UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For The Quarterly Period Ended March 31, 1998
OR
[X] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to .
----- ------
Commission Registrant; State of Incorporation; IRS Employer
File Number Address; and Telephone Number Identification Number
- ----------- ----------------------------- ---------------------
1-13739 UNISOURCE ENERGY CORPORATION 86-0786732
(An Arizona Corporation)
220 West Sixth Street
Tucson, AZ 85701
(520) 571-4000
1-5924 TUCSON ELECTRIC POWER COMPANY 86-0062700
(An Arizona Corporation)
220 West Sixth Street
Tucson, AZ 85701
(520) 571-4000
Indicate by check mark whether each registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days.
Yes X No
-------- ---------
At May 6, 1998, 32,137,409 shares of UniSource Energy Corporation's
Common Stock, no par value (the only class of Common Stock), were
outstanding.
UniSource Energy Corporation is the sole holder of the 32,162,167
shares of the outstanding Common Stock of Tucson Electric Power Company.
This combined Form 10-Q is separately filed by UniSource Energy Corporation
and Tucson Electric Power Company. Information contained herein relating to
Tucson Electric Power Company is filed by UniSource Energy Corporation and
separately by Tucson Electric Power Company on its own behalf. Tucson
Electric Power Company makes no representation as to information relating to
UniSource Energy Corporation or its subsidiaries, except as it may relate to
Tucson Electric Power Company.
TABLE OF CONTENTS
Page
----
Definitions.................................................................. iv
Report of Independent Accountants..............................................1
Independent Accountants' Review Report.........................................2
PART I - FINANCIAL INFORMATION
Item 1. -- Financial Statements
UniSource Energy Corporation
Comparative Condensed Consolidated Statements of Income (Loss)........3
Comparative Condensed Consolidated Statements of Cash Flows...........4
Comparative Condensed Consolidated Balance Sheets.....................5
Tucson Electric Power Company
Comparative Condensed Consolidated Statements of Income (Loss)........6
Comparative Condensed Consolidated Statements of Cash Flows...........7
Comparative Condensed Consolidated Balance Sheets.....................8
Notes to Condensed Consolidated Financial Statements
Note 1. Accounting for the Effects of Regulation.........................9
Note 2. Tax Assessments.................................................10
Note 3. Transfer of MEH from TEP to UniSource Energy....................11
Note 4. Loans and Guarantees for NEV....................................11
Note 5. Long-Term Debt..................................................11
Note 6. Rate Matters....................................................12
Note 7. Income Taxes....................................................13
Note 8. Reclassifications...............................................13
Note 9. Review by Independent Public Accountants........................13
Item 2. -- Management's Discussion and Analysis of Financial Condition and
Results of Operations
Overview.................................................................14
Competition
Wholesale............................................................15
Retail...............................................................16
Shared Savings Proposal Before ACC.......................................18
Accounting for the Effects of Regulation
Accounting Implications..............................................18
Recent Events That May Impact TEP's Application of FAS 71............19
Investments in Energy Related Ventures...................................19
Dividends on Common Stock
UniSource Energy.....................................................20
TEP..................................................................20
Earnings.................................................................21
Results of Operations
Utility Sales and Revenues..........................................21
Operating Expenses.................................................22
Other Income (Deductions)...........................................22
Interest Expense...................................................22
Events Affecting Future Results of Utility Operations
TEP Generating Resources...........................................22
Liquidity and Capital Resources
Cash Flows
UniSource Energy...................................................23
TEP................................................................23
Financing Developments
TEP Sale of Bonds..................................................23
TEP Credit Agreement...............................................24
TEP First Mortgage Bonds...........................................24
UniSource Energy...................................................24
UniSource Energy--Loans and Guarantees.............................25
Impact of Year 2000 on Computer Systems and Applications.................25
Safe Harbor for Forward-Looking Statements...............................25
PART II - OTHER INFORMATION
Item 1. -- Legal Proceedings
Tax Assessments..........................................................27
Item 5. - Other Information
Additional Financial Data................................................27
Item 6. -- Exhibits and Reports on Form 8-K..................................27
Signature Page................................................................28
Exhibit Index.................................................................29
DEFINITIONS
The abbreviations and acronyms used in the 1998 First Quarter Form 10-Q are
defined below:
- --------------------------------------------------------------------------------
ACC............... Arizona Corporation Commission.
ADOR.............. Arizona Department of Revenue.
AET............... Advanced Energy Technologies, Inc., a wholly-owned
subsidiary of MEH Corporation.
Banks............. The financial institutions party to the Credit
Agreement dated as of December 30, 1997.
Common Stock...... The Company's common stock, without par value.
Company or UniSource
Energy........... UniSource Energy Corporation.
Credit Agreement.. Credit Agreement between TEP and the Banks, dated as of
December 30, 1997.
EITF.............. Emerging Issues Task Force of the Financial Accounting
Standards Board.
FAS 71............ Statement of Financial Accounting Standards #71:
Accounting for the Effects of Certain Types of
Regulation.
FAS 101........... Statement of Financial Accounting Standards #101:
Regulated Enterprises - Accounting for the
Discontinuation of Application of FAS 71.
FAS 121........... Statement of Financial Accounting Standards #121:
Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to be Disposed Of.
FERC.............. Federal Energy Regulatory Commission.
First Mortgage
Bonds............ First mortgage bonds issued under the General First
Mortgage.
General First
Mortgage......... The Indenture, dated as of April 1, 1941, of Tucson
Gas, Electric Light and Power Company to The Chase
National Bank of the City of New York, as trustee, as
supplemented and amended.
General Second
Mortgage......... The Indenture, dated as of December 1, 1992,
of Tucson Electric Power Company to Bank of Montreal
Trust Company of the City of New York, as trustee, as
supplemented.
Global Solar...... Global Solar Energy, L.L.C., a corporation in which a
50% interest is owned by AET.
Holding Company
Order............. ACC Order issued November 25, 1997 granting TEP the
authority to organize a public utility holding
company.
IDBs.............. Industrial development revenue or pollution control
bonds.
IRS............... Internal Revenue Service.
Irvington......... Irvington Generating Station.
Irvington Lease... The leveraged lease arrangement relating to Irvington
Unit 4.
ISO............... Independent System Operator.
ITC............... Investment Tax Credit.
kWh............... Kilowatt-hour(s).
LOC............... Letter of Credit.
MEH............... MEH Corporation, a wholly-owned subsidiary of UniSource
Energy.
Millennium........ Millennium Energy Holdings, Inc., a wholly-owned
subsidiary of MEH.
MRA............... Master restructuring agreement between TEP and certain
banks which included the Renewable Term Loan,
Revolving Credit and certain replacement reimbursement
agreements, which was terminated on December 30, 1997.
MSR............... Modesto, Santa Clara and Redding Public Power Agency.
MW................ Megawatt(s).
NEV............... New Energy Ventures, L.L.C., a company in which a 50%
interest is owned by Millennium.
NEV California.... NEV California, L.L.C., a wholly-owned subsidiary of
NEV.
1994 Rate Order... ACC Rate Order concerning an increase in TEP's retail
base rates and certain regulatory write-offs, issued
January 11, 1994.
1996 Rate Order... ACC Rate Order concerning an
increase in TEP's retail base rates and the recovery
of Springerville Unit 2 costs, issued March 29, 1996.
NOL............... Net Operating Loss carryforward for income tax
purposes.
Renewable Term
Loan............. Credit facility that replaced the Term Loan pursuant
to the MRA Sixth Amendment, dated as of November 1,
1994, and effective March 7, 1995, and which was
terminated December 30, 1997.
Revolving Credit.. $100 million revolving credit facility entered into
under the Credit Agreement between a syndicate of
certain of the Banks and TEP.
SEC............... Securities and Exchange Commission.
Second Mortgage
Bonds............ TEP's second mortgage bonds issued under the General
Second Mortgage.
SES............... Southwest Energy Solutions, Inc., a wholly-owned
subsidiary of MEH.
Shareholders...... Holders of UniSource Energy Common Stock.
Springerville..... Springerville Generating Station.
Springerville Coal
Handling Facilities
Leases........... Leveraged lease arrangements relating to the coal
handling facilities serving Springerville.
Springerville
Common
Facilities....... Facilities at Springerville used in
common with Springerville Unit 1 and Springerville
Unit 2.
Springerville
Common Facilities
Leases........... Leveraged lease arrangements relating to an undivided
one-half interest in certain Springerville Common
Facilities.
Springerville
Unit 1 Leases..... Leveraged lease arrangements relating to
Springerville Unit 1, and an undivided one-half
interest in certain Springerville Common Facilities
and which has been assumed by TEP.
SSP............... Shared Savings Proposal filed by TEP with the ACC July
9, 1997 requesting a 1.1% annual retail rate
reduction.
SWPP.............. SWPP Investment Company, a wholly-owned subsidiary of
SES.
SWPPI............. SWPP International, a wholly-owned subsidiary of SES.
TEP............... Tucson Electric Power Company, the principal subsidiary
of UniSource Energy.
UniSource Energy.. UniSource Energy Corporation.
Valencia.......... Valencia Energy Company, previously a wholly owned
subsidiary of TEP, merged into TEP on May 31, 1996.
VSP............... Voluntary Severance Plan offered to TEP employees and
implemented in May 1996.
WSCC.............. Western Systems Coordinating Council.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
UniSource Energy Corporation and
to the Board of Directors of
Tucson Electric Power Company
We have reviewed the accompanying condensed consolidated balance sheet and
the related condensed consolidated statements of income and of cash flows of
UniSource Energy Corporation and its subsidiaries (the Company) and of
Tucson Electric Power Company and its subsidiaries (TEP) as of and for the
three-month period ended March 31, 1998. This financial information is the
responsibility of the Company's and TEP's management. The financial
statements as of March 31, 1997 were reviewed by other independent
accountants whose report dated February 23, 1998 stated that they were not
aware of any material modifications that should be made to such financial
information for it to be in conformity with generally accepted accounting
principles.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures
to financial data and making inquiries of persons responsible for financial
and accounting matters. It is substantially less in scope than an audit
conducted in accordance with generally accepted auditing standards, the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an
opinion.
Based on our review, we are not aware of any material modifications that
should be made to the accompanying financial information as of and for the
three-month period ended March 31, 1998 for it to be in conformity with
generally accepted accounting principles.
The financial statements of the Company and of TEP for the year ended
December 31, 1997 were audited by other independent accountants whose report
dated February 23, 1998 expressed an unqualified opinion on those
statements.
Price Waterhouse LLP
Phoenix, Arizona
May 5, 1998
INDEPENDENT ACCOUNTANTS' REVIEW REPORT
UniSource Energy Corporation and its Stockholders
Tucson Electric Power Company
220 West Sixth Street
Tucson, Arizona 85701
We have reviewed the condensed consolidated statements of income and cash
flows of UniSource Energy Corporation and its subsidiaries (the Company) and
Tucson Electric Power Company (TEP) for the three-month period ended March
31, 1997. These financial statements are the responsibility of the
Company's and TEP's management.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures
to financial data and of making inquiries of persons responsible for
financial and accounting matters. It is substantially less in scope than an
audit conducted in accordance with generally accepted auditing standards,
the objective of which is the expression of an opinion regarding the
financial statements taken as a whole. Accordingly, we do not express such
an opinion.
Based on our review, we are not aware of any material modifications that
should be made to such condensed consolidated financial statements for them
to be in conformity with generally accepted accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated balance sheets and statements of capitalization
of the Company and TEP as of December 31, 1997 and the related statements of
income, cash flows, and changes in stockholders' equity (deficit) for the
year then ended (not presented herein); and in our report dated February 23,
1998, we expressed an unqualified opinion on those consolidated financial
statements. In our opinion, the information set forth in the accompanying
condensed consolidated balance sheets as of December 31, 1997 is fairly
stated, in all material respects, in relation to the consolidated balance
sheet from which they have been derived.
