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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For The Quarterly Period Ended September 30, 2004
OR
[ ] 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)
One South Church Avenue, Suite 100
Tucson, AZ 85701
(520) 571-4000
1-5924 TUCSON ELECTRIC POWER COMPANY 86-0062700
(An Arizona Corporation)
One South Church Avenue, Suite 100
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
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
UniSource Energy Corporation Yes X No
--- ---
Tucson Electric Power Company Yes No X
--- ---
At November 3, 2004, 34,273,859 shares of UniSource Energy Corporation's
Common Stock, no par value (the only class of Common Stock), were outstanding.
At November 3, 2004, 32,139,555 shares of Tucson Electric Power Company's
common stock, no par value, were outstanding, of which 32,139,434 were held by
UniSource Energy Corporation.
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This combined Form 10-Q is separately filed by UniSource Energy Corporation and
Tucson Electric Power Company. Information contained in this document 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 Registered Public Accounting Firm........................1
PART I - FINANCIAL INFORMATION
Item 1. - Financial Statements
UniSource Energy Corporation
Comparative Condensed Consolidated Statements of Income....................2
Comparative Condensed Consolidated Statements of Cash Flows................3
Comparative Condensed Consolidated Balance Sheets..........................4
Condensed Consolidated Statement of Changes in Stockholders' Equity........5
Tucson Electric Power Company
Comparative Condensed Consolidated Statements of Income....................6
Comparative Condensed Consolidated Statements of Cash Flows................7
Comparative Condensed Consolidated Balance Sheets..........................8
Condensed Consolidated Statement of Changes in Stockholders' Equity........9
Notes to Condensed Consolidated Financial Statements
Note 1. Nature of Operations, Basis of Accounting Presentation and
Equity-Based Compensation........................................10
Note 2. Proposed Acquisition of UniSource Energy...........................14
Note 3. Regulatory Matters.................................................15
Note 4. TEP Credit Facility and Debt Redemption............................16
Note 5. Accounting Change: Accounting for Asset Retirement Obligations....17
Note 6. Accounting for Derivative Instruments and Trading Activities.......17
Note 7. Business Segments..................................................19
Note 8. Millennium ........................................................21
Note 9. Commitments and Contingencies......................................23
Note 10. TEP Wholesale Accounts Receivable and Allowances...................26
Note 11. UniSource Energy Earnings per Share (EPS)..........................26
Note 12. Employee Benefits Plans............................................27
Note 13. Equity-Based Compensation Plans....................................28
Note 14. Income and Other Taxes.............................................30
Note 15. New Accounting Pronouncements......................................31
Note 16. Supplemental Cash Flow Information.................................33
Note 17. Review by Independent Registered Public Accounting Firm............34
Item 2. - Management's Discussion and Analysis of Financial Condition
and Results of Operations
Overview of Consolidated Business...........................................35
UniSource Energy Consolidated
Results of Operations.....................................................37
ii
TABLE OF CONTENTS
(concluded)
Contribution by Business Segment............................................39
Liquidity and Capital Resources...........................................40
Tucson Electric Power Company
Results of Operations.....................................................42
Factors Affecting Results of Operations...................................47
Liquidity and Capital Resources...........................................49
UniSource Energy Services
Results of Operations.....................................................52
Factors Affecting Results of Operations...................................53
Liquidity and Capital Resources...........................................54
Millennium Energy Holdings, Inc.
Results of Operations.....................................................55
Liquidity and Capital Resources...........................................56
Critical Accounting Policies................................................57
New Accounting Pronouncements...............................................63
Safe Harbor for Forward-Looking Statements..................................64
Item 3. - Quantitative and Qualitative Disclosures about Market Risk..........65
Item 4. - Controls and Procedures.............................................68
PART II - OTHER INFORMATION
Item 1. - Legal Proceedings...................................................68
Item 5. - Other Information
Additional Financial Data...................................................70
Non-GAAP Measures...........................................................70
SEC Reports Available on UniSource Energy's Website.........................73
Item 6. - Exhibits............................................................73
Signatures....................................................................74
Exhibit Index.................................................................75
iii
DEFINITIONS
The abbreviations and acronyms used in the 2004 Third Quarter 10-Q are defined
below:
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ACC............................ Arizona Corporation Commission.
ACC Holding Company Order...... The order approved by the ACC in November 1997 allowing TEP to form a holding
company.
AHMSA.......................... Altos Hornos de Mexico, S.A. de C.V. AHMSA owns 50% of Sabinas.
AMT............................ Alternative Minimum Tax.
Capacity....................... The ability to produce power; the most power a unit can produce or
maximum that can be taken under a contract; measured in MWs.
CISO........................... California Independent System Operator.
Citizens....................... Citizens Communications Company.
Citizens Settlement Agreement.. An agreement with the ACC Staff dated April 1, 2003, addressing rate case and
financing issues in the acquisition by UniSource Energy of the Citizens'
Arizona gas and electric assets.
Common Stock................... UniSource Energy's common stock, without par value.
Company or UniSource Energy.... UniSource Energy Corporation.
Cooling Degree Days............ An index used to measure the impact of weather on energy usage calculated by
subtracting 75 from the average of the high and low daily temperatures.
CPX............................ California Power Exchange.
Credit Agreement............... Credit Agreement between TEP and a syndicate of lenders, dated as of March 25,
2004.
Emissions Allowance(s)......... An allowance issued by the Environmental Protection Agency which permits
emission of one ton of sulfur dioxide or one ton of nitrogen oxide. These
allowances can be bought and sold.
Energy......................... For electricity, the amount of instantaneous power produced over a given period
of time, measured in MWh. For natural gas, the high heat value content of the
amount of fuel delivered over a given period of time, measured in therms.
FAS 71......................... Statement of Financial Accounting Standards No. 71: Accounting for the Effects
of Certain Types of Regulation.
FAS 132........................ Statement of Financial Accounting Standards No. 132: Employers' Disclosures
about Pensions and Other Postretirement Benefits.
FAS 133........................ Statement of Financial Accounting Standards No. 133: Accounting for Derivative
Instruments and Hedging Activities.
FAS 143........................ Statement of Financial Accounting Standards No. 143: Accounting for Asset
Retirement Obligations.
FAS 149........................ Statement of Financial Accounting Standards No. 149: Amendment of Statement 133
on Derivative Instruments and Hedging Activities.
FERC........................... Federal Energy Regulatory Commission.
First Collateral Trust Bonds... Bonds issued under the Indenture of Trust, dated as of August 1, 1998, of TEP to
the Bank of New York, successor trustee.
First Mortgage Bonds........... First mortgage bonds issued under the Indenture dated as of April 1, 1941, of
TEP to JPMorgan Chase Bank, successor trustee, as supplemented and amended.
Four Corners................... Four Corners Generating Station.
GAAP........................... Generally Accepted Accounting Principles.
Global Solar................... Global Solar Energy, Inc., a company that develops and manufactures thin-film
photovoltaic cells and modules. Millennium owns 99% of Global Solar.
Haddington..................... Haddington Energy Partners II, LP, a limited partnership that funds energy-
related investments
iv
Heating Degree Days............ An index used to measure the impact of weather on energy usage calculated by
subtracting the average of the high and low daily temperatures from 65.
IDBs........................... Industrial development revenue or pollution control revenue bonds.
IPS............................ Infinite Power Solutions, Inc., a company that develops thin-film batteries.
Millennium owns 72% of IPS.
IRS............................ Internal Revenue Service.
ITN............................ ITN Energy Systems, Inc. was formed to provide research, development, and
other services. Millennium exchanged its ownership of ITN for increased
ownership of Global Solar and currently owns no interest in ITN.
ITC............................ Investment tax credit.
kWh............................ Kilowatt-hour(s).
kV............................. Kilovolt(s).
LIBOR.......................... London Interbank Offered Rate.
MEG............................ Millennium Environmental Group, Inc., a wholly-owned subsidiary of Millennium,
which manages and trades emission allowances, coal, and related financial
instruments.
MicroSat....................... MicroSat Systems, Inc. is a company formed to develop and commercialize
small-scale satellites. Millennium currently owns 35%.
Millennium..................... Millennium Energy Holdings, Inc., a wholly-owned subsidiary of UniSource
Energy.
Mimosa......................... Minerales de Monclova, S.A. de C.V., an owner of coal and associated gas
reserves and a supplier of metallurgical coal to the steel industry and thermal
coal to the Mexican electricity commission. Sabinas owns 19.5% of Mimosa.
MMBtus......................... Million British Thermal Units.
MW............................. Megawatt(s).
MWh............................ Megawatt-hour(s).
Navajo......................... Navajo Generating Station.
NOL............................ Net Operating Loss carryback or carryforward for income tax purposes.
PGA............................ Purchased Gas Adjustor, a retail rate mechanism designed to recover the cost
of gas purchased for retail gas customers.
PNM............................ Public Service Company of New Mexico.
Powertrusion................... POWERTRUSION International, Inc., a company owned 77% by Millennium, which
manufactures lightweight utility poles.
PPFAC.......................... Purchased Power and Fuel Adjustor Clause.
