCRUED POWER GENERATION REVENUES 43,327,905 41,386,500
OTHER ASSETS 602,593 619,693
----------------- -----------------
TOTAL ASSETS $ 54,945,363 $ 55,162,750
================= =================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 3,978,885 $ 5,873,689
Dividends payable on common stock 171,102 ---
Other current liabilities 2,668,224 3,939,664
----------------- -----------------
TOTAL CURRENT LIABILITIES 6,818,211 9,813,353
DEFERRED GAIN, NET 5,320,084 5,397,187
SECURED PROMISSORY NOTES PAYABLE
AND OTHER BORROWINGS 2,848,358 2,866,584
ACCRUED LEASE EXPENSES 43,327,905 41,386,500
MAINTENANCE RESERVE 2,351,279 2,258,049
----------------- -----------------
TOTAL LIABILITIES 60,665,837 61,721,673
----------------- -----------------
SHAREHOLDERS' DEFICIT:
Preferred Stock ($.01 par value; 1,000,000 shares authorized; no shares
issued at March 31, 1999 and December 31, 1998, respectively) -- --
Preferred Stock (no par value, 10 shares authorized; 10 shares
issued at March 31, 1999 and December 31, 1998, respectively) 100 100
Common Stock ($.01 par value; 20,000,000 shares authorized;
12,525,423 shares issued at March 31, 1999 and December 31, 1998,
respectively; 11,406,783 shares outstanding
at March 31, 1999 and December 31, 1998, respectively) 125,254 125,254
Accumulated deficit (4,579,826) (5,418,275)
----------------- -----------------
(4,454,472) (5,292,921)
Treasury stock (1,118,640 common shares, at cost, as of
March 31, 1999 and December 31, 1998, respectively) (456,271) (456,271)
Notes receivable from officers and board members (809,731) (809,731)
----------------- -----------------
TOTAL SHAREHOLDERS' DEFICIT (5,720,474) (6,558,923)
----------------- -----------------
TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIT $ 54,945,363 $ 55,162,750
================= =================
See Notes to Condensed Consolidated Financial Statements.
2
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended March 31
-----------------------------------------------
1999 1998
----------------------- -------------------
POWER GENERATION REVENUES $ 12,347,003 $ 12,178,487
----------------------- -------------------
COSTS AND EXPENSES:
Operating expenses 4,914,497 4,548,684
Lease expenses 5,628,452 6,037,834
General and administrative expenses 679,397 545,079
Depreciation and amortization 63,369 73,037
----------------------- -------------------
11,285,715 11,204,634
----------------------- -------------------
OPERATING INCOME 1,061,288 973,853
----------------------- -------------------
OTHER INCOME (EXPENSE), NET:
Interest income 29,605 53,029
Interest expense (84,883) (119,392)
Sale of NOx emission credits 629,720 ---
Other expense (32) ---
Amortization of deferred gain 77,103 77,103
----------------------- -------------------
651,513 10,740
----------------------- -------------------
INCOME BEFORE INCOME TAXES 1,712,801 984,593
INCOME TAX EXPENSE (702,000) (404,000)
----------------------- -------------------
NET INCOME $ 1,010,801 $ 580,593
======================= ===================
BASIC AND DILUTED EARNINGS PER
COMMON SHARE $ 0.09 $ 0.05
======================= ===================
DIVIDENDS PAID OR PAYABLE
Common shares $ 171,102 $ 342,203
Preferred shares 1,250 1,250
----------------------- -------------------
$ 172,352 $ 343,453
======================= ===================
DIVIDENDS PAID OR PAYABLE PER
COMMON SHARE $ 0.015 $ 0.030
======================= ===================
See Notes to Condensed Consolidated Financial Statements
3
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Three Months Ended March 31
--------------------------------------
1999 1998
---------------- ----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,010,801 $ 580,593
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 63,369 73,037
Deferred income taxes 18,000 245,000
Amortization of deferred gain (77,103) (77,103)
Accrued power generation revenues (1,941,405) (2,006,027)
Accrued lease expenses 1,941,405 2,006,027
Changes in operating assets and liabilities:
Decrease (increase) in receivable from utility 2,979,756 (129,677)
Decrease in other current assets 118,667 245,224
Increase in other assets (1,884) (955)
Decrease in accounts payable and
accrued expenses (1,894,804) (562,421)
Increase in long-term liabilities 2,850 2,819
Increase in maintenance reserve 93,230 56,237
---------------- ----------------
Net cash provided by operating activities 2,312,882 432,754
---------------- ----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from the collection of notes receivable 13,752 9,492
Increase in restricted cash (821,981) (131,167)
Property, plant and equipment expenditures (34,435) (5,196)
---------------- ----------------
Net cash used in investing activities (842,664) (126,871)
---------------- ----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividend payments (1,250) (10,267,355)
Net repayments of working capital loan (621,440) (171,620)
Repayment of secured promissory notes payable and
other borrowings (671,076) (150,000)
---------------- ----------------
Net cash used in financing activities (1,293,766) (10,588,975)
---------------- ----------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 176,452 (10,283,092)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 362,416 12,092,273
---------------- ----------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 538,868 $ 1,809,181
================ ================
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 three months ended March 31, 1999 are not necessarily indicative of
results to be expected for the year ending December 31, 1999. 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, 1998.
NOTE B -- 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 following table outlines the
calculation of basic earnings per share and diluted earnings per share for the
three months ended March 31, 1999 and 1998.