DELOITTE & TOUCHE LLP
Tucson, Arizona
February 23, 1998
PART I - FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
- -----------------------------------------------------------------------------
The weather causes seasonal fluctuations in UniSource Energy's sales. As a
result, quarterly results are not indicative of annual operating results. The
quarterly financial statements that follow are unaudited but reflect all normal
recurring accruals and other adjustments which we believe are necessary for a
fair presentation of the results for the interim periods presented. Also see
Item 2. - Management's Discussion and Analysis of Financial Condition and
Results of Operations. This quarterly report should be reviewed in conjunction
with the Company's 1997 Form 10-K.
UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)
Three Months Ended
March 31,
1998 1997
-Thousands of Dollars-
Operating Revenues
Retail Customers $138,087 $129,937
Amortization of MSR Option Gain Regulatory Liability - 5,013
Sales for Resale 22,854 19,331
--------- ---------
Total Operating Revenues 160,941 154,281
--------- ---------
Operating Expenses
Fuel and Purchased Power 48,400 45,646
Capital Lease Expense 25,778 26,276
Amortization of Springerville Unit 1 Allowance (7,631) (7,009)
Other Operations 26,298 23,363
Maintenance and Repairs 10,724 10,231
Depreciation and Amortization 22,563 21,774
Taxes Other Than Income Taxes 12,926 12,625
Employee Severance Plan Expense - Net - 2,933
Income Taxes (1,937) (2,348)
--------- ---------
Total Operating Expenses 137,121 133,491
--------- ---------
Operating Income 23,820 20,790
--------- ---------
Other Income (Deductions)
Income Taxes (631) 14,558
Interest Income 1,716 1,709
Unregulated Energy Businesses - Net (4,036) (932)
Other 810 (31)
--------- ---------
Total Other Income (Deductions) (2,141) 15,304
--------- ---------
Interest Expense
Long-Term Debt 17,111 14,117
Interest Imputed on Losses Recorded at Present Value 8,545 8,279
Other 3,058 2,206
--------- ---------
Total Interest Expense 28,714 24,602
--------- ---------
Net Income (Loss) $ (7,035) $ 11,492
========= =========
Average Shares of Common Stock Outstanding (000) 32,139 32,139
========= =========
Basic and Diluted Earnings per Share $ (0.22) $ 0.36
========= =========
See Notes to Condensed Consolidated Financial Statements.
UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Months Ended
March 31,
1998 1997
-Thousands of Dollars-
Cash Flows from Operating Activities
Cash Receipts from Retail Customers $146,532 $142,918
Cash Receipts from Sales for Resale 25,549 22,402
Fuel and Purchased Power Costs Paid (41,527) (39,847)
Wages Paid, Net of Amounts Capitalized (23,257) (20,259)
Payment of Other Operations and Maintenance Costs (23,690) (18,876)
Capital Lease Interest Paid (41,319) (37,512)
Interest Paid, Net of Amounts Capitalized (17,198) (13,400)
Taxes Paid, Net of Amounts Capitalized (11,519) (11,121)
Interest Received 2,361 2,262
Contract Termination Fee Paid (10,000) -
Other 1,982 410
--------- ---------
Net Cash Flows - Operating Activities 7,914 26,977
--------- ---------
Cash Flows from Investing Activities
Construction Expenditures (16,957) (15,602)
Investments in Joint Ventures (6,000) (1,338)
Other (35) 988
--------- ---------
Net Cash Flows - Investing Activities (22,992) (15,952)
--------- ---------
Cash Flows from Financing Activities
Proceeds from Issuance of Long-Term Debt 1,105 -
Payments on Renewable Term Loan - (31,000)
Payments to Retire Capital Lease Obligations (8,737) (4,061)
Other (1,751) 383
--------- ---------
Net Cash Flows - Financing Activities (9,383) (34,678)
--------- ---------
Net Decrease in Cash and Cash Equivalents (24,461) (23,653)
Cash and Cash Equivalents, Beginning of Year 146,256 130,291
--------- ---------
Cash and Cash Equivalents, End of Period $121,795 $106,638
========= =========
See Notes to Condensed Consolidated Financial Statements.
UNISOURCE ENERGY CORPORATION
SUPPLEMENTAL CONDENSED CONSOLIDATED CASH FLOW INFORMATION
Three Months Ended
March 31,
1998 1997
-Thousands of Dollars-
Net Income (Loss) $ (7,035) $ 11,492
Adjustments to Reconcile Net Income (Loss)
to Net Operating Cash Flows
Depreciation and Amortization Expense 22,563 21,774
Deferred Income Taxes and Investment Tax Credits-Net (4,117) (16,907)
Lease Payments Deferred (12,616) (8,306)
Amortization of Regulatory Assets & Liabilities,
Net of Interest Imputed on Losses Recorded at
Present Value 914 (3,743)
Deferred Contract Termination Fee (9,038) -
Loss (Unremitted Earnings) of Unconsolidated
Subsidiaries 6,591 (538)
Other (174) (1,416)
Changes in Assets and Liabilities which Provided
(Used) Cash Exclusive of Changes Shown Separately
Accounts Receivable 987 7,534
Materials and Fuel 251 153
Accounts Payable 508 2,369
Taxes Accrued 11,961 11,826
Other Current Assets and Liabilities (3,260) (436)
Other Deferred Assets and Liabilities 379 3,175
--------- ---------
Net Cash Flows - Operating Activities $ 7,914 $ 26,977
========= =========
Non-Cash Financing Activities (these activities do not affect the statements of
cash flows):
The proceeds from the issuance of $200 million of Pollution Control Revenue
Bonds in March 1998 are held in trust and will be released by the trustee in May
1998 to redeem $200 million of previously issued bonds. See Note 5.
See Notes to Condensed Consolidated Financial Statements.
UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
ASSETS
March 31, December 31,
1998 1997
- Thousands of Dollars -
Utility Plant
Plant in Service $2,211,650 $2,194,150
Utility Plant Under Capital Leases 893,064 893,064
Construction Work in Progress 70,692 72,404
----------- -----------
Total Utility Plant 3,175,406 3,159,618
Less Accumulated Depreciation and Amortization (1,001,685) (982,621)
Less Accumulated Amortization of Capital Leases (78,435) (73,728)
Less Springerville Unit 1 Allowance (168,670) (167,756)
----------- -----------
Total Utility Plant - Net 1,926,616 1,935,513
----------- -----------
Investments and Other Property 78,855 78,772
----------- -----------
Current Assets
Cash and Cash Equivalents 121,795 146,256
Accounts Receivable 70,238 71,225
Materials and Fuel 33,754 34,005
Deferred Income Taxes - Current 7,777 14,910
Long-Term Debt Proceeds Held by Trustee 205,721 6,960
Other 16,079 16,693
----------- -----------
Total Current Assets 455,364 290,049
----------- -----------
Deferred Debits - Regulatory Assets
Income Taxes Recoverable Through Future Rates 169,212 170,034
Deferred Springerville Common Facility Costs 57,587 58,222
Deferred Springerville Contract Termination Fee 47,115 48,077
Deferred Springerville Unit 2 Costs 9,267 11,590
Deferred Lease Expense 10,982 11,571
Other Deferred Regulatory Assets 10,858 11,089
Deferred Debits - Other 21,005 19,492
----------- -----------
Total Deferred Debits 326,026 330,075
----------- -----------
Total Assets $2,786,861 $2,634,409
=========== ===========
See Notes to Condensed Consolidated Financial Statements.
UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
CAPITALIZATION AND OTHER LIABILITIES
March 31, December 31,
1998 1997
- Thousands of Dollars -
Capitalization
Common Stock $ 638,873 $ 638,904
Accumulated Deficit (429,061) (422,026)
----------- -----------
Common Stock Equity 209,812 216,878
Capital Lease Obligations 883,607 890,257
Long-Term Debt 1,215,120 1,215,120
----------- -----------
Total Capitalization 2,308,539 2,322,255
----------- -----------
Current Liabilities
Current Obligations Under Capital Leases 15,238 14,552
Current Maturities of Long-Term Debt 200,500 500
Accounts Payable 35,417 34,909
Interest Accrued 47,004 64,812
Taxes Accrued 36,358 24,397
Contract Termination Fee Payable - 10,000
Other 12,412 19,051
----------- -----------
Total Current Liabilities 346,929 168,221
----------- -----------
Deferred Credits and Other Liabilities
Deferred Income Taxes - Noncurrent 66,107 77,606
Accumulated Deferred Investment Tax Credits
Regulatory Liability 11,332 11,905
Emission Allowance Gain Regulatory Liability 17,609 17,591
Other 36,345 36,831
----------- -----------
Total Deferred Credits and Other Liabilities 131,393 143,933
----------- -----------
Total Capitalization and Other Liabilities $2,786,861 $2,634,409
=========== ===========
See Notes to Condensed Consolidated Financial Statements.
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)
The weather causes seasonal fluctuations in TEP's sales. As a result, quarterly
results are not indicative of annual operating results. The quarterly financial
statements that follow are unaudited but reflect all normal recurring accruals
and other adjustments which we believe are necessary for a fair presentation of
the results for the interim periods presented. Also see Item 2. - Management's
Discussion and Analysis of Financial Condition and Results of Operations. This
quarterly report should be reviewed in conjunction with the TEP's 1997 Form 10-
K.
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)
Three Months Ended
March 31,
1998 1997
-Thousands of Dollars-
Operating Revenues
Retail Customers $138,149 $129,937
Amortization of MSR Option Gain Regulatory Liability - 5,013
Sales for Resale 22,854 19,331
--------- ---------
Total Operating Revenues 161,003 154,281
--------- ---------
Operating Expenses
Fuel and Purchased Power 48,400 45,646
Capital Lease Expense 25,778 26,276
Amortization of Springerville Unit 1 Allowance (7,631) (7,009)
Other Operations 26,298 23,363
Maintenance and Repairs 10,724 10,231
Depreciation and Amortization 22,563 21,774
Taxes Other Than Income Taxes 12,926 12,625
Employee Severance Plan Expense- Net - 2,933
Income Taxes (1,937) (2,348)
--------- ---------
Total Operating Expenses 137,121 133,491
--------- ---------
Operating Income 23,882 20,790
--------- ---------
Other Income (Deductions)
Income Taxes (1,560) 14,558
Interest Income 1,716 1,756
Interest Income-Note Receivable from UniSource Energy 2,300 -
Other 769 (1,010)
--------- ---------
Total Other Income (Deductions) 3,225 15,304
--------- ---------
Interest Expense
Long-Term Debt 17,111 14,117
Interest Imputed on Losses Recorded at Present Value 8,545 8,279
Other 3,058 2,206
--------- ---------
Total Interest Expense 28,714 24,602
--------- ---------
Net Income (Loss) $ (1,607) $ 11,492
========= =========
See Notes to Condensed Consolidated Financial Statements.
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Months Ended
March 31,
1998 1997
-Thousands of Dollars-
Cash Flows from Operating Activities
Cash Receipts from Retail Customers $146,532 $142,918
Cash Receipts from Sales for Resale 25,549 22,402
Fuel and Purchased Power Costs Paid (41,527) (39,847)
Wages Paid, Net of Amounts Capitalized (22,428) (20,259)
Payment of Other Operations and Maintenance Costs (22,106) (18,876)
Capital Lease Interest Paid (41,319) (37,512)
Interest Paid, Net of Amounts Capitalized (17,198) (13,400)
Taxes Paid, Net of Amounts Capitalized (11,477) (11,121)
Interest Received 1,828 2,262
Contract Termination Fee Paid (10,000) -
Other 937 410
--------- ---------
Net Cash Flows - Operating Activities 8,791 26,977
--------- ---------
Cash Flows from Investing Activities
Construction Expenditures (16,957) (15,602)
Transfer of MEH (45,412) -
Investments in Joint Ventures - (1,338)
Other (6) 988
--------- ---------
Net Cash Flows - Investing Activities (62,375) (15,952)
--------- ---------
Cash Flows from Financing Activities
Proceeds from Issuance of Long-Term Debt 1,105 -
Payments on Renewable Term Loan - (31,000)
Payments to Retire Capital Lease Obligations (8,737) (4,061)
Other (1,884) 383
--------- ---------
Net Cash Flows - Financing Activities (9,516) (34,678)
--------- ---------
Net Decrease in Cash and Cash Equivalents (63,100) (23,653)
Cash and Cash Equivalents, Beginning of Year 146,256 130,291
--------- ---------
Cash and Cash Equivalents, End of Period $ 83,156 $106,638
========= =========
See Notes to Condensed Consolidated Financial Statements.