PWCC........................... Pinnacle West Capital Corporation.
Revolving Credit Facility...... $60 million revolving credit facility entered into under the Credit Agreement
between a syndicate of banks and TEP.
RTO............................ Regional Transmission Organization.
Rules.......................... Retail Electric Competition Rules.
Sabinas........................ Carboelectrica Sabinas, S. de R.L. de C.V., a Mexican limited liability company.
Millennium owns 50% of Sabinas.
Saguaro Utility................ An Arizona limited partnership, whose general partner is Sage Mountain,
L.L.C. and whose limited partners include investment funds affiliated with
Kohlberg Kravis Roberts & Co., L.P., J.P. Morgan Partners, L.L.C. and Wachovia
Capital Partners.
San Juan....................... San Juan Generating Station.
Second Mortgage Bonds.......... TEP's second mortgage bonds issued under the Indenture of Mortgage and Deed of
Trust, dated as of December 1, 1992, of TEP to the Bank of New York, successor
trustee, as supplemented.
SCE............................ Southern California Edison Company.
SES............................ Southwest Energy Solutions, Inc., a wholly-owned subsidiary of Millennium.
v
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 Unit 1 and Unit 2.
Springerville Common
Facilities Leases............ Leveraged lease arrangements relating to an undivided one-half interest in
certain Springerville Common Facilities.
Springerville Unit 1........... Unit 1 of the Springerville Generating Station.
Springerville Unit 1 Lease..... Leveraged lease arrangement relating to Springerville Unit 1 and an undivided
one-half interest in certain Springerville Common Facilities.
Springerville Unit 2........... Unit 2 of the Springerville Generating Station.
Sundt Generating Station....... H. Wilson Sundt Generating Station (formerly known as the Irvington
Generating Station).
TEP............................ Tucson Electric Power Company, the principal subsidiary of UniSource Energy.
TEP Settlement Agreement....... TEP's Settlement Agreement approved by the ACC in November 1999 that
provided for electric retail competition and transition asset recovery.
Therm.......................... A unit of heating value equivalent to 100,000 British thermal units (Btu).
TruePricing.................... TruePricing, Inc., a start-up company established to market energy related
products.
UED............................ UniSource Energy Development Company, a wholly-owned subsidiary of
UniSource Energy, which engages in developing generation resources and
other project development services and related activities.
UES............................ UniSource Energy Services, Inc., an intermediate holding company established
to own the operating companies (UNS Gas and UNS Electric) which acquired
the Citizens Arizona gas and electric utility assets.
UniSource Energy............... UniSource Energy Corporation.
UNS Electric................... UNS Electric, Inc., a wholly-owned subsidiary of UES, which acquired the
Citizens Arizona electric utility assets.
UNS Gas........................ UNS Gas, Inc., a wholly-owned subsidiary of UES, which acquired the
Citizens Arizona gas utility assets.
vi
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
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 sheets of
UniSource Energy Corporation and its subsidiaries (the Company) and Tucson
Electric Power Company and its subsidiaries (TEP) as of September 30, 2004, and
the related condensed consolidated statements of income for each of the
three-month and nine-month periods ended September 30, 2004 and 2003 and the
condensed consolidated statement of cash flows for the nine-month periods ended
September 30, 2004 and 2003 and the condensed consolidated statement of changes
in stockholders' equity for the nine-month period ended September 30, 2004.
These interim financial statements are the responsibility of the Company's
management.
We conducted our review in accordance with the standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board, 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 reviews, we are not aware of any material modifications that should
be made to the accompanying condensed consolidated interim financial statements
for them to be in conformity with accounting principles generally accepted in
the United States of America.
As discussed in Note 1 to the condensed consolidated interim financial
statements, the Company and TEP have restated their financial statements for
unbilled revenues as of September 30, 2003 and for the three-month and
nine-month periods ended September 30, 2003.
We previously audited in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheet of
the Company and TEP as of December 31, 2003, and the related consolidated
statements of capitalization, of income, of changes in stockholders' equity, and
of cash flows for the year then ended (not presented herein), and in our report
dated February 20, 2004, except as to the restatement of unbilled revenue
described in Note 22, as to which the date is August 19, 2004, 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, 2003, is fairly stated in all material respects in
relation to the consolidated balance sheet from which it has been derived.
PricewaterhouseCoopers LLP
Los Angeles, California
November 8, 2004
1
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
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UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 RESTATED 2004 2003 RESTATED
(SEE NOTE 1) (SEE NOTE 1)
(UNAUDITED) (UNAUDITED)
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- -Thousands of Dollars- -Thousands of Dollars-
OPERATING REVENUES
$277,089 $254,680 Electric Retail Sales $675,508 $561,052
37,310 32,612 Electric Wholesale Sales 121,199 108,056
15,812 10,215 Gas Revenue 84,825 10,215
5,098 6,745 Other Revenues 13,942 13,249
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335,309 304,252 TOTAL OPERATING REVENUES 895,474 692,572
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OPERATING EXPENSES
63,514 64,247 Fuel 166,303 162,512
69,749 46,282 Purchased Energy 184,838 79,839
58,332 49,649 Other Operations and Maintenance 178,320 151,295
36,372 34,032 Depreciation and Amortization 108,068 95,472
19,112 13,647 Amortization of Transition Recovery Asset 39,712 25,266
12,769 12,676 Taxes Other Than Income Taxes 38,491 35,419
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259,848 220,533 TOTAL OPERATING EXPENSES 715,732 549,803
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75,461 83,719 OPERATING INCOME 179,742 142,769
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OTHER INCOME (DEDUCTIONS)
5,006 5,090 Interest Income 14,888 15,380
2,064 1,358 Other Income 12,724 4,152
(1,032) (950) Other Expense (6,353) (3,952)
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6,038 5,498 TOTAL OTHER INCOME (DEDUCTIONS) 21,259 15,580
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INTEREST EXPENSE
19,753 20,532 Long-Term Debt 62,903 58,917
20,792 21,257 Interest on Capital Leases 60,901 62,791
56 603 Other Interest Expense, Net of Amounts Capitalized (487) 903
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40,601 42,392 TOTAL INTEREST EXPENSE 123,317 122,611
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INCOME BEFORE INCOME TAXES AND
40,898 46,825 CUMULATIVE EFFECT OF ACCOUNTING CHANGE 77,684 35,738
17,099 19,449 Income Tax Expense 34,663 16,567
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23,799 27,376 INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 43,021 19,171
- - CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - 67,471
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$ 23,799 $ 27,376 NET INCOME $ 43,021 $ 86,642
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34,464 33,838 WEIGHTED-AVERAGE SHARES OF COMMON STOCK OUTSTANDING (000) 34,347 33,799
==========================================================================================================
BASIC EARNINGS PER SHARE
$0.69 $0.81 INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE $1.25 $0.56
- - CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - 2.00
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$0.69 $0.81 NET INCOME $1.25 $2.56
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DILUTED EARNINGS PER SHARE
$0.68 $0.80 INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE $1.23 $0.56
- - CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - 1.97
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$0.68 $0.80 NET INCOME $1.23 $2.53
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$ - $0.15 DIVIDENDS PAID PER SHARE $0.32 $0.45
==========================================================================================================
See Notes to Condensed Consolidated Financial Statements.
2
UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended
September 30,
2004 2003
(UNAUDITED)
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-Thousands of Dollars-
CASH FLOWS FROM OPERATING ACTIVITIES
Cash Receipts from Electric Retail Sales $ 701,075 $ 583,994
Cash Receipts from Electric Wholesale Sales 159,993 155,539
Cash Receipts from Gas Sales 108,414 10,634
MEG Cash Receipts from Trading Activity 125,435 64,282
Interest Received 22,178 22,248
Income Tax Refunds Received 5,427 -
Performance Deposits 4,954 (4,429)
Deposit - Second Mortgage Indenture 17,040 -
Other Cash Receipts 5,529 5,033
Fuel Costs Paid (158,976) (158,327)
Purchased Energy Costs Paid (213,009) (123,947)
Wages Paid, Net of Amounts Capitalized (68,880) (58,769)
Payment of Other Operations and Maintenance Costs (95,482) (81,532)
MEG Cash Payments for Trading Activity (125,293) (62,548)
Capital Lease Interest Paid (69,968) (74,142)
Taxes Paid, Net of Amounts Capitalized (93,613) (70,071)
Interest Paid, Net of Amounts Capitalized (68,169) (62,301)
Income Taxes Paid (9,452) (4,616)
Other 2,118 (4,946)
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NET CASH FLOWS - OPERATING ACTIVITIES 249,321 136,102
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CASH FLOWS FROM INVESTING ACTIVITIES
Capital Expenditures (108,197) (101,389)
Purchase of Citizens Assets - (228,910)
Investment in and Loans to Equity Investees (3,395) (1,661)
Return of Investment from Millennium Energy Businesses 9,916 -
Proceeds from Investment in Springerville Lease Debt and Equity 11,590 12,078
Payments for Investment in Springerville Lease Debt (4,499) -
Other 994 (1,467)
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NET CASH FLOWS - INVESTING ACTIVITIES (93,591) (321,349)
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CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from Borrowings under Revolving Credit Facility 20,000 45,000
Payments on Borrowings under the Revolving Credit Facility (20,000) (25,000)
Proceeds from Issuance of Short-Term Debt - 35,850
Repayments of Short-Term Debt - (960)
Proceeds from Issuance of Long-Term Debt - 160,000
Repayments of Long-Term Debt (28,732) (1,826)
Payment of Debt Issue Costs (9,241) (2,027)
Payments on Capital Lease Obligations (49,377) (42,444)
Common Stock Dividends Paid (10,909) (15,139)
Other 9,554 3,388
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NET CASH FLOWS - FINANCING ACTIVITIES (88,705) 156,842
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Net Increase (Decrease) in Cash and Cash Equivalents 67,025 (28,405)
Cash and Cash Equivalents, Beginning of Year 101,266 90,928
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CASH AND CASH EQUIVALENTS, END OF PERIOD $ 168,291 $ 62,523
===============================================================================================
See Note 16 for supplemental cash flow information.