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNTS
------------------ -------------------- ---------------
THREE MONTHS ENDED MARCH 31, 1999:
- ----------------------------------
Income available to shareholders $ 1,010,801 11,406,783 $ .09
Effect of dividends to preferred stockholders (1,250)
------------------ -------------------- ---------------
Basic EPS - income available to common shareholders 1,009,551 11,406,783 .09
Effect of dilutive securities:
Assumed exercise of dilutive stock options
------------------ -------------------- ---------------
Diluted EPS - income available to common shareholders $ 1,009,551 11,406,783 $ .09
================== ==================== ===============
THREE MONTHS ENDED MARCH 31, 1998:
- ----------------------------------
Income available to shareholders $ 580,593 11,406,783 $ .05
Effect of dividends to preferred stockholders (1,250)
------------------ -------------------- ---------------
Basic EPS - income available to common shareholders 579,343 11,406,783 .05
Effect of dilutive securities:
Assumed exercise of dilutive stock options 16,827
------------------ -------------------- ---------------
Diluted EPS - income available to common shareholders $ 579,343 11,423,610 $ .05
================== ==================== ===============
5
NOTE C -- NEW ACCOUNTING STANDARD
- ---------------------------------
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities. SFAS No. 133 requires that entities recognize all
derivative instruments as either assets or liabilities in the statement of
financial position and measure those instruments at fair value. If certain
conditions are met, a derivative instrument may be specifically designated as
(a) a hedge of the exposure to changes in the fair value of an asset or
liability or an unrecognized firm commitment, or (b) a hedge to the exposure to
variable cash flows of a forecasted transaction. The Lessor of the Scrubgrass
Project has entered into certain interest rate swaps with financial institutions
that may meet the definition of derivative instruments under SFAS No. 133. The
Company will be required to adopt SFAS No. 133 by January 1, 2000 and is
presently assessing whether the adoption of SFAS No. 133 will have any impact on
its Consolidated Financial Statements.
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. In
recent years, the Company also held varying ownership interests (100% to 40%) in
an approximately 51 Mw (net) waste coal-fired electric generating facility (the
"Sunnyside Project") located in Utah and owned the development rights to an
existing 43 Mw (net) coal-fired electric generating facility (the "Milesburg
Project") located in Pennsylvania which was retired from service in 1984. The
Company sold its remaining interest in the Sunnyside Project on December 31,
1994 and is presently involved in a litigation with the Purchasers to collect
the balance of the Purchasers' obligations for the sale. The Company sold its
development rights and real estate for the Milesburg Project on August 26, 1997
to the utility which had contracted to purchase electricity from such project
pursuant to an agreement which was finalized on December 5, 1997. The following
Management's Discussion and Analysis of Financial Condition and Results of
Operations compares the Company's results of operations for the three months
ended March 31, 1999 ("1999") with the results of operations for the three
months ended March 31, 1998 ("1998"). 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".
RESULTS OF OPERATIONS
Net income in 1999 amounted to $1,010,801 or nine cents per share as
compared to net income of $580,593 or five cents per share in 1998. The overall
increase in net results during 1999 is primarily attributable to an increase in
power generation revenues, a decrease in lease expenses and the sale of NOx
emission credits referred to below. The Company's overall increase in net
results during 1999 was offset in part by an increase in operating expenses and
an increase in general and administrative expenses. The reasons for the net
increase in the Company's 1999 net results are discussed in more detail in the
following paragraphs.
7
Power generation revenues in 1999 amounted to $12,347,003 as compared to
$12,178,487 in 1998 and all pertained to the Scrubgrass Project. The overall
increase in power generation revenues during 1999 is primarily attributable to a
5% increase in certain rates billed to the utility under the terms of the power
purchase agreement. The increase was offset in part by a decrease in the
capacity rate billed in 1999 since the Scrubgrass Project operated at 94.1% of
its capacity in 1999 as compared to 97.2% in 1998. The 1999 capacity factor was
affected by unscheduled shutdowns to respond to equipment malfunctions which
were similar to the unscheduled shutdowns which occurred during the year ended
December 31, 1998. The Company is addressing these troublesome areas during its
scheduled Scrubgrass plant outage during the second quarter of 1999 with major
overhauls which are expected to lessen the frequency of such equipment
malfunctions in the future.
Operating expenses in 1999 amounted to $4,914,497 as compared to $4,548,684
in 1998 and all pertained to the Scrubgrass Project. The overall increase during
1999 is primarily attributable to the following reasons. First, the Company
incurred higher fuel costs and higher operator fees in 1999 as a result of cost
escalations in certain operating and supply agreements. Second, the Company
incurred higher maintenance expenses in 1999 to make the necessary repairs
related to the equipment malfunctions discussed above and to accelerate its
reserves for future maintenance which the Company now expects will be performed
earlier than its previous schedule. Third, 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 1998 by comparison to 1999. However, because of the lower capacity rate
achieved in 1999, the Scrubgrass plant consumed less fuel in 1999 which lessened
the impact from the cost escalations in the fuel supply agreements.
Lease expenses in 1999 amounted to $5,628,452 as compared to $6,037,834 in
1998 and all pertained to the Scrubgrass Project. The overall decrease in lease
expenses during 1999 is primarily attributable to favorable interest rates which
decreased the Lessor's loan costs that were passed through to the Company in its
facility lease expenses. This decrease was offset in part by scheduled
increases in the base rent paid to the Lessor. However, because there was less
cash available from the Scrubgrass Project during 1999 (see a further discussion
under "--Liquidity and Capital Resources"), the Company realized a decrease in
additional rent paid to the Lessor which substantially offset the scheduled
increases in the base rent.