TUCSON ELECTRIC POWER COMPANY
SUPPLEMENTAL CONDENSED CONSOLIDATED CASH FLOW INFORMATION
Three Months Ended
March 31,
1998 1997
-Thousands of Dollars-
Net Income (Loss) $ (1,607) $ 11,492
Adjustments to Reconcile Net Income (Loss) to Net
Operating Cash Flows
Depreciation and Amortization Expense 22,563 21,774
Deferred Income Taxes and
Investment Tax Credits - Net (377) (16,907)
Lease Payments Deferred (12,616) (8,306)
Amortization of Regulatory Assets & Liabilities, Net
of Interest Imputed on Losses Recorded at
Present Value 914 (3,743)
Deferred Contract Termination Fee (9,038) -
Unremitted Earnings of Unconsolidated Subsidiaries (213) (538)
Other (1,911) (1,416)
Changes in Assets and Liabilities which Provided
(Used) Cash Exclusive of Changes Shown Separately
Accounts Receivable (74) 7,534
Materials and Fuel 250 153
Accounts Payable 1,561 2,369
Taxes Accrued 11,962 11,826
Other Current Assets and Liabilities (3,002) (436)
Other Deferred Assets and Liabilities 379 3,175
--------- ---------
Net Cash Flows - Operating Activities $ 8,791 $ 26,977
========= =========
Non-Cash Financing Activities (these activities do not affect the statements of
cash flows):
The proceeds from the issuance of $200 million of Pollution Control Revenue
Bonds in March 1998 are held in trust and will be released by the trustee in May
1998 to redeem $200 million of previously issued bonds. See Note 5.
See Notes to Condensed Consolidated Financial Statements.
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
ASSETS
March 31, December 31,
1998 1997
- Thousands of Dollars -
Utility Plant
Plant in Service $2,211,650 $2,194,150
Utility Plant Under Capital Leases 893,064 893,064
Construction Work in Progress 70,692 72,404
----------- -----------
Total Utility Plant 3,175,406 3,159,618
Less Accumulated Depreciation and Amortization (1,001,685) (982,621)
Less Accumulated Amortization of Capital Leases (78,435) (73,728)
Less Springerville Unit 1 Allowance (168,670) (167,756)
----------- -----------
Total Utility Plant - Net 1,926,616 1,935,513
----------- -----------
Investments and Other Property 58,029 78,772
----------- -----------
Note Receivable from UniSource Energy 71,640 -
---------- -----------
Current Assets
Cash and Cash Equivalents 83,156 146,256
Accounts Receivable 71,155 71,225
Materials and Fuel 33,715 34,005
Deferred Income Taxes - Current 7,777 14,910
Long-Term Debt Proceeds Held by Trustee 205,721 6,960
Other 14,904 16,693
----------- -----------
Total Current Assets 416,428 290,049
----------- -----------
Deferred Debits - Regulatory Assets
Income Taxes Recoverable Through Future Rates 169,212 170,034
Deferred Springerville Common Facility Costs 57,587 58,222
Deferred Springerville Contract Termination Fee 47,115 48,077
Deferred Springerville Unit 2 Costs 9,267 11,590
Deferred Lease Expense 10,982 11,571
Other Deferred Regulatory Assets 10,858 11,089
Deferred Debits - Other 21,005 19,492
----------- -----------
Total Deferred Debits 326,026 330,075
----------- -----------
Total Assets $2,798,739 $2,634,409
=========== ===========
See Notes to Condensed Consolidated Financial Statements.
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
CAPITALIZATION AND OTHER LIABILITIES
March 31, December 31,
1998 1997
- Thousands of Dollars -
Capitalization
Common Stock $ 645,261 $ 645,261
Capital Stock Expense (6,357) (6,357)
Accumulated Deficit (423,633) (422,026)
----------- -----------
Common Stock Equity 215,271 216,878
Capital Lease Obligations 883,607 890,257
Long-Term Debt 1,215,120 1,215,120
----------- -----------
Total Capitalization 2,313,998 2,322,255
----------- -----------
Current Liabilities
Current Obligations Under Capital Leases 15,238 14,552
Current Maturities of Long-Term Debt 200,500 500
Accounts Payable 35,642 34,909
Interest Accrued 47,004 64,812
Taxes Accrued 36,327 24,397
Contract Termination Fee Payable - 10,000
Other 12,442 19,051
----------- -----------
Total Current Liabilities 347,153 168,221
----------- -----------
Deferred Credits and Other Liabilities
Deferred Income Taxes - Noncurrent 72,381 77,606
Accumulated Deferred Investment Tax Credits
Regulatory Liability 11,332 11,905
Emission Allowance Gain Regulatory Liability 17,609 17,591
Other 36,266 36,831
----------- -----------
Total Deferred Credits and Other Liabilities 137,588 143,933
----------- -----------
Total Capitalization and Other Liabilities $2,798,739 $2,634,409
=========== ===========
See Notes to Condensed Consolidated Financial Statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. ACCOUNTING FOR THE EFFECTS OF REGULATION
- -------------------------------------------------
Accounting Implications
The ACC regulates TEP's utility business. TEP generally uses the same
accounting policies and practices used by nonregulated companies for financial
reporting under generally accepted accounting principles. However, sometimes
these principles, such as FAS 71, require special accounting treatment for
regulated companies to show the effect of regulation. For example, in setting
TEP's retail rates, the ACC may not currently allow TEP to charge its customers
to recover certain expenses but; instead, require that these charges be charged
to customers in the future. In this situation, FAS 71 requires TEP not to show
these expenses on its current income statements but to "defer" these items and
show them as "regulatory assets" on the balance sheet until TEP is allowed to
charge its customers. TEP then amortizes these items to the income statement as
charges are billed to customers. Similarly, certain items of revenue may be
deferred as regulatory liabilities which also are eventually amortized to the
income statement.
We have recorded regulatory assets and liabilities in our balance sheets in
accordance with FAS 71. A regulated company must satisfy certain conditions to
apply the accounting policies and practices of FAS 71. These conditions
include:
- an independent regulator sets rates;
- the regulator sets the rates to cover specific costs of delivering service;
and
- the service territory lacks competitive pressures to reduce rates below the
rates set by the regulator.
We periodically assess whether we continue to meet these conditions. If we were
required to stop applying FAS 71 to all or a portion of TEP's regulated utility
operations, we would write off the related balances of TEP's regulatory assets
and liabilities as a charge in our income statement. This means our earnings
would be reduced by the net amount of regulatory assets and liabilities, after
applicable deferred income taxes. Based on the balances of TEP's regulatory
assets and liabilities at March 31, 1998, if we stopped applying FAS 71 to all
of TEP's regulated operations, we would record an extraordinary loss of
approximately $178 million, net of the related deferred income tax benefit of
$99 million. While our cash flows may be affected by regulatory orders and
market conditions, our cash flows would not be affected if we stopped applying
FAS 71.
If we stop applying FAS 71, we would need to evaluate the likelihood that
we could recover the cost of TEP's electric plant in the marketplace using the
criteria in FAS 121. If undiscounted cash flows are less than the carrying
value of those assets, then we would need to write off as an expense a portion
of those plant assets to reflect their current market value. We cannot predict
if we would write off any plant assets as a result of applying FAS 121.
Recent Events That May Impact TEP's Application of FAS 71
Legislative and other regulatory measures are being developed in various
states to deregulate the electric generation business. The SEC and the EITF
have been reviewing whether electric utilities should stop applying FAS 71 to
the business transactions in states where deregulation is occurring. In
general, the EITF consensus states that utilities must stop accounting for the
electric generation portion of their business under FAS 71 when a deregulation
plan is in place and its terms are known. The EITF also concludes that
utilities do not need to write off regulatory assets(including those related to
generation) if the cash flow stream from regulated rates includes recovery of
the regulatory assets. We are uncertain how the EITF consensus will impact TEP
as deregulation activities develop in Arizona. In the future, we may need to
stop applying FAS 71 to the electric generation portion of TEP's business, even
if we believe that we will recover the full amount of our costs under the ACC
competition phase-in plan. Approximately 55% of TEP's net regulatory assets on
the balance sheet relate to electric generation.
In December 1996, the ACC adopted rules which would introduce retail
electric competition in Arizona. If implemented as adopted, the rules would
require each "Affected Utility" (TEP, Arizona Public Service Company, Citizens
Utilities Company and several cooperatives) to open its retail service area to
competing electric service providers on a phased-in basis over the period 1999
to 2003. However, the ACC has not adopted specific guidelines for
identification and recovery of stranded costs. Stranded costs represent costs
incurred by a utility in a regulated market that would not likely be recovered
through the prices charged for electricity and other services in a competitive
market.
Hearings were held in February 1998 to resolve issues relating to stranded
cost recovery. TEP, other Affected Utilities, the Residential Utility Consumer
Office, the ACC staff, and various intervenors participated in the hearings.
On May 6, 1998, the Hearing Officer issued a Proposed Order. The Proposed
Order indicates that the Affected Utilities should have a reasonable
opportunity to recover 100% of their stranded costs and gives the Affected
Utilities three options for stranded cost recovery. However, it is unclear
whether Affected Utilities would be able to recover 100% of their stranded
costs. The Proposed Order also specifies that some form of rate cap will be in
place for customers on standard offer during the transition period.
TEP is currently evaluating the financial implications if the Proposed
Order is adopted, including whether we would be able to apply FAS 71 to the
generation portion of TEP's business. TEP anticipates filing exceptions to the
Proposed Order. We cannot determine when the ACC will hold an open meeting to
consider the Proposed Order or whether the ACC will approve, modify or reject
the Proposed Order. If the Proposed Order is adopted,TEP would have 30 days to
file its choice of one of the three options for stranded cost recovery. At the
same time, TEP would file an implementation plan, including its estimate of
stranded costs related to generation and regulatory assets. Until such time, we
believe that any estimate of unrecoverable amounts of stranded costs would be
highly speculative.
Also in January 1998, the Arizona Legislature proposed legislation
introducing retail electric competition in Arizona. We cannot predict the
outcome of the proposed legislation or whether the ACC and the Arizona
Legislature will propose other initiatives on electric utility industry
restructuring. We believe, based on previous rate orders, that it is likely
that we will recover the full costs of our investments in electric utility
plant and regulatory assets. The ACC's final order may require us to stop
applying FAS 71 to the electric generation portion of TEP's utility
operations. If the order provides less than full recovery of stranded costs,
significant write-offs of assets may occur as discussed above.
Based on the activities that have occurred to date, TEP believes it
continues to meet the criteria to apply FAS 71 to its regulated activities.
However, we cannot predict the outcome of the deregulation efforts in Arizona
described above.
NOTE 2. TAX ASSESSMENTS
- ------------------------
Ruling on Arizona Sales Tax Assessments - Coal Sales
We have received sales tax assessments from the ADOR alleging that Valencia
is liable for sales tax on gross income from coal sales, transportation and
coal-handling services provided to TEP from November 1985 through May 1996. We
have protested these assessments. In September 1996, the Arizona Court of
Appeals upheld the validity of the assessment issued for the period November
1985 through March 1990. In July 1997, the Arizona Supreme Court granted a
Petition for Review, and oral arguments were held during December 1997. We
expect the Arizona Supreme Court to render its opinion in the second quarter of
1998. We are also protesting the assessments for the period April 1990 through
May 1996.
We have previously recorded an expense and a related liability for the
sales taxes and interest that we believe are probable of incurrence for the
period November 1985 through May 1996. Arizona law generally requires payment
of an assessment prior to pursuing the appellate process. We previously paid,
under protest, a total of $23 million of the disputed sales tax assessments.
These payments will be refunded if we are successful in the appeals process.