See Notes to Condensed Consolidated Financial Statements.
3
UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2004 2003 RESTATED
(UNAUDITED) (SEE NOTE 1)
- -----------------------------------------------------------------------------------------------------
ASSETS - Thousands of Dollars -
UTILITY PLANT
Plant in Service $ 2,997,807 $ 2,899,305
Utility Plant under Capital Leases 748,239 748,239
Construction Work in Progress 105,796 105,804
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TOTAL UTILITY PLANT 3,851,842 3,753,348
Less Accumulated Depreciation and Amortization (1,337,167) (1,262,962)
Less Accumulated Amortization of Capital Lease Assets (443,081) (421,171)
- -----------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT - NET 2,071,594 2,069,215
- -----------------------------------------------------------------------------------------------------
INVESTMENTS AND OTHER PROPERTY
Investments in Lease Debt and Equity 170,997 178,789
Other 85,789 109,570
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TOTAL INVESTMENTS AND OTHER PROPERTY 256,786 288,359
- -----------------------------------------------------------------------------------------------------
CURRENT ASSETS
Cash and Cash Equivalents 168,291 101,266
Trade Accounts Receivable 120,093 97,904
Unbilled Accounts Receivable 50,893 53,590
Allowance for Doubtful Accounts (16,526) (11,522)
Materials and Fuel Inventory 63,752 58,299
Trading Assets 87,713 21,507
Current Regulatory Assets 9,766 12,129
Deferred Income Taxes - Current 16,014 15,925
Interest Receivable - Current 5,479 11,561
Other 21,846 21,117
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TOTAL CURRENT ASSETS 527,321 381,776
- -----------------------------------------------------------------------------------------------------
REGULATORY AND OTHER ASSETS
Transition Recovery Asset 234,470 274,182
Income Taxes Recoverable Through Future Revenues 45,930 49,849
Other Regulatory Assets 13,613 12,327
Other Assets 55,111 46,594
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TOTAL REGULATORY AND OTHER ASSETS 349,124 382,952
- -----------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 3,204,825 $ 3,122,302
=====================================================================================================
CAPITALIZATION AND OTHER LIABILITIES
CAPITALIZATION
Common Stock Equity $ 593,590 $ 556,472
Capital Lease Obligations 720,197 762,968
Long-Term Debt 1,257,595 1,286,320
- -----------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION 2,571,382 2,605,760
- -----------------------------------------------------------------------------------------------------
CURRENT LIABILITIES
Current Obligations under Capital Leases 54,918 50,269
Current Maturities of Long-Term Debt 1,725 1,742
Accounts Payable 78,474 65,745
Interest Accrued 31,096 62,927
Trading Liabilities 86,627 18,753
Taxes Accrued 84,163 50,625
Accrued Employee Expenses 16,643 16,081
Other 26,189 15,839
- -----------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 379,835 281,981
- -----------------------------------------------------------------------------------------------------
DEFERRED CREDITS AND OTHER LIABILITIES
Deferred Income Taxes - Noncurrent 98,980 96,270
Regulatory Liability - Net Cost of Removal for Interim Retirements 67,381 60,998
Other 87,247 77,293
- -----------------------------------------------------------------------------------------------------
TOTAL DEFERRED CREDITS AND OTHER LIABILITIES 253,608 234,561
- -----------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES (NOTE 9)
- -----------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION AND OTHER LIABILITIES $ 3,204,825 $ 3,122,302
=====================================================================================================
See Notes to Condensed Consolidated Financial Statements.
4
UNISOURCE ENERGY CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Accumulated
Common Accumulated Other Total
Shares Common Earnings Comprehensive Stockholders'
Outstanding* Stock (Deficit) Income (Loss) Equity
- --------------------------------------------------------------------------------------------------------------------------------
(UNAUDITED)
- Thousands of Dollars-
BALANCES AT DECEMBER 31, 2003 RESTATED (SEE NOTE 1) 33,788 $ 668,022 $ (109,706) $ (1,844) $ 556,472
- ------------------------------------------------------------------------------------------------------------------------------
Comprehensive Income:
2004 Year-to-Date Net Income - - 43,021 - 43,021
Unrealized Gain on Cash Flow Hedges
(net of $1,307 income tax expense) - - - 1,994 1,994
Reclassification of Realized Loss on
Cash Flow Hedges to Net Income
(net of $53 income tax benefit) - - - 80 80
----------
Total Comprehensive Income 45,095
----------
Dividends Declared - - (16,392) - (16,392)
Shares Issued under Stock Compensation Plans 64 1,307 - - 1,307
Shares Distributed by Deferred Compensation Trust 1 16 - - 16
Shares Issued for Stock Options 372 7,032 - - 7,032
Other - 60 - - 60
- ------------------------------------------------------------------------------------------------------------------------------
BALANCES AT SEPTEMBER 30, 2004 34,225 $ 676,437 $ (83,077) $ 230 $ 593,590
==============================================================================================================================
* UniSource Energy has 75 million authorized shares of common stock.
See Notes to Condensed Consolidated Financial Statements.
5
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 RESTATED 2004 2003 RESTATED
(SEE NOTE 1) (SEE NOTE 1)
(UNAUDITED) (UNAUDITED)
- ----------------------------------------------------------------------------------------------------------
- -Thousands of Dollars- -Thousands of Dollars-
OPERATING REVENUES
$232,304 $231,055 Electric Retail Sales $564,388 $537,427
37,248 32,581 Electric Wholesale Sales 121,018 108,025
2,533 2,235 Other Revenues 7,395 6,734
- ----------------------------------------------------------------------------------------------------------
272,085 265,871 TOTAL OPERATING REVENUES 692,801 652,186
- ----------------------------------------------------------------------------------------------------------
OPERATING EXPENSES
63,514 64,247 Fuel 166,303 162,512
29,529 22,962 Purchased Power 54,868 56,516
43,319 36,676 Other Operations and Maintenance 133,724 122,757
31,597 30,592 Depreciation and Amortization 94,035 89,976
19,112 13,647 Amortization of Transition Recovery Asset 39,712 25,266
10,483 10,732 Taxes Other Than Income Taxes 31,671 32,678
- ----------------------------------------------------------------------------------------------------------
197,554 178,856 TOTAL OPERATING EXPENSES 520,313 489,705
- ----------------------------------------------------------------------------------------------------------
74,531 87,015 OPERATING INCOME 172,488 162,481
- ----------------------------------------------------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
4,965 5,055 Interest Income 14,826 15,259
2,345 2,581 Interest Income - Note Receivable from UniSource Energy 6,984 7,660
1,137 590 Other Income 3,531 1,717
(826) (255) Other Expense (2,726) (794)
- ----------------------------------------------------------------------------------------------------------
7,621 7,971 TOTAL OTHER INCOME (DEDUCTIONS) 22,615 23,842
- ----------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
16,977 18,999 Long-Term Debt 54,615 57,384
20,787 21,254 Interest on Capital Leases 60,873 62,781
(38) 144 Other Interest Expense, Net of Amounts Capitalized (537) 211
- ----------------------------------------------------------------------------------------------------------
37,726 40,397 TOTAL INTEREST EXPENSE 114,951 120,376
- ----------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES AND
44,426 54,589 CUMULATIVE EFFECT OF ACCOUNTING CHANGE 80,152 65,947
18,204 22,395 Income Tax Expense 35,119 28,342
- ----------------------------------------------------------------------------------------------------------
26,222 32,194 INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 45,033 37,605
- - CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - 67,471
- ----------------------------------------------------------------------------------------------------------
$ 26,222 $ 32,194 NET INCOME $ 45,033 $105,076
==========================================================================================================
See Notes to Condensed Consolidated Financial Statements.