General and administrative expenses in 1999 amounted to $679,397 as
compared to $545,079 in 1998. The overall increase in general and administrative
expenses during 1999 is primarily attributable to the following reasons. First,
the management fees for the Scrubgrass Project increased primarily because the
project manager passed along increases in its labor costs to the Company.
Second, the Company incurred pension expense in the first quarter of 1999 for a
defined benefit pension plan which was established in December 1998 for which
there was no pension expense reported during the first quarter of 1998. Third,
since legal efforts for both of its litigations accelerated in 1999, the Company
incurred higher legal expenses in 1999 by comparison to 1998 (See "Part II.
Other Information - Item 1. Legal Proceedings" for further information).
Sale of NOx emission credits amounted to $629,720 in 1999 and represented
the aggregate proceeds received in February 1999 from sales of Nitrogen Oxide
Ozone Transport Region Budget
8
Allowances ("NOx Credits"). The sale of NOx Credits is discussed further under
"-- Liquidity and Capital Resources - Cash Flow Outlook".
Income tax expense in 1999 amounted to $702,000 as compared to income tax
expense of $404,000 in 1998. The increase in income tax expense for 1999 is
primarily attributable to increased pre-tax earnings in 1999. The effective
income tax rate for 1999 is currently projected to be approximately 41% which is
consistent with rate reported for the comparative period in 1998.
1999 OUTLOOK
With a view towards the remainder of 1999, the Company expects to achieve
continuing operating earnings as a result of profits from Scrubgrass project
operations and management of its corporate general and administrative expenses.
The Company offers the following prospective information concerning significant
components of its results of operations for the year ending December 31, 1999
("Fiscal 1999") which are being compared to historical results of operations for
the year ended December 31, 1998 ("Fiscal 1998"):
Power generation revenues - Power generation revenues are expected to increase
in Fiscal 1999 as a result of a 5% increase in certain contracted rates under
the Scrubgrass power purchase agreement and improvements in the performance of
the Scrubgrass facility. During Fiscal 1998, the Scrubgrass facility was
inoperative for approximately 23 days for unscheduled shutdowns to respond to
equipment malfunctions. While the Company expects that the Scrubgrass facility
will incur equipment malfunctions from time to time, the Company does not
believe that Fiscal 1998 results are necessarily indicative of results
expected for Fiscal 1999.
Operating expenses - Operating expenses are expected to increase in Fiscal
1999 as a result of a 4% average increase in certain contracted rates under
fuel supply agreements, a 5% increase in certain contracted rates under the
Operations and Maintenance Agreement for the Scrubgrass Project and
anticipated increases in personnel costs at the Scrubgrass plant. In addition,
because the Company expects improvements in the performance of the Scrubgrass
facility for Fiscal 1999, 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, since the
Company is not projecting it will respond to as many equipment malfunctions
during Fiscal 1999, the Company expects that certain maintenance expenses
would be lower for Fiscal 1999. However, because the Company has been
accelerating its reserves for future scheduled maintenance which the Company
now expects will be performed earlier than its previous schedule, maintenance
expenses on the whole may increase for Fiscal 1999.
Lease expenses - Lease expenses are expected to increase significantly in
Fiscal 1999 for the following reasons. First, the Company expects that higher
contracted principal payments on the Lessor's term loans will increase the
Lessor's loan costs that are expected to be passed through to the Company in
its facility lease expenses. Second, the Company expects to incur scheduled
increases in equity rents for the Scrubgrass Project in Fiscal 1999. Third,
due to
9
projected increases in cash from Scrubgrass Project operations (See further
discussion under "--Liquidity and Capital Resources - Cash Flow Outlook"), 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 also increase
in Fiscal 1999. However, the Company has experienced improvements in its
variable interest rates in recent months. Should recent interest rates remain
consistent during Fiscal 1999, the Company would expect to incur a decrease in
lease expense due to reductions in the Lessor's loan costs that would be
passed through to the Company in its facility lease expenses.
General and administrative expenses - General and administrative expenses are
expected to increase slightly during Fiscal 1999 primarily as a result of
increases in management fees for the Scrubgrass Project and increases in
payroll expense for two of the Company's executive officers. During Fiscal
1998, such executive officers had repaid a portion of their annual salaries in
an amount equal to the benefit they expected to receive from the Company's
Fiscal 1998 contribution to its defined benefit pension plan. While the annual
salaries for such executive officers were decreased by an aggregate of
$100,000 during Fiscal 1999, such decrease was less than their aggregate
salary repayments made during Fiscal 1998. Depending on the demands of the
Company's two legal proceedings, the Company could also incur significant
fluctuations in its professional fees and management costs which cannot be
estimated at this time.
Other expense - In Fiscal 1998, the Company wrote-off its aggregate balances
as of December 31, 1998 of the notes receivable of $2,937,500 and the
receivable from sale of affiliate of $570,998 related to the 1994 sale of the
Sunnyside Project. This charge against operating results will not recur in
Fiscal 1999.
Other income - The Company entered into contracts to sell a portion of its
anticipated future Nitrogen Oxide Ozone Transport Region Budget Allowances
("NOx Credits"). The Company expects to generate other income from sales of
its NOx Credits beginning in Fiscal 1999. The sales of NOx credits are
discussed further under "--Liquidity and Capital Resources - Cash Flow
Outlook".