On May 31, 1996, Valencia was merged into TEP. Because TEP now acquires
coal directly from other companies, we do not believe we are liable for sales
tax computed on a basis similar to the assessments described above after May
31, 1996. For periods prior to May 31, 1996, we continue to record an
estimated interest expense on the disputed assessments.
Arizona Sales Tax Assessments - Leases
The ADOR has issued sales tax assessments to some of TEP's lessors of
generation-related facilities and equipment. The assessments allege sales tax
liability on a component of rents we paid on the Springerville Unit 1 Leases,
the Springerville Common Facilities Leases, the Irvington Lease and the
Springerville Coal Handling Facilities Lease from August 1, 1988 to September
30, 1993. Due to indemnification provisions in the lease agreements, if the
ADOR prevails, we would be required to reimburse the lessors for the sales
taxes that they pay.
We have recorded a liability for the probable amount of sales taxes and
interest due as of March 31, 1998. If the ADOR prevails, we would need to
record an additional expense and related liability. Even though it is
reasonably possible that the resolution of this issue could result in
approximately $22 million of additional sales tax expense, we do not believe
this outcome is likely. We do not expect that the resolution of this assessment
will have a material negative impact on the financial statements. We believe
that the ultimate resolution of this issue will occur over a period of two to
four years.
Income Tax Assessments
In February 1998, the IRS issued an income tax assessment for the 1992 and
1993 tax years. The IRS is challenging our treatment for income tax purposes of
various items relating to the 1992 Financial Restructuring, including the amount
of NOL and ITC generated before December 1991 that may be used to reduce taxes
in future periods.
Due to the Financial Restructuring, a change in ownership of TEP occurred
for tax purposes in December 1991. As a result, the use of the NOL and ITC
generated before December 1991 may be limited under the tax code. The IRS is
challenging our calculation of this limitation. At March 31, 1998, pre-change
federal NOL and ITC carryforwards were approximately $281 million and $26
million, respectively. In addition to the pre-change NOL and ITC which are
subject to the limitation, $180 million of federal NOL at March 31, 1998,is not
subject to the limitation.
Resolution of this matter is not expected to have a material adverse impact
on the financial statements.
NOTE 3. TRANSFER OF MEH FROM TEP TO UNISOURCE ENERGY
- -----------------------------------------------------
On January 1, 1998, TEP became a subsidiary of UniSource Energy. At the
same time,TEP transferred MEH to UniSource Energy and received as consideration
from UniSource Energy a $95 million 10-year promissory note with a yearly
interest rate of 9.78%. Approximately $25 million of this note represents a
gain to TEP. TEP has not recorded this gain. Instead, this gain will be
reflected as an increase in TEP's common equity when UniSource Energy pays the
principal portion of the note. The note receivable appears on TEP's
consolidated balance sheet but does not appear on UniSource Energy's
consolidated balance sheet because intercompany balances and transactions are
eliminated when financial statements are consolidated.
MEH owns Advanced Energy Technologies, Inc., Millennium Energy Holdings,
Inc., Nations Energy Corporation and Southwest Energy Solutions, Inc.
The transfer of MEH's cash balance of $45.4 million as part of the transfer
of MEH to UniSource Energy is included in the Cash Flows from Investing
Activities in TEP's cash flow statement for the three months ended March 31,
1998.
NOTE 4. LOANS AND GUARANTEES FOR NEV
- -------------------------------------
In December 1997, Millennium committed to provide NEV with $20 million of
funding. At NEV's option, the funding can be in the form of additional equity,
preferred equity, guarantees or it can be partially satisfied with $10 million
in loans from Millennium, or a combination of these alternatives. At April 30,
1998, NEV had received the following under the $20 million commitment:
- Millennium provided $7 million in loans to NEV.
- UniSource Energy issued guarantees in the aggregate amount of $5 million to
secure the obligations of NEV to counterparties to energy purchase and sale
agreements.
- UniSource Energy also issued a $1 million guarantee to secure the
obligations of NEV under its Agreement for Services with LG&E Energy
Marketing, Inc.
As a result of these loans and guarantees, the remaining commitment amount
available was $7 million at April 30, 1998.
UniSource Energy is the guarantor of $16.65 million of performance bonds
that secure the amounts NEV California owes to the California utility
distribution companies (UDCs) for services provided by the UDCs in connection
with NEV California's sales in the California retail electric market. NEV
California bills its customers for these UDC charges.
NOTE 5. LONG-TERM DEBT
- -----------------------
In March 1998, the Apache County, Arizona Industrial Development Authority
issued $200 million of Pollution Control Revenue Bonds and loaned the proceeds
to TEP. These bonds are included in Long-Term Debt on our balance sheet. The
new bonds, which are unsecured, were sold in three series: Series A ($83.7
million) bears interest at 5.85% and matures in 2028; Series B ($99.8 million)
bears interest at 5.875% and matures in 2033;and Series C ($16.5 million) bears
interest at 5.85% and matures in 2026.
The proceeds from the issuance of the new bonds will be used in May 1998 to
redeem $200 million of previously issued variable interest rate bonds that would
have matured in 2020 and 2021. The previously issued bonds are included in
Current Maturities of Long-Term Debt in our balance sheet at March 31, 1998.
Until the previously issued bonds are redeemed, the proceeds from issuance of
the new bonds will be recorded in the balance sheets under Current Assets as
Long-Term Debt Proceeds Held by Trustee.
NOTE 6. RATE MATTERS
- ---------------------
Shared Savings Proposal
On July 9, 1997, TEP filed with the ACC a request for an annual rate
reduction of $6.8 million (or 1.1%) for retail customers. This filing is in the
form of a Shared Savings Proposal (SSP) which includes a sharing of cost
containment benefits with customers and a reduction of potentially stranded
costs associated with the introduction of retail electric competition in
Arizona. The SSP identifies $20.8 million in savings allocable to ACC
jurisdictional operations. The cost containment savings were realized primarily
from renegotiated fuel contracts and a 15% reduction in our workforce from the
1996 Voluntary Severance Program. The ACC has not set a date to decide on this
matter.
The proposed $6.8 million rate reduction represents a 50/50 sharing between
TEP and its customers of $13.6 million of the cost savings. The SSP would allow
TEP to use the remaining $7.2 million of cost savings to reduce (mitigate)
potentially stranded costs by accelerating the amortization of Retail Excess
Capacity Deferrals. Retail Excess Capacity Deferrals represent operating and
capital costs associated with Springerville Unit 2 capacity which the ACC did
not allow TEP to recover in rates until the 1994 and 1996 Rate Orders. These
Retail Excess Capacity Deferrals totaled $87.5 million and $88.7 million at
March 31, 1998 and December 31, 1997, respectively. These deferrals are only
reflected in our regulatory calculations. The accompanying balance sheets do
not include these deferrals as the costs were expensed when incurred for
financial reporting purposes. The proposed $7.2 million (after tax) increase in
annual amortization expense for those excess capacity deferrals would decrease
the amortization period from 20 years to 5.6 years as of December 1996. The
proposed increase in amortization expense would be reflected in TEP's
regulatory accounting records but would have no impact on the expenses
included in the financial statements.
Springerville Coal Contract Termination Fee
On June 27, 1997, TEP signed an agreement with the coal supplier for the
Springerville Generating Station to terminate the then-existing coal supply
contract and enter into a new, more cost effective contract with the same
supplier. TEP paid a $50 million termination fee in three installments: $30
million paid on June 30, 1997; $10 million paid on September 30, 1997; and $10
million paid on March 31, 1998.
TEP asked the ACC, as part of the SSP, to allow the termination fee to be
recorded as a regulatory asset and to be amortized to fuel expense over the 13-
year term of the new agreement. On July 29, 1997, the ACC issued an interim
accounting order allowing TEP to defer the $50 million termination fee as a
regulatory asset in the balance sheet until the ACC decides whether the $50
million termination fee should be recovered through retail rates. The interim
accounting order also allowed TEP to begin amortizing the termination fee to
fuel expense. If the ACC ultimately disallows recovery,the unamortized portion
of the $50 million termination fee would be expensed immediately. The ACC has
not set a date to decide on this matter.
NOTE 7. INCOME TAXES
- ---------------------
The differences between the income tax expense (benefit) and the amount
obtained by multiplying income before income taxes by the U.S.statutory federal
income tax rate are as follows:
UniSource Energy TEP
---------------- ------------
Three Months Ended Three Months Ended
March 31, March 31,
1998 1997 1998 1997
---------------------------------------
- Thousands of Dollars -
Federal Income Tax Benefit
at Statutory Rate $(3,903) $ (1,895) $ (694) $ (1,895)
State Income Tax Benefit,
Net of Federal Deduction (601) (291) (107) (291)
Depreciation Differences
(Flow Through Basis) 1,040 - 1,040 -
Investment Tax Credit
Amortization (573) (976) (573) (976)
Reduction in Valuation
Allowance - (14,318) - (14,318)
Other (80) 574 (43) 574
-------- --------- ------- ---------
Total Benefit for Federal
and State Income Taxes $(4,117) $(16,906) $ (377) $(16,906)
======== ========= ======= =========
Income taxes are included in the income statements as follows:
UniSource Energy TEP
---------------- ------------
Three Months Ended Three Months Ended
March 31, March 31,
1998 1997 1998 1997
---------------------------------------
- Thousands of Dollars -
Operating Expenses $(1,937) $ (2,348) $(1,937) $ (2,348)
Other Income (Deductions) 631 (14,558) 1,560 (14,558)
Unregulated Energy
Businesses - Net (2,811) - - -
-------- --------- -------- ---------
Total Income Tax Benefit $(4,117) $(16,906) $ (377) $(16,906)
======== ========= ======== =========
The reduction in the valuation allowance and corresponding NOL benefit in
1997 are primarily due to revisions in the estimated amount of NOLs that we
expect to offset future taxable income. As of December 31, 1997, both UniSource
Energy and TEP had recorded the amount of prior period NOL benefit that we
expect to utilize on future income tax returns. At the present time, we are not
able to estimate future additional amounts of NOL benefit that we may recognize
in the income statements of either UniSource Energy or TEP. This is because
there are still open tax years for which there may be additional assessments
and because federal and state NOL carryforwards have varying expiration dates.
We do not expect to recognize additional amounts of NOL benefit until such
items are resolved.
NOTE 8. RECLASSIFICATIONS
- --------------------------
Minor reclassifications have been made to the prior year financial
statements to conform to the current year's presentation.
NOTE 9. REVIEW BY INDEPENDENT PUBLIC ACCOUNTANTS
- -------------------------------------------------
With respect to the unaudited consolidated financial information of
UniSource Energy and TEP for the three-month periods ended March 31,1998, Price
Waterhouse LLP reported that they have applied limited procedures in accordance
with professional standards for a review of such information. However, their
separate report dated May 5, 1998 appearing herein, states that they did not
audit and they do not express an opinion on that unaudited consolidated
financial information. Price Waterhouse LLP has not carried out any significant
or additional audit tests beyond those which would have been necessary if their
report had not been included. Accordingly, the degree of reliance on their
report on such information should be restricted in light of the limited nature
of the review procedures applied. Price Waterhouse LLP is not subject to the
liability provisions of section 11 of the Securities Act of 1933 for their
report on the unaudited consolidated financial information because that report
is not a "report" or a "part" of a registration statement prepared or certified
by Price Waterhouse LLP within the meaning of sections 7 and 11 of the Act.
ITEM 2. - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
- -----------------------------------------------------------------------------
UniSource Energy is a holding company which owns all of the outstanding
common stock of TEP and MEH. TEP is an operating public utility engaged in
the generation, purchase, transmission, distribution and sale of electricity
for customers in the greater Tucson, Arizona area and to wholesale
customers. MEH owns all of the outstanding common stock of four
subsidiaries established for the purpose of operating or investing in
various unregulated energy-related businesses.
TEP is the principal subsidiary of UniSource Energy and accounts for
substantially all of its assets, revenues and net income. The financial
condition and results of operations of TEP are currently the principal
factors affecting the financial condition and results of operations of
UniSource Energy on an annual basis.