6
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended
September 30,
2004 2003
(UNAUDITED)
- -----------------------------------------------------------------------------------------------
-Thousands of Dollars-
CASH FLOWS FROM OPERATING ACTIVITIES
Cash Receipts from Electric Retail Sales $ 586,480 $ 560,668
Cash Receipts from Electric Wholesale Sales 159,793 155,505
Interest Received 21,621 22,004
Deposit - Second Mortgage Indenture 17,040 -
Fuel Costs Paid (158,976) (158,327)
Purchased Power Costs Paid (84,131) (92,762)
Wages Paid, Net of Amounts Capitalized (50,646) (46,101)
Payment of Other Operations and Maintenance Costs (74,323) (70,492)
Capital Lease Interest Paid (69,964) (74,131)
Taxes Paid, Net of Amounts Capitalized (65,553) (66,081)
Interest Paid, Net of Amounts Capitalized (57,737) (62,095)
Income Taxes Refunds Received 286 -
Income Taxes Paid (10,002) (3,718)
Other 1,798 155
- -----------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES 215,686 164,625
- -----------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital Expenditures (81,544) (97,105)
Proceeds from Investment in Springerville Lease Debt and Equity 11,590 12,078
Payments for Investment in Springerville Lease Debt (4,499) -
Other - (1,902)
- -----------------------------------------------------------------------------------------------
NET CASH FLOWS - INVESTING ACTIVITIES (74,453) (86,929)
- -----------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from Borrowings under Revolving Credit Facility 20,000 45,000
Payments on Revolving Credit Facility (20,000) (25,000)
Repayments of Long-Term Debt (28,725) (1,725)
Payments on Capital Lease Obligations (49,333) (42,379)
Payment of Debt Issue Costs (8,865) (606)
Dividend Paid to UniSource Energy (19,000) (58,500)
Other 7,084 (16,359)
- -----------------------------------------------------------------------------------------------
NET CASH FLOWS - FINANCING ACTIVITIES (98,839) (99,569)
- -----------------------------------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents 42,394 (21,873)
Cash and Cash Equivalents, Beginning of Year 65,262 55,778
- -----------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $107,656 $ 33,905
===============================================================================================
See Note 16 for supplemental cash flow information.
See Notes to Condensed Consolidated Financial Statements.
7
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2004 2003 RESTATED
(UNAUDITED) (SEE NOTE 1)
- -----------------------------------------------------------------------------------------------------
ASSETS - Thousands of Dollars -
UTILITY PLANT
Plant in Service $ 2,750,206 $ 2,681,133
Utility Plant under Capital Leases 747,533 747,533
Construction Work in Progress 81,621 82,210
- -----------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT 3,579,360 3,510,876
Less Accumulated Depreciation and Amortization (1,320,816) (1,257,585)
Less Accumulated Amortization of Capital Lease Assets (442,977) (421,135)
- -----------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT - NET 1,815,567 1,832,156
- -----------------------------------------------------------------------------------------------------
INVESTMENTS AND OTHER PROPERTY
Investments in Lease Debt and Equity 170,997 178,789
Other 24,021 41,285
- -----------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS AND OTHER PROPERTY 195,018 220,074
- -----------------------------------------------------------------------------------------------------
NOTE RECEIVABLE FROM UNISOURCE ENERGY 77,117 70,132
- -----------------------------------------------------------------------------------------------------
CURRENT ASSETS
Cash and Cash Equivalents 107,656 65,262
Trade Accounts Receivable 86,000 70,415
Unbilled Accounts Receivable 38,584 31,104
Allowance for Doubtful Accounts (14,189) (11,034)
Intercompany Accounts Receivable 8,751 10,938
Materials and Fuel Inventory 53,366 50,107
Current Regulatory Assets 9,766 8,969
Deferred Income Taxes - Current 15,766 18,847
Interest Receivable - Current 5,479 11,561
Other 12,413 8,444
- -----------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 323,592 264,613
- -----------------------------------------------------------------------------------------------------
REGULATORY AND OTHER ASSETS
Transition Recovery Asset 234,470 274,182
Income Taxes Recoverable Through Future Revenues 45,930 49,849
Other Regulatory Assets 13,317 11,973
Other Assets 51,889 43,651
- -----------------------------------------------------------------------------------------------------
TOTAL REGULATORY AND OTHER ASSETS 345,606 379,655
- -----------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 2,756,900 $ 2,766,630
=====================================================================================================
CAPITALIZATION AND OTHER LIABILITIES
CAPITALIZATION
Common Stock Equity $ 436,689 $ 406,054
Capital Lease Obligations 719,651 762,323
Long-Term Debt 1,097,595 1,126,320
- -----------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION 2,253,935 2,294,697
- -----------------------------------------------------------------------------------------------------
CURRENT LIABILITIES
Current Obligations under Capital Leases 54,836 50,126
Current Maturities of Long-Term Debt 1,725 1,725
Accounts Payable 45,424 37,998
Intercompany Accounts Payable 8,629 8,413
Interest Accrued 29,533 58,620
Taxes Accrued 69,834 38,024
Accrued Employee Expenses 15,114 14,716
Other 10,052 8,063
- -----------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 235,147 217,685
- -----------------------------------------------------------------------------------------------------
DEFERRED CREDITS AND OTHER LIABILITIES
Deferred Income Taxes - Noncurrent 130,314 128,336
Regulatory Liability - Net Cost of Removal for Interim Retirements 65,665 60,417
Other 71,839 65,495
- -----------------------------------------------------------------------------------------------------
TOTAL DEFERRED CREDITS AND OTHER LIABILITIES 267,818 254,248
- -----------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES (NOTE 9)
- -----------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION AND OTHER LIABILITIES $ 2,756,900 $ 2,766,630
=====================================================================================================
See Notes to Condensed Consolidated Financial Statements.
8
TUCSON ELECTRIC POWER COMPANY
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Accumulated
Capital Accumulated Other Total
Common Stock Earnings Comprehensive Stockholders'
Stock Expense (Deficit) Income (Loss) Equity
- --------------------------------------------------------------------------------------------------------------------------------
(UNAUDITED)
- Thousands of Dollars -
BALANCES AT DECEMBER 31, 2003 RESTATED (SEE NOTE 1) $ 655,534 $ (6,357) $ (241,279) $ (1,844) $ 406,054
- ------------------------------------------------------------------------------------------------------------------------------
Comprehensive Income:
2004 Year-to-Date Net Income - - 45,033 - 45,033
Unrealized Gain on Cash Flow Hedges
(net of $1,307 income tax expense) - - - 1,994 1,994
Reclassification of Realized Loss on
Cash Flow Hedges to Net Income
(net of $53 income tax benefit) - - - 80 80
----------
Total Comprehensive Income 47,107
----------
Dividends Paid - - (19,000) - (19,000)
Capital Contribution from UniSource Energy 2,528 - - - 2,528
- ------------------------------------------------------------------------------------------------------------------------------
BALANCES AT SEPTEMBER 30, 2004 $ 658,062 $ (6,357) $ (215,246) $ 230 $ 436,689
==============================================================================================================================
See Notes to Condensed Consolidated Financial Statements.
9
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
NOTE 1. NATURE OF OPERATIONS, BASIS OF ACCOUNTING PRESENTATION AND EQUITY-BASED
COMPENSATION
------------------------------------------------------------------------
UniSource Energy Corporation (UniSource Energy) is an exempt holding
company under the Public Utility Holding Company Act of 1935. UniSource Energy
has no significant operations of its own. Operations are conducted by UniSource
Energy's subsidiaries, each of which is a separate legal entity with its own
assets and liabilities. UniSource Energy owns 99.9% of the common stock of
Tucson Electric Power Company (TEP) and all of the common stock of UniSource
Energy Services, Inc. (UES), Millennium Energy Holdings, Inc. (Millennium) and
UniSource Energy Development Company (UED).
TEP, a regulated public utility serving Tucson, Arizona for more than 100
years, is UniSource Energy's largest operating subsidiary and represented
approximately 84% of UniSource Energy's assets as of September 30, 2004. TEP
generates, transmits and distributes electricity. TEP serves approximately
373,000 retail electric customers in a 1,155 square mile area in Pima and
Cochise counties in Southern Arizona. TEP also sells electricity to other
utilities and power marketing entities primarily located in the western U.S.
On August 11, 2003, UniSource Energy completed the purchase of the Arizona
gas and electric system assets from Citizens Communications Company (Citizens)
and established two new operating companies, UNS Gas, Inc. (UNS Gas) and UNS
Electric, Inc. (UNS Electric), to acquire these assets, as well as an
intermediate holding company, UES, to hold the common stock of UNS Gas and UNS
Electric. UES has no significant operations of its own. The operating results of
UNS Gas, UNS Electric, and UES have been included in UniSource Energy's
consolidated financial statements since the acquisition date. UNS Electric
procures, transmits and distributes electricity to approximately 84,000 retail
electric customers in the Mohave county of Northern Arizona and the Santa Cruz
county of Southern Arizona. UNS Gas procures, transports and distributes natural
gas to approximately 130,000 customers in Mohave, Yavapai, Coconino, and Navajo
counties in Northern Arizona and Santa Cruz county in Southern Arizona.
Millennium's unregulated businesses are described in Note 8 and UED's
services are described in Note 7.
References to "we" and "our" are to UniSource Energy and its subsidiaries,
collectively.