Litigation recoveries - As of March 31, 1999, the Company is seeking to
recover approximately $4.2 million owed by the Purchasers of the Sunnyside
Project and approximately $3.2 million (of which 50% or approximately $1.6
million would be retained by the Lessor) by PENELEC which are the subject of
legal proceedings. See "Part II. Other Information - Item 1. Legal
Proceedings". Furthermore, should these legal proceedings resolve or settle in
favor of the Company, the Company could also receive additional financial
recoveries which include interest, punitive damages and reimbursements for
attorney's expenses. Any future recoveries from either of these legal
proceedings would be recorded as additional income in the Company's
Consolidated Statement of Operations.
10
RECENTLY ISSUED ACCOUNTING STANDARDS
See Note C to the Condensed Consolidated Financial Statements for recently
issued accounting standards which are required to be adopted in the future.
LIQUIDITY AND CAPITAL RESOURCES
Operating Activities
The Company had cash provided by operating activities of $2,312,882 and
$432,754 in 1999 and 1998, respectively. During these periods, the Company's
only sources of cash from operating activities were operating profits from the
Scrubgrass Project and investment earnings.
The Company's net income during 1999 and 1998 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 1999 net income to its net cash provided by operating
activities.
Depreciation and amortization - During 1999, the Company recognized
depreciation and amortization for its lease rights of $37,251, deferred
financing costs of $18,984, machinery and equipment modifications of $5,466
and equipment and furniture of $1,668.
Deferred income tax asset - The Company's net deferred income tax asset
amounted to $1,808,561 as of March 31, 1999 as compared to $1,826,561 as of
December 31, 1998. The deferred tax asset decreased in 1999 primarily because
the Company's maintenance reserves and deferred gain are reported in
different periods for financial reporting purposes than for income tax
reporting purposes.
Deferred gain, net - The Company's deferred gain, net, amounted to $5,320,084
as of March 31, 1999 as compared to $5,397,187 as of December 31, 1998. 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 1999:
Receivable from utility - The Company's receivable from utility relates to
the Scrubgrass Project and amounted to $3,619,108 as of March 31, 1999 as
compared to $6,598,864 as of December 31, 1998. The Scrubgrass Project
collects its receivable from utility on a monthly basis 23 business days
after the month of power generation. Typically, the Company's balance sheet
at the end of each quarter reflects two months of outstanding receivables
from the utility. However, because March had 23 business days in 1999, the
Company collected its revenues for power generation in February 1999 on March
31, 1999. As such, the Company's receivable from utility as of March 31,
1999, which included power
11
generation revenues for March 1999, decreased significantly by comparison to the
balance as December 31, 1998, which included power generation revenues for
November and December of 1998. The aforementioned decrease in receivable from
utility as of March 31, 1999 was offset in part by the increases in revenues
discussed above under "Results of Operations".
Other current assets - The Company's other current assets amounted to $702,795
as of March 31, 1999 as compared to $821,462 as of December 31, 1998. The change
in other current assets is largely due to seasonal decreases in fuel inventory
and prepaid insurance.
Accounts payable and accrued expenses - The Company's accounts payable and
accrued expenses amounted to $3,978,885 as of March 31, 1999 as compared to
$5,873,689 as of December 31, 1998. The decrease as of March 31, 1999 is
primarily attributable to the following reasons. First, due to the
requirements of certain operating agreements, the Scrubgrass Project must pay
certain accounts payable and accrued expenses on the same day it collects the
receivable from utility. As such, the Company's accounts payable and accrued
expenses had a comparable decrease to the receivable from utility (see
"Receivable from utility" above). Second, 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 March 31,
1999 included only three months of expense as compared to 12 months of expense
as of December 31, 1998. The overall decrease was offset in part primarily by
the following factors which increased accounts payable and accrued expenses as
of March 31, 1999. First, the Company is projecting its taxable income for the
year ending December 31, 1999 will be significantly greater than the same period
in 1998. As such, the Company's accounts payable and accrued expenses includes
corporate taxes payable of $1,004,165 as of March 31, 1999 versus $156,682 as of
December 31, 1998. Second, the Company's 1998 contribution to its defined
benefit pension plan had not been funded as of March 31, 1999. As such, the
accrued pension liability increased as of March 31, 1999 by the 1999 periodic
pension cost. Third, primarily due to the increases in operating expenses and
general and administrative expenses discussed under "Results of Operations"
above, the Company realized an increase in certain accounts payable and accrued
expenses as of March 31, 1999.
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 "Investing Activities-Restricted
Cash" below). The maintenance reserve increased to $2,351,279 as of March 31,
1999 from $2,258,049 as of December 31, 1998 primarily due to scheduled reserves
provided for the ongoing maintenance of the plant. The scheduled reserves were
offset in part by expenditures of $88,130 for major equipment overhauls.
12
Investing Activities
The Company used $842,664 and $126,871 in investing activities during 1999
and 1998, 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 $13,752 and $9,492 from notes
receivable related to the Scrubgrass Project in 1999 and 1998, respectively.
The notes receivable related to the Sunnyside Project, with a principal
balance of $2,937,500 and outstanding interest balance of $882,256 as of
March 31, 1999, are the subject of a legal proceeding. Due to uncertainties
surrounding the timing of resolving this legal proceeding, the Company wrote-
off the outstanding balances of these receivables as of December 31, 1998 and
is no longer recognizing future interest income on the notes. "See Part II.
Other Information - Item 1. Legal Proceedings" for further information about
this litigation.