Management's Discussion and Analysis explains the general financial
condition and the results of operations for UniSource Energy and its
business subsidiaries including:
-operating results during the first quarter compared with the same period
in the prior year,
-the outlook for dividends on common stock,
-changes in liquidity and capital resources during the first quarter of
1998, and
-expectations of identifiable material trends which may affect our
business in the future.
Management's Discussion and Analysis should be read along with the
Company's Condensed Consolidated Financial Statements, beginning on page 2,
which present the results of operations for the quarters ended March 31,
1998 and 1997. Management's Discussion and Analysis analyzes and explains
the differences between periods for specific line items of the Condensed
Consolidated Financial Statements.
OVERVIEW
- --------
UniSource Energy recorded a net loss of $7.0 million for the first
quarter of 1998, compared with net income of $11.5 million in the first
quarter of 1997. The results in the first quarter of 1997 included the
effect of non-recurring tax benefits, which was partially offset by non-
recurring expenses, as set forth below:
-$14.3 million net operating loss carryforward tax benefits,
-$2.9 million in pre-tax VSP expense, and
-$1.1 million in pre-tax consulting fees paid to new business ventures.
Excluding these one-time adjustments, we would have recorded a net loss of
$0.3 million in the first quarter of 1997. Our results in the first quarter
of 1998 were affected primarily by the following factors: losses from
unregulated energy-related subsidiaries ($4.0 million after-tax), lower non-
cash regulatory revenues ($5.0 pre-tax), and higher interest expense ($4.1
million pre-tax). These factors are discussed in more detail in Results of
Operations and Investments in Energy-Related Ventures, below.
Utility operating revenues grew by 4% while operating income grew by
15% in the first quarter of 1998 compared with the first quarter of 1997.
Growth in the number of customers in TEP's retail service area, increased
kilowatt-hour sales to both retail and wholesale customers due to cooler
weather, and a moderate 3% overall increase in operating expenses
contributed to this improvement in the first quarter of 1998.
The Company's and TEP's financial prospects continue to be subject to
regulatory, economic, and other uncertainties. These uncertainties include
the extent to which TEP can alter operations and reduce costs in response to
industry changes or unanticipated economic downturns, which may be limited
by continued high financial and operating leverage. Our future success will
depend, in part, on our ability to contain and/or reduce the costs of
serving retail customers and the level of sales to those customers. Until
the uncertainties surrounding the introduction of retail competition in
Arizona are resolved, predicting the level of TEP's future energy sales and
the composition of its future revenues is difficult. However, we expect
retail competition will exist in our local market within the next five
years. See Competition, Retail below. In a deregulated environment,
revenues from energy sales will be less certain, although revenues from
transmission and distribution services, which we expect to remain regulated,
would likely continue to grow. Even in a deregulated environment, TEP
expects to continue to benefit from population and economic growth in the
Tucson area through increased revenues from its regulated distribution
services.
The Company is addressing the uncertainties discussed above and is
positioning itself to benefit from the changing regulatory environment. We
are improving cost measurement and management techniques and are re-
engineering various functions at TEP. We have also extended contracts,
where appropriate, for large wholesale and retail customers, and are
developing new affiliates to provide energy services to markets beyond TEP's
retail service territory. See Results of Operations; Competition, Retail;
Shared Savings Proposal Before the ACC; and Investments in Energy-Related
Ventures, below.
Since April 1997, we have made significant progress in our financial
strategy to reduce refinancing risk by extending maturities of long-term
debt and letters of credit and to reduce exposure to variable interest rates
by refinancing with fixed interest rates. TEP refinanced variable rate debt
obligations at fixed rates and entered into a new bank Credit Agreement to
replace the MRA. Long-term debt obligations totaling $192 million currently
mature between 1999 and 2003. TEP plans to refinance a substantial portion
of these obligations during 1998. See Financing Developments, TEP First
Mortgage Bonds, below.
Despite these improvements, TEP's and UniSource Energy's consolidated
capital structures remain highly leveraged. Although TEP refinanced and
extended the maturities of certain debt obligations at favorable rates and
terms in 1997 and during the first quarter of 1998, the Company might not
have continued access to the capital markets at similar rates and terms.
Despite the reduction in variable rate debt obligations, changes in interest
rates on its remaining variable rate debt will continue to affect TEP's
earnings and cash flow. Following the redemption of certain pollution
control revenue bonds on May 15, 1998, TEP will have $329 million aggregate
principal amount of variable debt obligations. On March 31, 1997, variable
rate debt totaled $805 million. See Financing Developments, TEP Sale of
Bonds, below.
TEP is currently unable to pay dividends to UniSource Energy because it
fails to meet certain requirements contained in some of its First Mortgage
Bond obligations. As a result, cash flow from TEP to UniSource Energy is
limited. This, in turn, limits UniSource Energy's ability to pay dividends.
See Dividends on Common Stock below.
During the next twelve months, TEP expects to fund its operating
activities and construction expenditures with internal cash flows, existing
cash balances, and, if necessary, borrowings under the Revolving Credit. As
of May 6, 1998, cash balances, including cash equivalents for UniSource
Energy, were approximately $104 million, of which $65 million was held by
TEP and its consolidated subsidiaries.
COMPETITION
- -----------
WHOLESALE
TEP competes with other utilities, marketers and independent power
producers in the sale of electric capacity and energy in the wholesale
market. FERC generally does not permit TEP's prices for wholesale sales of
capacity and energy to exceed rates determined on a cost of service basis.
However, in the fall of 1997, FERC granted TEP a tariff to sell at market-
based rates. In the current market, wholesale prices are substantially
below total cost of service, but in all instances, we make wholesale sales
at prices which exceed fuel and other variable costs. In addition, we
expect competition to sell capacity to remain vigorous. Prices may remain
depressed for at least the next several years due to increased competition
and surplus capacity in the southwestern United States. Competition for the
sale of capacity and energy is influenced by the following factors:
-availability of capacity in the southwestern United States,
-the availability and prices of natural gas and oil,
-spot energy prices, and
-transmission access.
The FERC issued two orders pertaining to transmission access in April
1996. FERC Order No. 888 requires all public utilities that own, control,
or operate interstate transmission facilities to offer transmission service
to others under a single tariff. This tariff must incorporate certain
minimum terms and conditions of transmission service established by the FERC
and must also be used by public utilities for their own wholesale market
transactions. Transmission and generation services for new wholesale
service are to be unbundled and priced separately. FERC Order No. 889
requires transmission service providers to establish or participate in an
open access same-time information system (OASIS) that provides information
on the availability of transmission capacity to wholesale market
participants. The order also establishes standards of conduct to prevent
employees of a public utility engaged in marketing functions from obtaining
preferential access to OASIS-related information or from engaging in
discriminatory business practices. TEP is in compliance with the
requirements of FERC Orders 888 and 889.
TEP, along with other transmission owners and users located in the
southwestern United States, is investigating the feasibility of forming an
independent system operator (ISO) for the region. An ISO would be
responsible for ensuring transmission reliability and nondiscriminatory
access to the regional transmission grid. The working group held three sets
of public meetings to obtain input to the study and completed the initial
feasibility study in September 1997. The participants have begun detailed
developmental work. The formation of an ISO would be subject to approval by
the FERC and state regulatory authorities in the region. The financial
aspects of forming an independent system operator, including the potential
effects on TEP's future results of operations, will be examined as part of
the development work.
RETAIL
Under current law, TEP does not compete with other companies for
electric service in TEP's retail service territory. However, TEP competes
against gas service suppliers and others who provide energy services. TEP
actively markets energy and customized energy-related services. We have not
lost any customers to self-generation partly because of these efforts. For
example, in recent years, TEP executed new contracts with two principal
customers that provide approximately 9% of TEP's total annual retail
revenues. Both customers are in the copper mining business. The new
contracts include price reductions, term extensions, and a provision for
interruptible service. These contracts expire in March 2001 and January
2003. These mining customers cannot terminate the contracts early without
giving us at least one and up to two years prior notice. We have not
received any such notices.
In December 1996, the ACC adopted rules that, if implemented as
adopted, would require a phase-in of retail electric competition in Arizona
over a four-year period beginning January 1, 1999. The adopted rules are a
framework to implement competition. The ACC rules, if implemented as
adopted, would require each "Affected Utility" (TEP, APS, Citizens Utilities
Company, and several electric cooperatives) to open its retail service area
to competing electric service providers over the period 1999 to 2003 and
would permit Affected Utilities to sell power at unregulated market prices.
Beginning January 1, 1999, 20% of retail customers would be eligible to
choose their electric service provider from companies certificated by the
ACC. This percentage increases to 50% beginning January 1, 2001 and to 100%
by January 1, 2003. Under the adopted rules, it is unclear which customers
would be eligible to choose during the transition years. Electric service
providers would include Affected Utilities as well as other entities
(including power marketers and out-of-state utilities) that apply for and
receive a certificate of convenience and necessity from the ACC. Other
electric utilities not regulated by the ACC, such as the Salt River Project
and certain municipal utilities, would be granted certificates to compete
under the ACC's rules if these utilities would allow their service
territories to be similarly open to competing service providers.
Under the rules, Affected Utilities would be required to provide
distribution wheeling services (i.e., retail wheeling) at rates approved by
the ACC. Retail wheeling involves a utility transmitting energy produced by
other entities over its transmission and distribution system to consumers
located in its present retail service area. The availability of wheeling
services will make it easier for entities to provide services outside their
traditional service territory. This exposes TEP to the risk that TEP's
distribution customers may choose to purchase their energy from competitors.
However, TEP would have the opportunity to sell power at market prices to
retail customers outside of TEP's current service area. Until retail
competition has been substantially implemented, each Affected Utility would
be required to offer services to all consumers located in their present
retail service areas.
The rules, as adopted by the ACC, specify that the ACC would allow
recovery of unmitigated stranded costs by Affected Utilities. Stranded
costs represent costs incurred by a utility in a regulated market that
likely would not be recovered through the prices charged for electricity and
other services in a competitive market. According to the adopted rules, to
recover stranded costs, utilities will need to demonstrate to the ACC that
they have taken every feasible, cost-effective measure to mitigate or offset
stranded costs. Also, Affected Utilities would have to seek ACC approval of
distribution charges or other means of recovering stranded costs from
current customers who elect to use another electricity provider.
In January 1998, TEP filed its position regarding stranded cost
recovery with the ACC. We believe that TEP and other Affected Utilities
should have the opportunity to recover all of their stranded costs and that
stranded costs should be calculated as the difference between future
revenues under traditional regulation and future revenues in a competitive
market.
Hearings were held in February 1998 to resolve issues relating to
stranded cost recovery. TEP, other Affected Utilities, the Residential
Utility Consumer Office, the ACC staff, and various intervenors participated
in the hearings. On May 6, 1998, the Hearing Officer issued a Proposed
Order. The Proposed Order indicates that the Affected Utilities should have
a reasonable opportunity to recover 100% of their stranded costs and gives
the Affected Utilities three options for stranded cost recovery.
(1) Net Revenues Lost Methodology--This option would provide for recovery
of stranded costs through a Competitive Transition Charge (CTC) using a
net revenues lost approach for a five-year period beginning in 1999. A
net revenues lost approach would compare estimates of generation
revenues under competition to generation revenues under continued
regulation. The difference, if any, would represent stranded costs.
Under this option, customers remaining on standard offer service would
pay 100% of their proportionate share of stranded costs each year.
Customers who elect to purchase energy from competitors would pay 100%
of their proportionate share of stranded costs in the first year
through the CTC, and during each successive year, this percentage would
decrease by 20%. The Proposed Order indicates that through customer
growth and other mitigation efforts, Affected Utilities should still be
able to collect 100% of their stranded costs despite the annual
reduction in the CTC.
(2) Divestiture/Auction Methodology--This option would provide for an
auction and divestiture of generation assets where the difference
between market and book value would represent stranded costs. The
Affected Utility would be permitted to collect 100% of stranded costs
through a CTC over a 10-year period. However, no return would be
provided on the unamortized balance of stranded costs during this 10-
year period.