The accompanying quarterly financial statements of UniSource Energy and TEP
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. These financial statements are presented in
accordance with the Securities and Exchange Commission's (SEC) interim reporting
requirements which do not include all the disclosures required by accounting
principles generally accepted in the United States of America (GAAP) for audited
annual financial statements. The year-end condensed balance sheet data was
derived from audited financial statements, but does not include disclosures
required by GAAP for audited annual financial statements. This quarterly report
should be read in conjunction with UniSource Energy and TEP's 2003 Combined
Annual Report on Form 10-K.
Weather, among other factors, causes seasonal fluctuations in TEP and UES'
sales; therefore, quarterly results are not indicative of annual operating
results. UniSource Energy and TEP have made minor reclassifications to the prior
year financial statements for comparative purposes. These reclassifications had
no effect on net income.
UNBILLED REVENUE ESTIMATION METHODOLOGY AT TEP
TEP and UES' retail revenues include an estimate of MWhs/therms delivered
but unbilled at the end of each period. Unbilled revenues are dependent upon a
number of factors that require judgment including estimates of retail sales and
customer usage patterns. The unbilled revenue is estimated by comparing the
actual MWhs/therms delivered to the MWhs/therms billed to TEP and UES retail
customers. The excess of MWhs/therms delivered over MWhs/therms billed is then
allocated to the retail customer classes based on estimated usage by each
customer class. TEP and UES then record revenue for each customer class based on
the various bill rates for each customer class. Due to the seasonal fluctuations
of TEP's actual load, the unbilled revenue amount increases during the spring
and summer months and decreases during the fall and winter months. The unbilled
revenue amount for UES gas sales increases during the fall and winter months and
decreases during the spring and summer months, whereas, the unbilled revenue
amount for UES electric sales increases during the spring and summer months and
decreases during the fall and winter months.
10
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
In May 2004, we determined that the kWh information used to estimate kWhs
delivered to TEP customers was generally understated. Additionally, we
determined that TEP's then existing method of pricing estimated unbilled kWh
sales quantities among customer classes weighted usage by lower-priced customers
too heavily and weighted usage by higher-priced customers too lightly. For TEP,
the price paid by customers varies from a low of 3.7 cents per kWh for
interruptible industrial load to a high of 13 cents per kWh for small commercial
customers, so that allocations among customer classes are a significant element
of unbilled revenues. Effective with the second quarter of 2004, we changed the
estimation methodology used to quantify unbilled kWh sales and price the
computed unbilled kWh sales quantities to more accurately reflect actual usage
and restated prior periods.
Under the revised estimation methodology, unbilled sales are estimated for
the month by reviewing the meter reading schedule and determining the number of
billed and unbilled kWhs for each cycle. Current month unbilled kWhs are
allocated by customer class. New unbilled revenue amounts are recorded and
unbilled revenue estimates from the prior month are reversed.
The Condensed Consolidated Statements of Income for the three months ended
and the nine months ended September 30, 2003 of UniSource Energy and TEP have
been restated to correct the understated revenues. The change in methodology and
correction of understated revenues resulted in the following revisions to the
consolidated financial statements:
CONSOLIDATED STATEMENTS OF INCOME
UNISOURCE ENERGY TEP
------------------------------------------------------------
AS AS
PREVIOUSLY AS PREVIOUSLY AS
THREE MONTHS ENDED SEPTEMBER 30, 2003 REPORTED RESTATED REPORTED RESTATED
- ------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Electric Retail Sales $ 253,391 $ 254,680 $ 229,735 $ 231,055
Operating Revenues 302,798 304,252 264,415 265,871
Amortization of Transition Recovery Asset 13,472 13,647 13,472 13,647
Total Operating Expenses 220,224 220,533 178,545 178,856
Operating Income 82,574 83,719 85,870 87,015
Income Before Income Taxes 45,680 46,825 53,444 54,589
Income Taxes 18,996 19,449 21,942 22,395
Net Income 26,684 27,376 31,502 32,194
Basic Earnings per Share:
Net Income $0.79 $0.81
Diluted Earnings per Share:
Net Income $0.78 $0.80
- ------------------------------------------------------------------------------------------------------------------
11
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
UNISOURCE ENERGY TEP
-----------------------------------------------------------
AS AS
PREVIOUSLY AS PREVIOUSLY AS
NINE MONTHS ENDED SEPTEMBER 30, 2003 REPORTED RESTATED REPORTED RESTATED
- ------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Electric Retail Sales $ 557,174 $ 561,052 $ 533,518 $ 537,427
Operating Revenues 688,672 692,572 648,285 652,186
Amortization of Transition Recovery Asset 24,842 25,266 24,842 25,266
Total Operating Expenses 549,386 549,803 489,289 489,705
Operating Income 139,286 142,769 158,996 162,481
Income Before Income Taxes and Cumulative
Effect of Accounting Change 32,253 35,738 62,462 65,947
Income Taxes 15,187 16,567 26,962 28,342
Income Before Cumulative Effect of
Accounting Change 17,066 19,171 35,500 37,605
Net Income 84,537 86,642 102,971 105,076
Basic Earnings per Share:
Income Before Cumulative Effect of
Accounting Change $0.50 $0.56
Net Income $2.50 $2.56
Diluted Earnings per Share:
Income Before Cumulative Effect of
Accounting Change $0.50 $0.56
Net Income $2.47 $2.53
- ------------------------------------------------------------------------------------------------------------------
CHANGE IN PLANT ASSET DEPRECIABLE LIVES - TEP
During the first quarter of 2004, TEP engaged an independent third party to
review the economic estimated useful lives of its owned generating assets in
Springerville, Arizona. TEP then hired a different independent third party to
perform a depreciation study for its generation assets, taking into
consideration the newly determined economic useful life for the Springerville
assets, and changes in generation plant life information used by the operators
and other participants of the joint power plants in which TEP participates. As a
result of these analyses, in July 2004, TEP lengthened the estimated useful
lives of various generation assets for periods ranging from 11 to 22 years.
Consequently, depreciation rates and the corresponding depreciation expense have
been revised prospectively to reflect the life extensions. These changes in
depreciation rates decreased depreciation expense by approximately $2 million
for both the three months and nine months ended September 30, 2004. The expected
annual impact of the changes in depreciation rates is a reduction of
depreciation expense of $9 million.
EQUITY-BASED COMPENSATION
UniSource Energy has two equity-based compensation plans, the 1994 Outside
Director Stock Option Plan (Directors' Plan) and the 1994 Omnibus Stock and
Incentive Plan (Omnibus Plan). See Note 13. We account for those plans under the
recognition and measurement principles of APB Opinion No. 25, Accounting for
Stock Issued to Employees (APB 25), as allowed by Statement of Financial
Accounting Standards No. 123, Accounting for Stock-Based Compensation (FAS 123).
Our stock options are granted with an exercise price equal to the market
value of the stock at the date of the grant. Accordingly, no compensation
expense is recorded for these awards. However, compensation expense is
recognized for restricted stock, stock unit and performance share awards over
the performance/vesting period.