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 1999 and 1998, such deposits and interest thereon exceeded the
payments for major equipment overhauls by $218,932 and $131,167,
respectively. During 1999, the Company received $629,720 from the sale of a
portion of its NOx Credits (see the discussion under "--Cash Flow Outlook")
and designated that $600,000 of such proceeds be used to purchase and install
certain machinery related to the production of NOx Credits. Pending the
purchase and installation of this machinery, the Company has invested such
proceeds in restricted cash, which investments have increased restricted cash
by $603,049 during 1999.
Property, plant and equipment - The Company invested $34,435 and $5,196 in
property, plant and equipment expenditures during 1999 and 1998,
respectively. The 1999 expenditures were machinery and equipment
modifications made at the Scrubgrass facility. The 1998 expenditures were
primarily purchases of computer equipment for the Company's corporate office.
Financing Activities
The Company utilized $1,293,766 and $10,588,975 in financing activities
during 1999 and 1998, 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 declared dividends of $171,102 (1.5
cents per share) during the first quarter of 1999 which were paid on April
17, 1999 and $342,203 (3 cents per share) during the first quarter of 1998
which were paid on April 10, 1998. The Company also had dividends payable as
of December 31, 1997 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-
13
out) which were declared during the fourth quarter of 1997 and paid on
January 7, 1998. As such, dividends paid for common stock amounted to $-0-
and $10,266,105 during the first quarter of 1999 and first quarter of 1998,
respectively. The Company also paid dividends to its subsidiary's preferred
stockholder of $1,250 during both the first quarter of 1999 and first quarter
of 1998. As such, the Company paid total dividends of $1,250 and $10,267,355
during the first quarter of 1999 and first quarter of 1998, 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. The Company decreased its outstanding
borrowings under the Lessee Working Capital Loan Agreement from $2,389,664 as
of December 31, 1998 to $1,768,224 as of March 31, 1999. As discussed under
the caption "Receivable from utility" above, the Company collected an extra
payment during 1999 from the utility, a portion of which was used to reduce
the borrowings under the Lessee Working Capital Loan.
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. On July 1, 1998, the maximum allowable
borrowings under this credit facility began reducing in $600,000 increments
every six months through July 3, 2000 when the credit facility will be
payable in full. The Company made payments to reduce this obligation by
$650,000 and $150,000 during 1999 and 1998, respectively to ensure that the
outstanding borrowings would not exceed the maximum allowable borrowings on
the dates indicated.
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 $1,020,166 and $1,228,192,
respectively as of March 31, 1999. 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 are the subject of a litigation described in "Part II. Other
Information - Item 1. Legal Proceedings". The Scrubgrass Project obligation
has scheduled maturities which began in 1998 and continue through 2005. The
Company made payments of $21,076 and $-0- for the Scrubgrass Project
obligation in 1999 and 1998, respectively.
Cash Flow Outlook
During Fiscal 1999, 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 in its Annual Report on Form 10-K for Fiscal 1998, 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.
14
As discussed under the caption "--Results of Operations - 1999 Outlook",
the Company expects that the Scrubgrass Project will be profitable in Fiscal
1999 and will generate cash flows from its operating activities. Due primarily
to an approximate 5% increase in the contracted rates under the Scrubgrass power
purchase agreement and expected improvements in the performance of the
Scrubgrass facility, the Company believes that such expected cash flows would
exceed previous Fiscal 1998 levels. Nevertheless, the Company anticipates that
its expected cash flows in Fiscal 1999 would continue to be affected by debt and
maintenance reserve repayments. According to the terms of certain Scrubgrass
Project obligations, the Company will be required to reduce the outstanding
balance of its term credit facility in Fiscal 1999 by $1,550,000 and will be
required to make installment payments in Fiscal 1999 aggregating $60,695 under
the $1.3 million Scrubgrass Project note. Furthermore, pursuant to the
provisions of certain Scrubgrass Project agreements, the Company will also be
required to make additional scheduled deposits of $82,275 in Fiscal 1999 to
replenish restricted cash balances which were used to finance certain 1997
maintenance expenses. However, as discussed in its Annual Report on Form 10-K
for Fiscal 1998, 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 Fiscal 1999 from the
Scrubgrass Project would only be reduced by 50 percent of any required debt and
maintenance reserve repayments. During Fiscal 1998, the Company received
distributions of $1,371,690 from the Scrubgrass Project. During Fiscal 1999
through the date of this filing, the Company has received distributions from the
Scrubgrass Project of $637,365, of which $268,222 was received during the first
quarter of 1999. Due to restrictions in certain operating agreements, cash is
not expected to be distributed as quickly from the Scrubgrass Project during the
first half of 1999 when compared to same period in 1998. However, as discussed
above, the Company presently expects that distributions for Fiscal 1999 will
exceed distributions for Fiscal 1998.
During December 1998 and January 1999, the Company entered into contracts
to sell a portion of its anticipated future Nitrogen Oxide Ozone Transport
Region Budget Allowances ("NOx Credits"). Each year, the Environmental
Protection Agency and the Pennsylvania Department of Environmental Protection
grant NOx Credits to the Company based on numerous factors which pertain to the
design and operation of the Scrubgrass facility. The NOx Credits establish the
quantity (in tons) of nitrogen oxide that the Scrubgrass facility can emit into
the environment before the Company will be fined by the EPA. During Fiscal
1999, the Company plans to install machinery, with a cost of approximately
$600,000, which is expected to significantly lower the quantity of nitrogen
oxide which the Scrubgrass facility would emit into the environment. As such,
the Company anticipates that it may not require a portion of its future NOx
Credits to maintain its compliance with EPA standards. Because NOx Credits are
transferable and marketable, the Company contracted to sell 839 tons of its
projected available NOx Credits which it anticipates may not be required to
comply with EPA standards. Under the terms of the contracts, the Company
currently expects to receive aggregate proceeds from sales of anticipated NOx
Credits of $2,240,933 through 2000, from which $600,000 would be utilized to
purchase and install the machinery discussed above. The Company has received
proceeds of $629,720 from sales of NOx Credits through March 31, 1999.