(3) Financial Integrity Methodology--This option would provide for stranded
cost recovery through a CTC which would be calculated to provide
sufficient revenues for the Affected Utility to maintain its financial
integrity and to meet minimum financial ratios (not specified in the
Proposed Order) for a 10-year period.
The Proposed Order also specifies that some form of rate cap would be in
place for customers on standard offer during the transition period.
TEP is currently evaluating the Proposed Order to determine the
potential financial implications to the Company if it is adopted. TEP
anticipates filing exceptions to the Proposed Order. We cannot determine
when the ACC will hold an open meeting to consider the Proposed Order or
whether the ACC will approve, modify or reject the Proposed Order. If the
Proposed Order is adopted, TEP would have 30 days to file its choice of one
of the three options for stranded cost recovery. At the same time, TEP
would need to file an implementation plan, including its estimate of
stranded costs related to generation and regulatory assets. Until such
time, we believe that any estimate of unrecoverable amounts of stranded
costs would be highly speculative.
In February 1997, TEP filed an appeal of the ACC order adopting retail
electric competition rules in the Arizona Superior Court. The Company filed
a motion for summary judgment, claiming, among other things that the
Competition Rules: (a) violated the Regulatory Compact between TEP and the
State of Arizona; (b) confiscated TEP's property; and (c) violated due
process. The Court did not grant summary judgment but ruled that the
Commission must hold hearings before it can modify TEP's Certificate of
Convenience and Necessity (CC&N). No trial date has been set in the case
and no final order has been issued. We are unable to predict the outcome
of the appeal or the effects such rules would have on future results of
operations.
A legislative study committee established by the Arizona Legislature
issued a report on retail electric competition in December 1997. The report
identified tax and other issues for the legislature to address. In January
1998, Arizona legislators introduced HB 2663 regarding the implementation of
retail electric competition in Arizona. This bill is currently under
consideration in the Arizona State Legislature, and would require the
introduction of customer choice to 20% of each utility's retail load by
December 31, 1998 and to all utility retail customers by December 31, 2000.
This legislation only relates directly to government-owned utility companies
such as SRP; however, the bill encourages broader application of the
legislation's principles by the ACC to the state's investor-owned utilities
and cooperatives, including TEP.
We cannot predict the outcome of the proposed legislation or the ACC's
retail competition rules. However, we believe that certain matters in the
ACC's current retail competition rules may require legislative changes,
while others may require amendments to the Arizona state constitution.
Additionally, federal legislators introduced several retail competition
initiatives in Congress which, if passed, could modify or override the
actions taken by the ACC or the Arizona Legislature. We will continue to
assess the likely impact on TEP of the ACC's retail competition rules,
proposed legislation, and other potential market reforms. We are unable to
predict the ultimate impact of increased retail competition on future
results of our operations. See Accounting for the Effects of Regulation
below for a discussion of the potential impact of increased competition on
the Company's accounting policies.
SHARED SAVINGS PROPOSAL BEFORE THE ACC
- --------------------------------------
On July 9, 1997, TEP filed with the ACC a request for an annual rate
reduction of $6.8 million (or 1.1%) for retail customers. This filing is in
the form of a Shared Savings Proposal (SSP) which includes a sharing of cost
containment benefits with customers and a reduction of potentially stranded
costs associated with the introduction of retail electric competition in
Arizona. The SSP identifies $20.8 million in savings allocable to ACC
jurisdictional operations. The cost containment savings were realized
primarily from renegotiated fuel contracts and a 15% reduction in our
workforce from the 1996 Voluntary Severance Program. The ACC has not set a
date to decide on this matter.
The proposed $6.8 million rate reduction represents a 50/50 sharing
between TEP and its customers of $13.6 million of the cost savings. The SSP
would allow TEP to use the remaining $7.2 million of cost savings to reduce
(mitigate) potentially stranded costs by accelerating the amortization of
Retail Excess Capacity Deferrals. Retail Excess Capacity Deferrals
represent operating and capital costs associated with Springerville Unit 2
capacity which the ACC did not allow TEP to recover in rates until the 1994
and 1996 Rate Orders. Those Retail Excess Capacity Deferrals totaled $87.5
million and $88.7 million at March 31, 1998 and December 31, 1997,
respectively. Those deferrals are only reflected in our regulatory
calculations. The accompanying balance sheets do not include these
deferrals as the costs were expensed when incurred for financial reporting
purposes. The proposed $7.2 million increase in annual amortization expense
for those excess capacity deferrals would decrease the amortization period
from 20 years to 5.6 years as of December 1996. The proposed increase in
amortization expense would be reflected in TEP's regulatory accounting
records but would have no impact on the expenses included in the financial
statements.
ACCOUNTING FOR THE EFFECTS OF REGULATION
- ----------------------------------------
Accounting Implications
The ACC regulates TEP's utility business. TEP generally uses the same
accounting policies and practices used by nonregulated companies for
financial reporting under generally accepted accounting principles.
However, sometimes these principles, such as FAS 71, require special
accounting treatment for regulated companies to show the effects of
regulation. For example, in setting TEP's retail rates, the ACC may not
currently allow TEP to charge its customers to recover certain expenses but,
instead, require that these charges be charged to customers in the future.
In this situation, FAS 71 requires TEP not to show these expenses on its
current income statements but to "defer" these items and show them as
"regulatory assets" on the balance sheet until TEP is allowed to charge its
customers. TEP then amortizes these items to the income statement as
charges are billed to customers. Similarly, certain items of revenue may
be deferred as regulatory liabilities which are also eventually amortized
to the income statement.
We have recorded regulatory assets and liabilities in our balance
sheets in accordance with FAS 71. A regulated company must satisfy certain
conditions to apply the accounting policies and practices of FAS 71. These
conditions include:
- an independent regulator sets rates;
- the regulator sets the rates to cover specific costs of delivering
service; and
- the service territory lacks competitive pressures to reduce rates
below the rates set by the regulator.
We periodically assess whether we continue to meet these conditions. If we
were required to stop applying FAS 71 to all or a portion of TEP's regulated
utility operations, we would write off the related balances of TEP's
regulatory assets and liabilities as a charge in our income statement. This
means our earnings would be reduced by the net amount of regulatory assets
and liabilities, after applicable deferred income taxes. Based on the
balances of TEP's regulatory assets and liabilities at March 31, 1998, if we
stopped applying FAS 71 to all of TEP's regulated operations, we would
record an extraordinary loss of approximately $178 million, net of the
related deferred income tax benefit of $99 million. While our cash flows
may be affected by regulatory orders and market conditions, our cash flows
would not be affected if we stopped applying FAS 71.
If we stop applying FAS 71, we would need to evaluate the likelihood
that we could recover the cost of TEP's electric plant in the marketplace
using the criteria in FAS 121. If undiscounted cash flows are less than the
carrying value of those assets, then we would need to write-off as an
expense a portion of those plant assets to reflect their current market
value. We cannot predict if we would write-off any plant assets as a result
of applying FAS 121.
Recent Events That May Impact TEP's Application of FAS 71
Legislative and other regulatory measures are being developed in
various states to deregulate the electric generation business. The SEC and
the EITF have been reviewing whether electric utilities should stop applying
FAS 71 to the business transactions in states where deregulation is
occurring. In general, the EITF consensus states that utilities must stop
accounting for the electric generation portion of their business under FAS
71 when a deregulation plan is in place and its terms are known. The EITF
also concludes that utilities do not need to write off regulatory assets
(including those related to generation) if the cash flow stream from
regulated rates includes recovery of the regulatory assets. We are uncertain
how the EITF consensus will impact TEP as deregulation activities develop in
Arizona. In the future, we may need to stop applying FAS 71 to the electric
generation portion of TEP's business, even if we believe that we will
recover the full amount of our costs under the ACC competition phase-in
plan. Approximately 55% of TEP's net regulatory assets on the balance sheet
relate to electric generation.
In December 1996, the ACC adopted rules that, if implemented as
adopted, would introduce retail electric competition in Arizona. See
Competition, Retail for a discussion of the ACC competition rules. Hearings
were held in February 1998 to resolve issues relating to stranded cost
recovery. On May 6, 1998, the Hearing Officer issued a Proposed Order. The
Proposed Order indicates that the Affected Utilities should have a
reasonable opportunity to recover 100% of their stranded costs and gives
the Affected Utilities three options for stranded cost recovery.
However, it is unclear whether Affected Utilities would be able to recover
100% of their stranded costs. See Competition, Retail for a discussion of
the Proposed Order.
TEP is currently evaluating the financial implications if the Proposed
Order is adopted, including whether we would be able to continue to apply
FAS 71 to the generation portion of TEP's business. TEP anticipates filing
exceptions to the Proposed Order. We cannot determine when the ACC will
hold an open meeting to consider the Proposed Order or whether the ACC will
approve, modify or reject the Proposed Order. If the Proposed Order is
adopted, TEP would have 30 days to file its choice of one of the three
options for stranded cost recovery. At the same time, TEP would need to
file an implementation plan, including its estimate of stranded costs
related to generation and regulatory assets. Until such time, we believe
that any estimate of unrecoverable amounts of stranded costs would be highly
speculative.
Also in January 1998, the Arizona Legislature proposed legislation
introducing retail electric competition in Arizona. We cannot predict the
outcome of the proposed legislation or whether the ACC and the Arizona
Legislature will propose other initiatives on electric utility industry
restructuring. We believe, based on previous rate orders, that it is likely
that we will recover the full costs of our investments in electric utility
plant and regulatory assets. The ACC's final order may require us to stop
applying FAS 71 to the electric generation portion of TEP's utility
operations. If the order provides less than full recovery of stranded
costs, significant write-offs of assets may occur as discussed above.
Based on the activities that have occurred to date, TEP believes it
continues to meet the criteria to apply FAS 71 to its regulated activities.
However, we cannot predict the outcome of the deregulation efforts in
Arizona described above.
INVESTMENTS IN ENERGY-RELATED VENTURES
- --------------------------------------
MEH Corporation (MEH), a wholly-owned subsidiary of UniSource Energy,
owns 100% of the stock of four subsidiaries. We established these
subsidiaries to pursue various unregulated energy-related investment
opportunities:
1) Nations Energy Corporation (Nations Energy) develops independent
power projects worldwide.
2) Millennium Energy Holdings, Inc. (Millennium) holds a 50% interest
in New Energy Ventures, L.L.C. (NEV). NEV, a buyer's agent, provides
electric load aggregation and advisory services to retail purchasers of
electric energy. As of March 31, 1998, NEV had contracts to purchase
energy for and sell energy to customers principally in California with
a combined electrical demand of more that 1,000 MW. NEV began serving
its California customers on March 31, 1998 when the California retail
electricity market opened to competition.
3) Advanced Energy Technologies, Inc. (AET) holds a 50% interest in
Global Solar Energy, L.L.C. (Global Solar), a manufacturer of thin-film
photovoltaic cells.
4) Southwest Energy Solutions, Inc. (SES) provides ancillary energy
services to electric consumers. SES owns 100% of the stock of SWPP
Investment Company (SWPP) and SWPP International, Ltd. (SWPPI), which
hold ownership interests in businesses engaged in the manufacture and
sale of concrete power poles.
Our investments in the energy-related ventures described above
(included in Investments and Other Property in UniSource Energy's
consolidated balance sheet) comprise less than 1% of total assets. However,
the net loss related to these start-up operations totaled $4.0 million for
the first quarter of 1998. This loss is included in the Other Income
(Deductions) section on UniSource Energy's income statement. Almost all of
MEH's loss in the first quarter of 1998 occurred at NEV. The California
electricity market was originally scheduled to open to competitors such as
NEV on January 1, 1998. However, technical matters related to the
California Independent System Operator and the California Power Exchange
delayed the opening of the electricity market until March 31, 1998.
Therefore, NEV could not make retail power sales in California in the first
quarter. Although the delays in establishment of the competitive market
caused losses at NEV in the first quarter, and may continue to cause losses
in the second quarter, NEV expects losses to decline as more customers are
added throughout the year.