The following table illustrates the effect on UniSource Energy's net income
and earnings per share and TEP's net income as if we had applied the fair value
recognition provisions of FAS 123 and recognized compensation expense for all
equity-based employee compensation awards:
12
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
UNISOURCE ENERGY:
----------------
Three Months Ended September 30,
2004 2003 RESTATED
- ---------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
Net Income - As Reported $ 23,799 $ 27,376
Add: Equity-Based Compensation Expense
Included in Reported Net Income, Net of Related
Tax Effects 60 73
Deduct: Total Equity-Based Employee Compensation
Expense Determined Under Fair Value Based Method
for All Awards, Net of Related Tax Effects (68) (321)
- ---------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 23,791 $ 27,128
=========================================================================================================
Basic Earnings per Share:
As Reported $0.69 $0.81
Pro Forma $0.69 $0.80
=========================================================================================================
Diluted Earnings per Share:
As Reported $0.68 $0.80
Pro Forma $0.68 $0.79
=========================================================================================================
Nine Months Ended September 30,
2004 2003 RESTATED
- ---------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
Net Income - As Reported $ 43,021 $ 86,642
Add: Equity-Based Compensation Expense
Included in Reported Net Income, Net of
Related Tax Effects 1,369 499
Deduct: Total Equity-Based Employee Compensation
Expense Determined Under Fair Value Based Method
for All Awards, Net of Related Tax Effects (2,140) (1,232)
- ---------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 42,250 $ 85,909
=========================================================================================================
Basic Earnings per Share:
As Reported $1.25 $2.56
Pro Forma $1.23 $2.54
=========================================================================================================
Diluted Earnings per Share:
As Reported $1.23 $2.53
Pro Forma $1.21 $2.51
=========================================================================================================
TEP:
---
Three Months Ended September 30,
2004 2003 RESTATED
- --------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Net Income - As Reported $ 26,222 $ 32,194
Add: Equity-Based Compensation Expense
Included in Reported Net Income, Net of
Related Tax Effects 44 66
Deduct: Total Equity-Based Employee Compensation
Expense Determined Under Fair Value Based Method
for All Awards, Net of Related Tax Effects (50) (310)
- --------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 26,216 $ 31,950
========================================================================================================
13
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
Nine Months Ended September 30,
2004 2003 RESTATED
- ---------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Net Income - As Reported $ 45,033 $ 105,076
Add: Equity-Based Compensation Expense
Included in Reported Net Income, Net of
Related Tax Effects 1,220 483
Deduct: Total Equity-Based Employee Compensation
Expense Determined Under Fair Value Based Method
for All Awards, Net of Related Tax Effects (1,975) (1,206)
- ---------------------------------------------------------------------------------- -- -------------------
Pro Forma Net Income $ 44,278 $ 104,353
================================================================================== == ===================
The fair value of each stock option grant is estimated on the date of grant
using the Black-Scholes option-pricing model. There were no stock options
granted during the nine months ended September 30, 2004. For the options granted
under the Omnibus Plan and Directors' Plan during the nine months ended
September 30, 2003, the following weighted average assumptions were used:
2003
- ---------------------------------------------------------------------------------------------------------
Expected Life (Years) 5
Interest Rate 2.78%
Volatility 23.38%
Dividend Yield 3.44%
Weighted-Average Grant-Date Fair Value of Options Granted During
The Period $2.92
- ---------------------------------------------------------------------------------------------------------
NOTE 2. PROPOSED ACQUISITION OF UNISOURCE ENERGY
- -------------------------------------------------
At a special meeting on March 29, 2004, UniSource Energy's shareholders
voted to approve an acquisition agreement UniSource Energy entered into on
November 21, 2003 with Saguaro Acquisition Corp., a wholly-owned indirect
subsidiary of Saguaro Utility Group L.P. (Saguaro Utility), providing for the
acquisition of all of the common stock of UniSource Energy for $25.25 per share
by an affiliate of Saguaro Utility. The acquisition agreement provides that
Saguaro Acquisition Corp. will merge with and into UniSource Energy, with
UniSource Energy surviving the merger as a wholly-owned indirect subsidiary of
Saguaro Utility. Upon consummation of the acquisition, Saguaro Utility will
cause the surviving corporation to pay approximately $880 million in cash to
UniSource Energy's shareholders and holders of stock options, stock units,
restricted stock and performance shares awarded under our stock based
compensation plans. In connection with the closing of the acquisition, Saguaro
Utility intends to cause the surviving corporation (i) to repay the $95 million
inter-company loan to UniSource Energy from TEP and (ii) to contribute up to
$168 million of equity into TEP. TEP will use a significant portion of these
proceeds to retire outstanding debt.
On October 12, 2004, the Federal Energy Regulatory Commission (FERC) issued
an order authorizing the proposed acquisition. In accordance with the Federal
Power Act, FERC reviewed the proposed transaction and concluded that the
transaction is consistent with the public interest. The acquisition still
requires approval by the Arizona Corporation Commission (ACC) and the SEC under
the Public Utility Holding Company Act.
On November 8, 2004, an ACC administrative law judge (ALJ), appointed by
the ACC to review the acquisition, recommended that the ACC deny the application
of Unisource Energy seeking ACC approval for the acquisition. The ALJ's
recommendation was contained in a form of opinion and order which concludes that
the acquisition is not in the public interest.
UniSource Energy vigorously disputes the ALJ's recommendation, which is not
binding on the ACC. The ACC rules permit the filing of exceptions to the ALJ's
recommendation, and Unisource Energy intends to file exceptions. Following the
filing of exceptions, the ACC and its staff will set the date for an open
meeting of the ACC to deliberate the acquisition. The ACC will then issue its
own opinion and order regarding the acquisition.
The acquisition agreement contains operating covenants with respect to the
operations of UniSource Energy's business pending the consummation of the
acquisition. Generally, unless UniSource Energy obtains Saguaro Acquisition
Corp.'s prior written consent, UniSource Energy must conduct business in the
ordinary course consistent with past practice and use all commercially
reasonable efforts to preserve substantially intact the present business
organization and present regulatory, business and employee relationships. In
addition, the acquisition agreement restricts certain activities, subject to the
receipt of Saguaro Acquisition Corp.'s prior written consent, including the
issuance or repurchase of capital stock, the amendment of organizational
documents, acquisitions and dispositions of assets, capital expenditures,
incurrence of indebtedness, modification of employee compensation and benefits,
changes in accounting methods, discharge of liabilities, and matters relating to
UniSource Energy's investment in Millennium.
14
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
Either UniSource Energy or Saguaro Acquisition Corp. may terminate the
acquisition agreement in certain circumstances, including if the acquisition is
not consummated by March 31, 2005 or certain regulatory approvals are not
obtained. In certain circumstances, upon the termination of the acquisition
agreement, UniSource Energy would be required to pay Saguaro Acquisition Corp.'s
expenses related to the acquisition agreement and a termination fee in an
aggregate amount of up to $25 million. In the event that the ACC denies the
acquisition, issues an order approving the acquisition which does not satisfy
the conditions of the acquisition agreement or fails to approve the transaction
by March 31, 2005, Saguaro Acquisition Corp. may terminate the acquisition
agreement and UniSource Energy would be obligated to reimburse up to $7 million
of its expenses.
An affiliate of Saguaro Utility entered into a $410 million credit
agreement on March 25, 2004 that will be funded upon closing of the acquisition
of UniSource Energy. The credit agreement includes a $50 million revolving
credit facility for general corporate purposes and a $360 million term loan to
be used to fund a portion of the acquisition. The lenders' obligation to make
such loans is subject to various customary closing conditions. The lenders'
financing commitments under this credit agreement expire on February 21, 2005.
The March 29, 2004 shareholder vote to approve the proposed merger
triggered vesting of all outstanding stock options under the Omnibus Plan, but
no additional compensation expense resulted from such vesting. See Note 13 for a
description of additional compensation expense recorded for the performance
shares due to accelerated vesting of the awards as a result of the March 29,
2004 shareholder vote.
While UniSource Energy is hopeful that the ACC will recognize the benefits
of the acquisition and approve the transaction, in light of the ALJ's
recommendation we are unable to predict whether the required regulatory
approvals will be obtained in order to permit the transaction to close. If the
required regulatory approvals are obtained and the other closing conditions are
satisfied, we would expect to close the transaction by the end of the first
quarter of 2005.
NOTE 3. REGULATORY MATTERS
- --------------------------
REGULATORY ACCOUNTING
TEP and UES generally use the same accounting policies and practices used
by unregulated companies for financial reporting under GAAP. However, sometimes
these principles, such as Statement of Financial Accounting Standards No. 71,
Accounting for the Effects of Certain Types of Regulation (FAS 71), require
special accounting treatment for regulated companies to show the effect of
regulation. For example, in setting TEP and UES' retail rates, the ACC may not
allow TEP or UES to currently charge their customers to recover certain
expenses, but instead requires that these expenses be charged to customers in
the future. In this situation, FAS 71 requires that TEP and UES defer these
items and show them as regulatory assets on the balance sheet until TEP and UES
are allowed to charge their customers. TEP and UES then amortize these items as
expense to the income statement as these charges are recovered from customers.
Similarly, certain revenue items may be deferred as regulatory liabilities,
which are also eventually amortized to the income statement as rates to
customers are reduced.
The conditions a regulated company must satisfy to apply the accounting
policies and practices of FAS 71 include:
o an independent regulator sets rates;
o the regulator sets the rates to recover specific costs of
delivering service; and
o the service territory lacks competitive pressures to reduce rates
below the rates set by the regulator.
IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71
TEP
Upon approval by the ACC of a settlement agreement (TEP Settlement
Agreement) in November 1999, TEP discontinued application of FAS 71 for its
generation operations. TEP continues to apply FAS 71 to its regulated
operations, which include the transmission and distribution portions of its
business.
TEP's regulatory assets, net of regulatory liabilities, totaled $238
million at September 30, 2004. Regulatory assets of $23 million are not
presently included in rate base and consequently are not earning a return on
investment.
TEP regularly assesses whether it can continue to apply FAS 71 to its
regulated operations. If TEP stopped applying FAS 71 to these operations, it
would write off the related balances of its regulatory assets as an expense and
its regulatory liabilities as income on its income statement. Based on the
regulatory asset balances, net of regulatory liabilities, at September 30, 2004,
if TEP had stopped applying FAS 71 to its remaining regulated operations, it
would have recorded an extraordinary after-tax loss of $144 million. While
regulatory orders and market conditions may affect cash flows, TEP's cash flows
15
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
would not be affected if it stopped applying FAS 71 unless a regulatory order
limited its ability to recover the cost of its regulatory assets.
UES
UES' regulatory liabilities, net of regulatory assets, totaled $7 million
at September 30, 2004. If UES stopped applying FAS 71 to its regulated
operations, it would write off the related balances of its regulatory assets as
an expense and its regulatory liabilities as income on its income statement.
Based on the regulatory liability balances, net of regulatory assets, at
September 30, 2004, if UES had stopped applying FAS 71 to its regulated
operations, it would have recorded an extraordinary after-tax gain of $4
million. UES' cash flows would not be affected if it stopped applying FAS 71
unless a regulatory order limited its ability to recover the cost of its
regulatory assets.