15
As of March 31, 1999, the Company is seeking to recover approximately $4.2
million owed by the Purchasers of SCA and approximately $3.2 million (of which
50% or approximately $1.6 million would be retained by the Lessor) owed by
PENELEC which are the subject of legal proceedings. See "Part II. - Other
Information - Item 1. Legal Proceedings". In addition, the Company is seeking
financial recoveries which include interest, punitive damages and/or
reimbursements for attorney's expenses. The Company believes its positions in
both of these litigations are meritorious and, should they resolve or settle in
favor of the Company, they could materially enhance the Company's financial
position in the future. Recently, the Company has been in discussions with
PENELEC regarding a settlement of that legal proceeding. The Company currently
believes that the prospect of a final settlement of all outstanding issues with
PENELEC is good. However, there can be so assurance if or when the Company will
resolve or settle either of these legal proceedings.
In September 1998, the Company filed its 1997 corporate tax returns which
clarified its corporate tax position. Prior to 1997, the Company had
substantial net operating loss carryforwards which sheltered the Company from
paying Federal and certain state corporate taxes during its profitable periods.
However, primarily as a result of the 1997 Milesburg Project sale, the Company
had substantial taxable income in 1997 which utilized all of the Company's
previous net operating loss carryforwards. As such, for tax years beginning in
1997, the Company's cash flows have been negatively effected by the payment of
significant Federal and state corporate taxes. Presently, the Company is
reviewing its corporate tax position and is considering tax strategies which
could mitigate the effect that corporate taxes are expected to have on its
future cash flows.
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. The Scrubgrass power purchase agreement has contracted
rate escalations which, assuming the Scrubgrass Project meets its targeted
capacity rates, would ensure a material increase in revenues in future years.
Furthermore, as discussed above, the Company is involved in settlement
discussions with PENELEC regarding its legal proceeding and has entered into
contracts for the sale of NOx Credits which could both materially enhance the
anticipated increases in the Company's cash flows. Notwithstanding, the
Scrubgrass Project will obviously bear the burden of repaying the debt
obligations relating to the 1997 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 existing cash
reserves, 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 its
dividend policy and the Company's then current and projected operating
performance and capital requirements. See the further discussions under "--
Certain Factors That May Affect Future Results" below.
16
YEAR 2000 READINESS
General
The Company continues to address the issue of Year 2000 Readiness ("the Y2K
Project") and is proceeding on a schedule designed to complete the Y2K Project
by June 1999. In 1997, the Company began establishing procedures to assess the
risks associated with the Y2K Project. The Company's procedures to assess the
risks of the Y2K Project have included an inventory of stand-alone hardware and
software ("IT Systems"), an inventory of all system components embedded in the
Scrubgrass plant operating control systems ("Non-IT Systems"), the
identification of critical vendors, customers and business partners, the testing
of both IT Systems and Non-IT systems and a solicitation of responses from all
critical vendors, customers and business partners indicating their readiness for
the Year 2000.
Presently, the Company has completed its testing of IT Systems and Non-IT
Systems. Based on the results of these tests, the Company has identified IT
Systems and components of Non-IT Systems which are not Year 2000 compliant.
With respect to IT systems, the Company has either already upgraded such systems
or has placed orders to upgrade such systems in the near future. As far as Non-
IT Systems, the Company has received recommendations from third parties
regarding solutions to either upgrade or replace non-compliant system
components. At this time, the Company has received assurances from such third
parties that solutions to remedy the non compliant system components are readily
available and could be implemented within the Company's time parameters for the
Y2K Project. The upgrades and/or replacements of non-compliant system
components are expected to be performed during the Scrubgrass Project annual
outage which began on April 24, 1999 and was in process at the time of this
filing.
The Company has made substantial progress in securing responses from most
critical vendors, and business partners indicating their readiness for Year
2000. Based on the responses received to date, the Company has not identified
any conditions of potential non-compliance which the Company estimates would
materially impact its business.
Costs
The Company does not expect that the total costs to remediate Year 2000
issues would be material to its financial position. The Company has incurred
cumulative costs to remediate Year 2000 issues of approximately $178,000 through
March 31, 1999. The Company estimates that it will incur additional costs of
approximately $87,000 to remediate Year 2000 issues. The Company expects to fund
such costs from its operating cash flows.
Risks and Contingency Plans
The Company believes that it has established a viable plan designed to
ensure that the Y2K Project is completed prior to the year 2000. However, in
connection with its Y2K Project, the Company is also developing a contingency
plan which describes the steps the Company would take if the Y2K Project is not
completed as planned. The Y2K Project efforts are ongoing and the
17
Company will endeavor to update the Y2K Project activities and its contingency
plans as new information becomes available.
The Year 2000 problem is a world-wide concern and there is a tremendous
amount of uncertainty about the effect this problem will have on any business.