Depending on the nature of future investment opportunities, we expect
to make additional investments in these subsidiaries and in other energy-
related ventures. Over time, investments in unregulated energy-related
ventures may have a material impact on our profitability and cash flows.
The ACC Holding Company Order requires that the capitalization (debt and
equity) of TEP's sister companies not exceed 30% of TEP's capitalization
unless otherwise approved by the ACC.
DIVIDENDS ON COMMON STOCK
- -------------------------
UniSource Energy
UniSource Energy's ability to pay dividends depends upon cash flow
from TEP and MEH. TEP comprises substantially all of UniSource Energy's
assets. As described below, TEP is currently unable to declare or pay
dividends. TEP has not declared or paid a dividend on common stock since
1989. Until TEP is able to pay dividends to UniSource Energy, UniSource
Energy will probably be unable to declare or pay dividends on its Common
Stock.
TEP
Five outstanding issues of First Mortgage Bonds (aggregating $184
million in principal amount) prevent TEP from paying dividends until
specific cash flow coverage and retained earnings tests are met. As of
March 31, 1998, TEP met the cash flow coverage test, but did not meet the
retained earnings test, which requires positive retained earnings. These
covenants will apply until these First Mortgage Bonds have been paid or
redeemed or the applicable mortgage indentures have been amended. The
latest maturity of these First Mortgage Bonds is in 2003. To amend these
bonds would require approval by 75% of all First Mortgage Bonds holders.
During 1998, TEP plans to refinance or retire all of the First Mortgage
Bonds that prohibit the payment of dividends. See Financing Developments,
TEP First Mortgage Bonds, below.
TEP's Credit Agreement allows TEP to pay dividends if it maintains
compliance with the agreement and meets certain financial covenants,
including a covenant that requires TEP to maintain a minimum level of net
worth. As of March 31, 1998, the required minimum net worth was $166.4
million. See Financing Developments, TEP Credit Agreement, below. As of
March 31, 1998, TEP is in compliance with the terms of the Credit Agreement.
The ACC Holding Company Order states that TEP may not pay dividends to
UniSource Energy in excess of 75% of its earnings until TEP's equity ratio
equals 37.5% of total capital (excluding capital lease obligations). As of
March 31, 1998, TEP's equity ratio was 15%.
In addition to these restrictive covenants, the Federal Power Act
states that dividends shall not be paid out of funds properly included in
the capital account. Although the terms of the Federal Power Act provisions
are unclear, we believe that there is a reasonable basis to pay dividends
from current year earnings. We are continuing to evaluate this situation.
EARNINGS
- --------
UniSource Energy recorded a net loss of $7.0 million in the first
quarter of 1998 compared with net income of $11.5 million in the first
quarter of 1997. The net loss per average share of Common Stock was $0.22
for the first quarter of 1998 compared with net income per average share of
Common Stock of $0.36 for the first quarter of 1997. We would have recorded
a net loss of $0.3 million or $0.01 per share in the first quarter of 1997
excluding the recognition of tax benefits and other one-time adjustments.
The major reasons for the variance between the results for the first quarter
of 1998 and the adjusted results for the first quarter of 1997 were:
-higher losses from investments in unregulated energy-related businesses,
-lower non-cash regulatory revenues, and
-higher interest expense.
RESULTS OF OPERATIONS
- ---------------------
Currently, TEP's financial condition and results of operations are the
primary factors affecting the financial condition and results of operations
of UniSource Energy on an annual basis. We note any fluctuations that are
not primarily due to TEP activities. All nonutility operating transactions
are reflected in Other Income (Deductions) on the UniSource Energy
Consolidated Statement of Income.
Utility Sales and Revenues
Comparisons of TEP's kilowatt-hour sales and electric revenues are
shown below:
Increase/(Decrease)
-------------------
Three Months Ended March 31 1998 1997 Amount Percent
- --------------------------- --------- ----------- ------- --------
Electric kWh Sales (000):
Retail Customers 1,790,309 1,622,441 167,868 10.3%
Sales for Resale 850,132 715,187 134,945 18.9
--------- --------- -------
Total 2,640,441 2,337,628 302,813 13.0
Electric Revenues (000):
Retail Customers $138,149 $129,937 $8,212 6.3%
Amortization of MSR Option
Gain Regulatory Liability 0 5,013 (5,013) (100.0)
Sales for Resale 22,854 19,331 3,523 18.2
-------- -------- -------
Total $161,003 $154,281 $6,722 4.4
TEP's kWh sales to retail customers increased by 10.3% during the first
quarter of 1998 compared to the first quarter of 1997. This increase is
because: 1) our average number of retail customers increased 1.8%; 2) the
weather was cooler in February and March of 1998 than in 1997, which
increased the electric heating load; 3) sales to our mining customers
increased after contract amendments went into effect in mid-1997; and 4)
reported sales in 1998 were impacted by various billing adjustments.
Revenues from sales to retail customers increased by 6.3% in the first
quarter of 1998 compared to the same period in 1997 because of the higher
kWh sales. This increase in retail revenues did not correspond exactly to
the increase in kWh sales as a result of new long-term contracts with large
commercial, industrial and mining customers. These contracts went into
effect after the first quarter of 1997 and have lower rates than the prior
contracts.
Our kWh sales for resale increased by 18.9% and the related revenues
grew by 18.2% in the first quarter of 1998 relative to the same period in
1997. There were higher economy energy sales in 1998 because cooler weather
in the southwestern United States during the first quarter resulted in
increased use of electricity for heat.
TEP's non-cash revenue from the Amortization of the MSR Option Gain
Regulatory Liability was $5.0 million lower in the first quarter of 1998
compared to the same period in 1997. This regulatory liability was fully
amortized in May 1997. If we exclude the revenue from the MSR Option Gain
amortization, total operating revenues were 7.9% higher in the first quarter
of 1998 than the first quarter of 1997.
Operating Expenses
Fuel and Purchased Power expense increased by 6% in the first quarter
of 1998 compared with the same period in 1997 because of the increased sales
we discussed above. Savings from the new Springerville coal contract helped
reduce the cost per kWh sold to 1.83 cents in the first quarter of 1998 from
1.95 cents in the same period in 1997.
If we exclude the growth in Fuel and Purchased Power expense, other
operating expenses increased in total by only 1% in the first quarter of
1998 over the same period in 1997. Other Operations expense was $2.9
million higher in the first quarter of 1998 than during the first quarter of
1997. This change was mainly due to increases in salaries, pension and
benefit expense. Employee Severance Plan Expense of $2.9 million in 1997
represents VSP costs for non-pension post-retirement benefits that we
recognized in the first quarter.
Other Income (Deductions)
Compared with the first quarter of 1997, 1998 income tax benefits
included in Other Income (Deductions) decreased by $15.2 million and $16.1
million for UniSource Energy and TEP, respectively. This change is due
mainly to lower recognition of Net Operating Loss (NOL) benefit. UniSource
Energy and TEP recognized $14.3 million of NOL benefit in the first quarter
of 1997 and none in the first quarter of 1998. As of December 31, 1997,
both UniSource Energy and TEP had recorded the amount of prior period NOL
benefit that we expect to use on future income tax returns. At the present
time, we are not able to estimate future additional amounts of NOL benefit
that we may recognize in the income statements of either UniSource Energy or
TEP. This is because there are still open tax years for which there may be
additional assessments and because federal and state NOL carryforwards have
varying expiration dates. We do not expect to recognize additional amounts
of NOL benefit until such items are resolved.
The unregulated energy subsidiaries owned by MEH reported a net loss of
$4.0 million for the first quarter of 1998, compared with a net loss of $0.9
million for the first quarter of 1997. The delayed implementation of
California's competitive electricity market until March 31, 1998 and other
subsidiary development activities affected the financial results for these
businesses. See Investments in Energy-Related Ventures.
Interest Expense
Interest expense increased by $4.1 million in the first quarter of 1998
relative to the same period in 1997. We had higher letter of credit fees in
TEP's new Credit Agreement, as well as higher interest rates from the
refinancing of certain variable rate debt obligations with fixed rate debt
obligations. (See Financing Developments, TEP Sale of Bonds, below). These
refinancings benefited TEP by extending debt maturities and reducing the
risk from changes in variable interest rates.
EVENTS AFFECTING FUTURE RESULTS OF UTILITY OPERATIONS
TEP Generating Resources
On May 1, 1998, TEP allowed a lease to expire on three internal
combustion turbine generating units having a combined generating capacity of
96 MW. As a result, TEP may need to purchase firm capacity during the
summer months to meet operating reserve requirements. TEP will re-evaluate
the need for additional peaking generation resources. Firm capacity
purchases needed to replace the expired leased capacity are not expected to
have a material negative impact on UniSource Energy or TEP financial
results.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
CASH FLOWS
UniSource Energy
Cash and cash equivalents increased by $15.2 million, or 14%, from the
March 31, 1997 ending balance of $106.6 million to the March 31, 1998 ending
balance of $121.8 million. For the twelve-month period ended March 31,
1998, net cash flows from operating activities exceeded the cash needed for
investing and financing activities.
Net cash flows from operating activities decreased in aggregate by
$19.1 million in the first three months of 1998 compared with the same
period in 1997. This decrease was due mainly to the payment of $10.0
million in contract termination fees to the Springerville coal supplier in
the first quarter of 1998 (see Note 6 of Notes to Condensed Consolidated
Financial Statements--Rate Matters). In addition to the contract
termination fees, we had higher cash outflows for the following: 1) Other
Operations and Maintenance Costs increased $4.8 million; 2) Interest Paid
increased $3.8 million; 3) Capital Lease Interest Paid increased $3.8
million; and 4) Wages Paid increased $3.0 million. These increases in cash
outflows were partially offset by a $6.8 million increase in cash receipts
from retail and wholesale customers.
Total net cash outflows from investing activities increased by $7.0
million during the first quarter of 1998 compared with the same period in
1997. A $4.7 million increase in Loans and Investments to Joint Ventures
and a $1.4 million increase in Construction Expenditures were the primary
reasons for this change.
Total net cash outflows from financing activities decreased by $25.3
million in the first quarter of 1998 compared with the same period in 1997.
In the first quarter of 1997, TEP repaid the $31 million balance outstanding
on its Renewable Term Loan. The new bond issuance activity described below
in Financing Developments, TEP Sale of Bonds had no impact on net cash flow
in the first quarter of 1998. This is because the cash from the bonds
issued is being held in trust until the 1981 Apache Series A and Series B
bonds are redeemed on May 15, 1998.
Our consolidated cash balance, including cash equivalents, at May 6,
1998 was approximately $104 million. Of this amount, $65 million was held
by TEP and its wholly-owned subsidiaries. We invest cash balances in high-
grade money market securities with an emphasis on preserving the principal
amounts invested.
During 1998 and beyond, our sources of cash will be primarily dividends
from TEP (when allowed) and proceeds from sales of securities. Potential
cash needs may include funds for subsidiaries, funds to meet debt
obligations and funds to pay dividends to shareholders. See Dividends on
Common Stock and Financing Developments, UniSource Energy for details on
these sources and uses of funds.
TEP
Cash and cash equivalents decreased by $23.5 million, or 22%, from the
March 31, 1997 ending balance of $106.6 million to the March 31, 1998 ending
balance of $83.2 million. This decrease is due to the transfer of MEH's
cash balance of $45.4 million, included in Cash Flows from Investing
Activities in TEP's Statement of Cash Flows for the quarter ended March 31,
1998. See Note 3 of Notes to the Condensed Consolidated Financial
Statements--Transfer of MEH from TEP to UniSource Energy.
TEP expects to generate enough cash flow during 1998 to fund continuing
operating activities and construction expenditures. Actual cash flows may
vary from projections if there are changes in wholesale revenues, changes in
short-term interest rates or other factors. If cash flows were to fall
short of our expectations, TEP would use existing cash balances and, if
necessary, borrow from the Revolving Credit Facility. At May 6, 1998, there
was no outstanding balance due under the Revolving Credit Facility.