RATES AND REGULATION - TEP
The TEP Settlement Agreement provided for certain retail rate reductions
from 1998 through 2000. In addition, TEP was required to file general rate case
information including an updated cost of service study with the ACC by June 1,
2004. Under the terms of the TEP Settlement Agreement, no rate case filed by TEP
through 2008, including the filing on June 1, 2004, may result in a rate
increase. Any rate decrease resulting from the 2004 filing would be effective no
earlier than June 1, 2005.
On June 1, 2004, TEP filed general rate case information with the ACC.
TEP's filing does not propose any change in retail rates. Absent the restriction
on raising rates provided in the TEP Settlement Agreement, the data presented by
TEP would justify a request by TEP for an increase in retail rates of 16%. The
general rate case information uses a historical test year ended December 31,
2003 and establishes, based on TEP's Standard Offer service, that TEP is
experiencing a revenue deficiency of $115 million. The proposed weighted cost of
capital for the test year ended December 31, 2003 is 8.78%, including an 11.5%
return on equity.
On November 5, 2004, a procedural conference with the ACC was held to
discuss how the review of the general rate case information will proceed. The
ACC staff proposed a schedule that calls for staff and intervenor testimony to
be filed in April 2005 and hearings, as appropriate, to begin in July 2005. No
parties opposed the staff's recommendation. The administrative law judge took
the matter under advisement and will issue a procedural order.
NOTE 4. TEP CREDIT FACILITY AND DEBT REDEMPTION
- -----------------------------------------------
CREDIT FACILITY
On March 25, 2004, TEP entered into a new $401 million credit agreement.
The agreement replaces the credit facilities provided under TEP's $401 million
credit agreement that would have expired in 2006. The new credit agreement
includes a $60 million revolving credit facility for general corporate purposes
and a $341 million letter of credit facility, to support $329 million aggregate
principal amount of tax-exempt variable rate bonds. The credit agreement has a
five year term through June 30, 2009 and is secured by $401 million in aggregate
principal amount of Second Mortgage Bonds issued under TEP's General Second
Mortgage Indenture.
The credit agreement contains a number of restrictive covenants, including
restrictions on additional indebtedness, liens, sale of assets and
sale-leasebacks. The credit agreement also contains several financial covenants
including: (a) minimum consolidated tangible net worth, (b) a minimum cash
coverage ratio, and (c) a maximum leverage ratio. Under the terms of the credit
agreement, TEP may pay dividends so long as it maintains compliance with the
credit agreement. The previous credit agreement had provided that dividends
could not exceed 65% of TEP's net income. The elimination of such covenant is
expected to satisfy, in part, one of the closing conditions contained in the
acquisition agreement that UniSource Energy entered into with Saguaro
Acquisition Corp. by permitting TEP to dividend all of its net income to its
shareholders. The credit agreement also provides that under certain
circumstances, certain regulatory actions could result in a required reduction
of the commitments. As of September 30, 2004, TEP was in compliance with the
terms of the Credit Agreement.
The letter of credit fee of 2.35% on the new facility is significantly
lower than the previous credit agreement's weighted average letter of credit fee
of approximately 5%. The agreement also provides for letter of credit fronting
16
fees of 0.25%, which will reduce to 0.125% upon the closing of Saguaro
Acquisition Corp.'s acquisition of UniSource Energy; the previous agreement's
fronting fee was 0.25%. Unreimbursed drawings on a letter of credit bear a
variable rate of interest based on LIBOR plus 2.25% per annum. Interest savings
in 2004 will be partially offset by the March 2004 write-off of $2 million of
fees associated with the prior facility that were capitalized and being
amortized through 2006. Fees of $9 million associated with the entry into the
new facility are being amortized through June 2009. This expense is included in
Long-Term Debt Interest Expense in UniSource Energy and TEP's income statements.
At September 30, 2004, TEP had no outstanding borrowings under the
revolving credit facility. If TEP borrows under the revolving credit facility,
the borrowing costs would be at a variable interest rate consisting of a spread
over LIBOR or an alternate base rate. The spread is based upon a pricing grid
tied to TEP's leverage. The per annum rate currently in effect on borrowings
under TEP's revolving credit facility, based on its leverage, is LIBOR plus
2.25%. If TEP's leverage were to change, the spread over LIBOR could range from
1.50% to 2.25%. TEP also pays a commitment fee of 0.50% on the unused portion of
the revolving credit facility.
DEBT REDEMPTION
In July 2004, TEP redeemed the remaining $27 million of its 8.5% First
Mortgage Bonds which were due in 2009. TEP paid a premium of $0.4 million
related to this redemption. A portion of this premium was expensed immediately,
while the remainder is being amortized over the original life of the bonds.
NOTE 5. ACCOUNTING CHANGE: ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
- ------------------------------------------------------------------------
TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. TEP also has certain environmental obligations at the San
Juan Generating Station (San Juan). TEP has estimated that its share of these
obligations will be approximately $38 million at the date of retirement. As of
September 30, 2004 and December 31, 2003, TEP had accrued approximately $1
million for the final decommissioning of its generating facilities. This accrued
asset retirement obligation is included with Other Liabilities on UniSource
Energy and TEP's balance sheets.
TEP and UES have various transmission and distribution lines that operate
under land leases and rights of way that contain end dates and restorative
clauses. TEP and UES operate their transmission and distribution systems as if
they will be operated in perpetuity and would continue to be used or sold
without land remediation. A final retirement occurs when an entire transmission
or distribution line is permanently removed from service. Interim retirements
occur as components of the system are replaced. As a result, TEP and UES are not
recognizing the costs of final removal of the transmission and distribution
lines in their financial statements. As of September 30, 2004 and December 31,
2003, TEP had accrued $66 million and $60 million and UES had accrued $2 million
and $1 million for the net cost of removal for interim retirements from its
transmission, distribution and general plant. These amounts have been recorded
as a regulatory liability on UniSource Energy and TEP's balance sheets.
Millennium and UED have no asset retirement obligations.
Upon adoption of FAS 143 on January 1, 2003, TEP recorded an asset
retirement obligation of $38 million at its net present value of $1 million,
increased depreciable assets by $0.1 million for asset retirement costs,
reversed $113 million of costs previously accrued for final removal from
accumulated depreciation, reversed previously recorded deferred tax assets of
$44 million and recognized the cumulative effect of accounting change as a gain
of $112 million ($67 million net of tax).
NOTE 6. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND TRADING ACTIVITIES
- ---------------------------------------------------------------------
TEP has a natural gas supply agreement under which it purchases all of its
gas requirements at spot market prices from Southwest Gas Corporation (SWG). TEP
also has agreements to purchase power that are priced using spot market gas
prices. These contracts meet the definition of normal purchases and are not
required to be marked to market. During the first nine months of 2004, in an
effort to minimize price risk on these purchases, TEP entered into commodity
price swap agreements under which TEP purchases gas at fixed prices and
simultaneously sells gas at spot market prices. The spot market price in the
swap agreements is tied to the same index as the purchases under the SWG and
17
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
purchased power contracts. These swap agreements, which expire during the summer
months through 2006, were entered into with the goal of locking in fixed prices
on at least 45% and not more than 80% of TEP's expected summer monthly gas risk
prior to entering into the month. The swap agreements are marked to market on a
monthly basis; however, since the agreements satisfy the requirements for cash
flow hedge accounting, the unrealized gains and losses are recorded in Other
Comprehensive Income, a component of Common Stock Equity, rather than being
reflected in the income statement. As the gains and losses on these cash flow
hedges are realized, a reclassification adjustment is recorded in Other
Comprehensive Income for realized gains and losses that are included in net
income.
TEP and MEG's derivative activities are reported as follows:
INCOME STATEMENT LINE
-----------------------------------------------------------------------
NET UNREALIZED GAINS NET REALIZED GAINS
AND LOSSES AND LOSSES
- ---------------------------------------------------------------------------------------------------------------
TEP Forward Sales Contracts Electric Wholesale Sales Electric Wholesale Sales
TEP Forward Purchase Contracts Purchased Power Purchased Power
TEP Commodity Price Swaps Other Comprehensive Income Fuel Expense
(Balance Sheet)
MEG Trading Activities Other Operating Revenues Other Operating Revenues
- ----------------------------------------------------------------------------------------------------------------
Although MEG's realized gains and losses on trading activities are reported
net on UniSource Energy's income statement, the related cash receipts and cash
payments are reported separately on UniSource Energy's statement of cash flows.