The Company is endeavoring to understand the impact that failures of third
parties could have on its business. However, even with a diligent effort, the
Company may not be able to conceive every scenario in which a third party
failure could impact its business. However, through direct solicitation, the
Company has taken steps to assess the risk that known third parties with whom it
has significant business relationships are sufficiently prepared for the Year
2000.
The Company has key relationships with numerous vendors and business
partners. Presently, the Company has received responses from most key vendors
and business partners indicating their readiness for the Year 2000. Based on the
responses received to date, the Company has not identified any conditions of
potential non-compliance which the Company estimates would materially impact its
business. The Company has considered its relationships with the vendors and
business partners who have not yet indicated their readiness for Year 2000.
Based on this review, the Company does not believe that its business would be
materially effected if any of these vendors or key business partners failed to
ensure that they were Year 2000 compliant.
The Company has one customer, PENELEC, a public utility which is
contractually obligated to purchase all of the power supplied by the Scrubgrass
facility. While the Company believes that PENELEC is taking the appropriate
steps to ensure that it is ready for the Year 2000, the Company has received no
formal correspondence which indicates that PENELEC expects to be ready. While
the computer systems at Scrubgrass are not directly connected to those at
PENELEC, it is conceivable that the Company could still experience business
interruptions if PENELEC fails to ensure that its systems are Year 2000
compliant. Because the Company is dependent on this one customer, any business
interruptions could have a material impact on the Company's financial position
and results of operations.
The Company has taken steps it deems prudent to understand its Year 2000
risks, to estimate the costs to complete its Y2K Project and to understand the
extent to which it could be impacted by third parties who fail to ensure they
are ready for the Year 2000. However, there can be no assurance that all non-
compliant systems or system components will be identified, that the Company's
systems will be Year 2000 compliant, that the Company will achieve its estimated
remediation costs or timetable, or that a failure by a third party to be Year
2000 compliant would not have a material adverse affect on the Company's
business. However, by completing its Y2K Project, the Company believes it will
have taken appropriate steps to mitigate the risk that any of the aforementioned
items would have a material adverse affect on its business.
18
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.
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
19
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 in "Part II. - Other Information - 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 $882,256, respectively as of March 31, 1999.
The balance of a purchase price closing 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 in "Part II. - Other Information - Item 1. Legal Proceedings",
the Company has been involved in a legal proceeding with PENELEC since October
1995 whereby, among other complaints, the Company alleges that PENELEC has
failed to pay the Lessor and the Company contract rates for power in excess of
80 MW produced by the Scrubgrass facility. The Company is presently involved
in discussions with PENELEC to settle this litigation which, if settled, could
significantly improve the Company's results of operations and financial
position. However, there can be no assurance that the Company would be
successful in settling this litigation.
Financial Results
To date the Company has incurred substantial losses, primarily due to its
development activities, which have resulted in an accumulated deficit of
$4,579,826 as of March 31, 1999. While the Company was profitable from
operating activities during 1998, 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.
20
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.
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 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 consists of variable rate and
fixed rate debt obligations. The Company's subsidiary also has a variable rate
working capital loan, a variable rate term loan and a variable rate term credit
facility all of which were advanced from the Lessor under various
21
Scrubgrass project agreements. The Company offers the following information
about these debt obligations:
BALANCE AT MATURES
DESCRIPTION OF THE OBLIGATION 3/31/99 INTEREST RATE THROUGH
- -------------------------------------------------------------------------------------------------------------------
Lessor debt obligations:
Variable-rate tax exempt bonds $135,600,000 Quoted Tax Exempt Bond Rate 2012
Variable rate term loan 15,942,751 Fixed swap rate of 6.4225% 2005
Variable rate term loan 10,396,808 LIBOR rate plus 1.250% 2004
Fixed rate junior subordinated debt 223,622 8% 1999
The Company's debt obligations:
Variable rate working capital loan 1,768,224 LIBOR rate plus 1.125% REVOLVING
Variable rate term loan 1,228,192 LIBOR rate plus 1.250% 2004
Variable rate term credit facility 1,500,000 LIBOR rate plus 1.125% 2000
The Lessor entered into interest rate swaps which had the effect of fixing
the interest rate for its term loan which matures in 2005 at 6.4225%. The Lessor
also has junior subordinated debt obligations which incur interest at a fixed
rate of 8%. However, the remainder of the Lessor's debt obligations and all of
the Company's debt obligations incur interest at 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 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.
22
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 with competitors
discovering lower cost alternatives for providing electricity. The electric
industry is also characterized by rapid changes in regulations which the Company
expects could continue to increase competition. For instance, as discussed
under the caption "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. More recently, as discussed under the caption "Energy
Regulation", there has been new state legislation to deregulate the generation
component of the electric business. Furthermore, proposed changes to repeal or
modify 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 would seek to renegotiate the terms of the
Scrubgrass power purchase agreement (see further discussion under the caption
"Energy Regulation"), the Company does not believe the Scrubgrass Project would
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
creating strategic alignments with other development firms with greater
financial and technical resources could enable it to continue to compete
effectively in the development market if and 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. However, the Company is currently
evaluating whether it should seek development opportunities in new areas.
23
Presently, there is significant merger and consolidation activity occurring
in the electric industry. From time to time, the Company considers merger and
acquisition 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 the 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 the 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 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.