FINANCING DEVELOPMENTS
TEP Sale of Bonds
On March 17, 1998, the Apache County, Arizona Industrial Development
Authority issued $200 million of new bonds for the benefit of TEP. These
bonds are included in Long-Term Debt on TEP's balance sheet. The proceeds
will be used on May 15, 1998 to redeem the 1981 Series A Apache County
Pollution Control Revenue Bonds due 2020 ($100 million) and the 1981 Series
B Apache County Pollution Control Revenue Bonds due 2021 ($100 million).
Until the previously issued bonds are redeemed, they are included in the
balance sheet as Current Maturities of Long-Term Debt. The proceeds from
the issuance of the new bonds are recorded in the balance sheet under
Current Assets as Long-Term Debt Proceeds Held by Trustee. The new bonds,
which are unsecured, were issued in three series: Series A Pollution Control
Revenue Bonds ($83.7 million) bears interest at 5.85% and matures in 2028;
Series B Pollution Control Revenue Bonds ($99.8 million) bears interest at
5.875% and matures in 2033; and Series C Industrial Development Revenue
Bonds ($16.5 million) bears interest at 5.85% and matures in 2026.
The 1981 Series A Apache Bonds are supported by a letter of credit.
This LOC is collateralized by Second Mortgage Bonds under the terms of TEP's
Credit Agreement. When TEP redeems these bonds, the Letter of Credit
Facility will decrease from $444 million to $341 million and the Second
Mortgage Bonds collateralizing those LOCs will decrease by $103 million.
The 1981 Series B Apache Bonds are supported by a letter of credit outside
of the Credit Agreement. This LOC is collateralized by First Mortgage
Bonds. When TEP redeems these bonds, this will eliminate the supporting LOC
and retire $103 million of First Mortgage Bonds collateralizing the LOC.
TEP Credit Agreement
As of March 31, 1998 and as of May 6, 1998, TEP had no borrowings
outstanding under its $100 million Revolving Credit Facility.
As described above in TEP Sale of Bonds, after TEP redeems the 1981
Series A Apache County Pollution Control Revenue Bonds on May 15, 1998, the
amount of its Letter of Credit Facility will be $341 million and the amount
of its total facilities under the Credit Agreement, which includes the
Revolving Credit Facility discussed above, will be $441 million.
TEP is required by its Credit Agreement to maintain certain financial
covenants including (a) a minimum Consolidated Tangible Net Worth equal to
the sum of $133 million plus 40% of cumulative Consolidated Net Income since
January 1, 1997, (b) a minimum Cash Coverage Ratio ranging from 1.30 in 1998
and gradually increasing to 1.55 in 2002, and (c) a maximum Leverage Ratio
ranging from 7.00 in 1998 and gradually decreasing to 6.20 in 2002. For the
quarter ended March 31, 1998, TEP was in compliance with each of these
covenants.
TEP First Mortgage Bonds
In 1997 the ACC granted authority to TEP to refinance up to $184
million of its First Mortgage Bonds scheduled to mature between 1999 and
2003, as well as any redemption premiums, by issuing new debt and/or equity
securities. As described below, TEP plans to negotiate and complete these
transactions during 1998. TEP's objective is to extend maturities and
eliminate certain restrictive covenants contained in the existing First
Mortgage Bonds.
On April 29, 1998, TEP sent an offering memorandum to registered
holders of its 12.22% First Mortgage Bonds due 2000. TEP is offering to
exchange existing 12.22% First Mortgage Bonds for an identical amount of new
12.22% Exchange Series First Mortgage Bonds due 2000. With the exception of
a covenant pertaining to the payment of dividends, the new bonds would have
substantially the same terms and conditions as the existing bonds. The
Exchange Series Bonds are structured to allow TEP to pay dividends. This
exchange offer expires May 15, 1998 and may be extended or withdrawn by TEP
prior to that time at its discretion.
During the second quarter of 1998, TEP intends to issue up to $195
million of Second Mortgage Bonds and use the proceeds to redeem all of its
First Mortgage Bonds due in 1999, 2001, 2002, and 2003, as well as any of
the 12.22% First Mortgage Bonds not tendered for exchange as described
above. If TEP redeems the bonds as described above, TEP would eliminate
covenants that currently prohibit it from paying common stock dividends so
long as it has an accumulated earnings deficit (see Dividends on Common
Stock).
There is no assurance that any of the transactions described above will
be completed.
UniSource Energy
UniSource Energy plans to establish a direct stock purchase plan in
1998. Under this plan, we may issue up to 1,000,000 shares of common stock.
The ACC Holding Company Order states that 60% of the proceeds of any
public equity issuance undertaken by the Company in its first five years of
operations must be used to reduce TEP's debt or add to TEP's equity account.
UniSource Energy--Loans and Guarantees
In December 1997, Millennium committed to provide NEV with $20 million
of funding. At NEV's option, the funding can be in the form of additional
equity, preferred equity, guarantees or it can be partially satisfied with
$10 million in loans from Millennium, or a combination of these
alternatives. At April 30, 1998, NEV had received the following under the
$20 million commitment:
-Millennium provided $7 million in loans to NEV.
-UniSource Energy issued guarantees in the aggregate amount of $5 million
to secure the obligations of NEV to counterparties to energy purchase and
sale agreements.
-UniSource Energy also issued a $1 million guarantee to secure the
obligations of NEV under its Agreement for Services with LG&E Energy
Marketing, Inc.
As a result of these loans and guarantees, the remaining commitment amount
available was $7 million at April 30, 1998.
UniSource Energy is the guarantor of $16.65 million of performance
bonds that secure the amounts NEV California owes to the California utility
distribution companies (UDCs) for services provided by the UDCs in
connection with NEV California's sales in the California retail electric
market. NEV California bills its customers for these UDC charges.
IMPACT OF YEAR 2000 ON COMPUTER SYSTEMS AND APPLICATIONS
- --------------------------------------------------------
The Company continues to review, test and make modifications to its
computer systems and applications to ensure that its generation,
transmission and distribution facilities will provide uninterrupted service
and that year 2000 transactions can be processed. We are reviewing our
information systems, the control and embedded systems of TEP's utility plant
(including the units that TEP owns part of but does not operate), as well as
whether major vendors are addressing the problem. The Company has
identified the major vendors from whom we purchase products or services. We
are contacting those vendors to determine their plans to correct any
problems they may face with year 2000 compliance and investigate any
potential impact on TEP. TEP and other electric service providers in the
WSCC are evaluating potential year 2000 risks resulting from interconnected
electric and informational systems.
At this time we believe that all identified modifications to systems
which the Company operates will be made within the required time frames.
We currently estimate that the year 2000 project costs are not material to
the Company's operating results. We cannot assure the year 2000 compliance
status of systems or parties that the Company does not control. We cannot
assess the effect on the Company of non-compliance by systems or parties
that the Company does not control.
SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS
- ------------------------------------------
This Quarterly Report on Form 10-Q contains forward-looking statements
as defined by the Private Securities Litigation Reform Act of 1995.
UniSource Energy and TEP include the following cautionary statements to take
advantage of the safe harbor provisions of the Private Securities Litigation
Reform Act of 1995 for any forward-looking statements made by, or for,
UniSource Energy or TEP in this Quarterly Report on Form 10-Q. Forward-
looking statements include statements concerning plans, objectives, goals,
strategies, future events or performance and underlying assumptions. They
include statements which are not statements of historical fact. Such
forward-looking statements may be identified by the use of words such as
"anticipates," "estimates," "expects," "intends," "plans," "predicts,"
"projects," and similar expressions. UniSource Energy and TEP may
occasionally publish or make available forward-looking statements of this
nature. These cautionary statements and any other cautionary statements
which may accompany the forward-looking statements expressly qualify all
such forward-looking statements, whether written or oral, and whether made
by or for UniSource Energy or TEP. In addition, UniSource Energy and TEP
disclaim any obligation to update any forward-looking statements to reflect
events or circumstances after the date we make forward-looking statements.
Forward-looking statements involve risks and uncertainties which could
cause actual results or outcomes to differ materially from those we express
in the forward-looking statements. We express in good faith the
expectations, beliefs and projections contained in this document. We
believe we have a reasonable basis to make such statements based on our
examination of historical operating trends, data contained in our records
and other data available from third parties. However, we cannot assure that
we will achieve our expectations, beliefs or projections. In addition to
other factors and matters discussed in this document, we believe some of the
important factors that could cause actual results to differ materially from
those we discuss in the forward-looking statements include the following:
1. Effects of restructuring initiatives in the electric industry and other
energy-related industries.
2. Changes in economic conditions, demographic patterns and weather
conditions in TEP's retail service area.
3. Changes affecting TEP's cost of providing electrical service including
changes in fuel costs, generating unit operating performance, interest
rates, tax laws, environmental laws, and the general rate of inflation.
4. Changes in governmental policies and regulatory actions with respect to
allowed rates of return, financings, rate structures, and methods of
establishing rates.
5. Changes affecting the cost of competing energy alternatives, including
changes in available generating technologies and changes in the cost of
natural gas.
6. Changes in accounting principles or the application of such principles to
UniSource Energy, TEP, or any subsidiary.
PART II - OTHER INFORMATION
ITEM 1. -- LEGAL PROCEEDINGS
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TAX ASSESSMENTS
See Note 2 of Notes to Condensed Consolidated Financial Statements, Tax
Assessments.
ITEM 5. - OTHER INFORMATION
- ------------------------------------------------------------------------------
ADDITIONAL FINANCIAL DATA
The following table reflects the ratio of earnings to fixed charges for TEP:
12 Months Ended
----------------
March 31, December 31,
1998 1997
---- ----
Ratio of Earnings to Fixed 1.41 1.39
Charges
ITEM 6. -- EXHIBITS AND REPORTS ON FORM 8-K
- ------------------------------------------------------------------------------
(a) Exhibits.
-- See Exhibit Index.
(b) Reports on Form 8-K.
-- The Company and TEP have not filed any Current Reports on Form 8-K
since filing the Form 10-K for 1997.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
each registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized. The signature for each
undersigned company shall be deemed to relate only to matters having
reference to such company or its subsidiary.
UNISOURCE ENERGY CORPORATION
-----------------------------
(Registrant)
Date: May 13, 1998 Ira R. Adler
----------------------------------
Ira R. Adler
Senior Vice President and
Principal Financial Officer
TUCSON ELECTRIC POWER COMPANY
-----------------------------
(Registrant)
Date: May 13, 1998 Ira R. Adler
----------------------------------
Ira R. Adler
Executive Vice President and
Principal Financial Officer
EXHIBIT INDEX
4a - Loan Agreement, dated as of March 1, 1998, between The Industrial
Development Authority of the County of Apache and TEP relating to
Pollution Control Revenue Bonds, 1998 Series A (Tucson Electric
Power Company Project).
4b - Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and First
Trust of New York, National Association, authorizing Pollution
Control Revenue Bonds, 1998 Series A (Tucson Electric Power Company
Project).
4c - Loan Agreement, dated as of March 1, 1998, between The Industrial
Development Authority of the County of Apache and TEP relating to
Pollution Control Revenue Bonds, 1998 Series B (Tucson Electric
Power Company Project).
4d - Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and First
Trust of New York, National Association, authorizing Pollution
Control Revenue Bonds, 1998 Series B (Tucson Electric Power Company
Project).
4e - Loan Agreement, dated as of March 1, 1998, between The Industrial
Development Authority of the County of Apache and TEP relating to
Industrial Development Revenue Bonds, 1998 Series C (Tucson
Electric Power Company Project).
4f - Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and First
Trust of New York, National Association, authorizing Industrial
Development Revenue Bonds, 1998 Series C (Tucson Electric Power
Company Project).
11 - Statement re computation of per share earnings - UniSource Energy.
12 - Computation of Ratio of Earnings to Fixed Charges - TEP.
15a - Letter regarding unaudited interim financial information (Price
Waterhouse LLP).
15b - Letter regarding unaudited interim financial information
(Deloitte &Touche LLP).
27a - Financial Data Schedule - UniSource Energy.
27b - Financial Data Schedule - TEP.