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On December 3, 1996, in response to changes in the electric industry, 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 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 expires December 31, 2000. The Customer
Choice Act required that all electric utilities file restructuring plans with
the PUC 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. As such, PENELEC filed a proposed restructuring plan in 1997 with the
PUC which was heavily contested by a number of affected parties. Eventually,
the litigation resulted in a settlement which was approved by the PUC on October
20, 1998, and which satisfied all but one of the litigants. This settlement 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. The settlement is currently being
appealed in the Commonwealth Court of Pennsylvania by the party which opposed
such settlement. However, the Company presently does not anticipate that such
appeal will have a significant effect, if any, on PENELEC's restructuring plan
as far as that plan affects the Scrubgrass Project. 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.
Presently, neither the Customer Choice Act (and PENELEC's restructuring
plan filed thereunder), nor proposed legislation directly impacts the Company,
since the legislation and restructuring plan pertain to the retail market or new
contracts in the wholesale market. However, as discussed above, the Company
could possibly be impacted in the future by, among other things, increases in
competition as a result of deregulation, or the chance that PENELEC would
attempt to renegotiate the existing power contract. 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
25
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 reputable contractors and using appropriate technology to measure
compliance with the applicable standards.
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 3 months of 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 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). U.S.
Generating Company, the Manager of the Scrubgrass Project, 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 October 11, 1995, the Lessor and Buzzard (collectively the "Plaintiffs")
filed a complaint against 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 December 31,
1998, after giving effect to certain payments made by PENELEC which are
discussed below, they have incurred damages of approximately $3.2 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
March 31, 1999, the Scrubgrass Project has recognized cumulative power
generation revenues of approximately $1,749,218 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 by denying 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". 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
27
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 and settlement
discussions dissipated. On July 7, 1998, PENELEC filed an appeal to the Court's
order dated June 8, 1998 with the Superior Court of Pennsylvania. On July 27,
1998, the Plaintiffs filed with the Superior Court of Pennsylvania a Motion to
Quash the Appeal. On September 4, 1998, the Superior Court of Pennsylvania
granted the Plaintiff's Motion to Quash the Appeal. Since the decision of the
Superior Court of Pennsylvania, PENELEC has indicated its desire to resume
settlement discussions. On November 12, 1998, the Plaintiffs and PENELEC met to
discuss possible settlement scenarios. At the time of the meeting, the parties
were in essential agreement on the amount currently due assuming the correctness
of the Court's Order of June 8, 1998. The primary matter discussed at the
meeting was the manner of calculating future payments for power in excess of 80
MW. At the meeting, PENELEC made a proposal which was taken into consideration
by the Plaintiffs. On December 21, 1998, the Plaintiffs counterproposed with an
alternative to the PENELEC proposal which was considered by PENELEC during the
first quarter of 1999. On April 12, 1999, the Plaintiffs and PENELEC met and
reached a tentative agreement in settlement of all outstanding issues (the
"Settlement Agreement"). Under the terms of the Settlement Agreement, which is
subject to approval by the senior management and lenders involved with the
Scrubgrass Project, the parent Company of PENELEC, and the PUC, PENELEC will pay
for all previous production in excess of 80 MW at contract rates and future
production in excess of 80 MW at contract rates, subject to certain hourly and
annual limits. The Settlement Agreement also provides that PENELEC would pay for
energy supplied in excess of these hourly and annual limits at a negotiated
rate.
On May 3, 1996, Sunnyside II L.P. (f/k/a B&W Sunnyside L.P.), Babcock &
Wilcox Investment Company, Sunnyside I, Inc. (f/k/a NRG Sunnyside Inc.), NRG
Energy Inc., and Sunnyside Cogeneration Associates (collectively the
"Plaintiffs") filed a complaint, which was amended on June 27, 1996, December
21, 1998, and March 17, 1999 against EPC and three of its wholly-owned
subsidiaries (collectively hereafter "the Company") in Seventh District Court
for Carbon County, State of Utah (the "Court"). The third 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
("SCA"), a joint venture which owned and operated a nominal 51 megawatt waste
coal fired facility located in Carbon County, Utah. The third 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
$882,256, respectively at March 31, 1999. On April 9, 1999, in response to the
Plaintiffs' third amended complaint, the Company filed an answer and restatement
of its earlier restated counterclaim dated January 21, 1999. In the answer to
the third amended complaint, the Company denied all material allegations and
asserted numerous affirmative defenses. In the restated 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 restated 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
28
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. The
Plaintiffs have not yet responded to the restated counterclaim. The Company
plans to vigorously defend against the third amended complaint and vigorously
pursue the causes of action in the restated 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 and the plaintiffs appeared in Court on November 19, 1998 to present
oral arguments on the Company's Motion for Summary Judgment with Respect to
Claims Regarding the Power Purchase Agreement. The Court has not yet rendered a
decision on such motion. On February 12, 1999, the Plaintiffs also filed a
Motion for Partial Summary Judgment wherein the Plaintiffs allege that the
Company misrepresented whether SCA had a basis to commence legal proceedings as
of December 31, 1994 against Pacificorp, the utility purchasing energy from the
Sunnyside facility. On April 9, 1999, the Company filed an opposition to the
Plaintiffs' Motion for Partial Summary Judgment and also filed a cross motion
for partial summary judgment. In its cross motion, the Company asserts that the
claim on which the Plaintiffs move for partial summary judgment should be
dismissed as a matter of law. Briefing on the Plaintiffs' and the Company's
cross motions for partial summary judgment is not yet completed. Discovery
remains ongoing.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 11 - Computation of Earnings Per Share
(b) Reports on Form 8-K - None
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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
May 11, 1999 /s/ William D. Linehan
--------------------------------------
William D. Linehan
Treasurer and
Chief Financial Officer
(principal accounting officer
and authorized officer)
30