The net pre-tax gains and losses from TEP and MEG's derivative activities
were as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
TEP:
Net Unrealized Gain on Forward Sales Contracts $ 0.5 $ 0.3 $ 1.3 $ 0.2
Net Unrealized Loss on Forward Purchase Contracts (0.2) (0.1) (0.3) (0.1)
Net Unrealized Gain on Commodity Price Swaps 1.3 - 3.4 -
Net Realized Loss on Commodity Price Swaps (0.5) - (0.1) -
MEG:
Net Gain from Trading Activities 1.1 0.7 1.0 0.3
- -------------------------------------------------------------------------------------------------------------
TEP and MEG's derivative assets and liabilities are reported as follows:
BALANCE SHEET LINE
-------------------------------------------------------
ASSETS LIABILITIES
- -------------------------------------------------------------------------------------------------------------
TEP (Net) Other Current Assets Other Current Liabilities
MEG (Including Emissions Allowance Inventory) Trading Assets Trading Liabilities
- -------------------------------------------------------------------------------------------------------------
The fair value of TEP and MEG's derivative assets and liabilities were as
follows:
September 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
-Millions of Dollars-
TEP:
Net Derivative Assets (Liabilities) $ 4.1 $ (0.4)
MEG:
Trading Assets 87.7 21.5
Trading Liabilities (86.6) (18.8)
- --------------------------------------------------------------------------------
Beginning January 1, 2004, the settlement of forward purchase and sales
contracts that do not result in physical delivery are recorded net as a
component of Electric Wholesale Sales in TEP's income statement. For the three
18
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
months ended September 30, 2004, just over $1 million in sales were netted
against just over $1 million in purchases, resulting in a small net loss. For
the nine months ended September 30, 2004, $3 million in sales were netted
against $3 million in purchases, resulting in a small net gain.
NOTE 7. BUSINESS SEGMENTS
- --------------------------
Based on the way we organize our operations and evaluate performance, we
have four reportable business segments:
(1) TEP, a vertically integrated electric utility business, is
UniSource Energy's largest subsidiary.
(2) UES is the holding company for UNS Gas, a regulated gas
distribution utility business, and UNS Electric, a regulated
electric distribution utility business. See Note 1.
(3) Millennium holds interests in unregulated energy and emerging
technology businesses. See Note 8.
(4) UED developed generating resources and performed other project
development activities, including the expansion of the
Springerville Generating Station.
Significant reconciling adjustments consist of the elimination of
intercompany activity and balances. Millennium recorded revenue from
transactions with TEP of $6 million and $4 million during the three-month
periods ended September 30, 2004 and September 30, 2003, and $15 million and $11
million during the nine-month periods ended September 30, 2004 and September 30,
2003. TEP's related expense is reported in Other Operations and Maintenance
expense on its income statement. Millennium's revenue and TEP's related expense
are eliminated in UniSource Energy consolidation. Other significant reconciling
adjustments include the elimination of the intercompany note between UniSource
Energy and TEP, as well as the related interest income and expense.
In June 2004, UED recognized an impairment loss on its note receivable from
an investee of Haddington Energy Partners II, LP (Haddington). As discussed in
Note 8, Haddington wrote down its investment in this investee. As UED's recovery
of the note receivable from the entity is subordinated to the rights of others,
UED wrote off the entire $2 million balance due on the note at the time that
Haddington determined that its investment was impaired.
We record our percentage share of the earnings of affiliated companies,
except for investments where we provide all of the financing, in which case we
recognize 100% of the losses. See Note 8.
We disclose selected financial data for our business segments in the
following table:
19
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
SEGMENTS UNISOURCE
------------------------------------------------- RECONCILING ENERGY
TEP UES MILLENNIUM UED ADJUSTMENTS CONSOLIDATED
- ------------------------------------------------------------------------------------------------------------------------------------
- Millions of Dollars -
INCOME STATEMENT
- ----------------
THREE MONTHS ENDED SEPTEMBER 30, 2004:
Operating Revenues - External $ 272 $ 62 $ 1 $ - $ - $ 335
Operating Revenues - Intersegment - - 6 - (6) -
Income (Loss) Before Income Taxes 44 1 (2) - (2) 41
Net Income (Loss) 26 - (1) - (1) 24
THREE MONTHS ENDED SEPTEMBER 30, 2003 RESTATED
(SEE NOTE 1):
Operating Revenues - External $ 266 $ 34 $ 4 $ - $ - $ 304
Operating Revenues - Intersegment - - 4 - (4) -
Income (Loss) Before Income Taxes 55 - (4) - (4) 47
Net Income (Loss) 32 - (3) - (2) 27
NINE MONTHS ENDED SEPTEMBER 30, 2004:
Operating Revenues - External $ 692 $ 199 $ 4 $ - $ - $ 895
Operating Revenues - Intersegment 1 - 15 - (16) -
Income (Loss) Before Income Taxes 80 10 (4) (2) (6) 78
Net Income (Loss) 45 6 (3) (1) (4) 43
NINE MONTHS ENDED SEPTEMBER 30, 2003
RESTATED (SEE NOTE 1):
Operating Revenues - External $ 652 $ 34 $ 7 $ - $ - $ 693
Operating Revenues - Intersegment - - 11 - (11) -
Income (Loss) Before Income Taxes and
Cumulative Effect of Accounting Change 66 - (20) - (10) 36
Net Income (Loss) 105 - (12) - (6) 87
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET
TOTAL ASSETS, SEPTEMBER 30, 2004 $ 2,757 $ 318 $ 241 $ 4 $ (115) $ 3,205
TOTAL ASSETS, DECEMBER 31, 2003 RESTATED (SEE 2,767 309 181 3 (138) 3,122
(SEE NOTE 1)
- ------------------------------------------------------------------------------------------------------------------------------------
20
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
NOTE 8. MILLENNIUM
- -------------------
See Note 7 for selected financial data of Millennium.
Through affiliates, Millennium holds investments in unregulated energy and
emerging technology companies. Millennium's assets represent 6% of UniSource
Energy's total assets at September 30, 2004 and 4% at December 31, 2003. Under
the acquisition agreement described in Note 2, UniSource Energy is limited as to
the amount it can invest in Millennium in the future. Consequently, Millennium's
ability to provide future funding for the operations of emerging companies could
be affected.
Millennium accounts for these investments under the consolidation and
equity methods. In some cases, Millennium is an investment's sole funder. When
this is the case, Millennium recognizes 100% of an investment's losses, because
as sole provider of funds it bears all of the financial risk. To the extent an
investment becomes profitable and Millennium has recognized losses in excess of
its percentage ownership, Millennium will recognize 100% of an investment's net
income until Millennium's recognized losses equal its ownership percentage of
losses.
A brief summary of Millennium's investments follows:
Global Solar Energy, Inc. (Global Solar) primarily develops and
manufactures light weight thin-film photovoltaic cells and panels. Global
Solar's target markets have included military, space and commercial
applications. Millennium owns 99% of Global Solar. Millennium accounts for
Global Solar under the consolidation method and recognizes 100% of Global
Solar's losses. Global Solar recognizes expense when funding is used for
research, development and administrative costs. During the first nine months of
2004, Millennium made no contributions to Global Solar. However, UniSource
Energy provided $5 million to Global Solar under a tax sharing agreement.
Millennium has no remaining funding commitments to Global Solar, other than the
tax sharing agreement with UniSource Energy.
Infinite Power Solutions, Inc. (IPS) develops thin-film lithium ion
batteries. Millennium owns 72% of IPS and accounts for it under the
consolidation method. IPS recognizes expense when funding is used for research,
development and administrative costs. Millennium's debt commitment to IPS was
$0.5 million at December 31, 2003. In April 2004, Millennium and Dow Corning
Enterprises, Inc. (DCEI) committed to loan up to an additional $1 million each
to IPS. During the first nine months of 2004, Millennium funded all $1.5 million
of its commitments to IPS and DCEI funded its $1 million commitment. Millennium
has no further funding commitments to IPS. Pursuant to the terms of the amended
promissory notes with IPS, Millennium and DCEI have the right to convert at any
time the outstanding debt amounts to equity ownership. DCEI holds warrants to
purchase additional preferred shares of IPS that if exercised, could result in
Millennium's ownership of IPS being reduced to as low as 59%.
Millennium and DCEI are continuing to evaluate the ongoing viability of
IPS. In the event the operations of IPS are discontinued, Millennium would
recognize an after-tax loss of less than $1 million.
MicroSat Systems, Inc. (MicroSat) develops small-scale satellites under a
U.S. government contract. In February 2004, pursuant to a settlement agreement,
the contract was terminated and MicroSat granted the government the right to use
the design data and transferred all hardware assets developed under the contract
to the government in exchange for the elimination of further cost-sharing
obligations under the contract. These assets will be used under a new contract
between MicroSat and the government, and may be used by the government for other
satellite development contracts not involving MicroSat. However, MicroSat
retains the right to use the design data on other government and commercial
contracts. MicroSat had previously deferred $2 million, before tax, of revenues
earned under the original contract. These revenues have now been recognized, and
Millennium recorded the income in the first quarter of 2004. Millennium owns 35%
of MicroSat and, as sole funder, recognizes 100% of MicroSat's net losses.
Millennium made no contributions to MicroSat during the first nine months of
2004 and has no further funding commitments to MicroSat.
MEG is a wholly-owned subsidiary of Millennium, which manages and trades
emissions allowances, coal, and related financial instruments. MEG's activities
are described in Note 6.
Haddington funds energy-related investments. A member of the UniSource
Energy Board of Directors has an investment in Haddington and is a managing
director of the general partner of the limited partnership. Millennium committed
21
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
$15 million in capital, excluding fees, to Haddington in exchange for
approximately 31% ownership. At September 30, 2004, Millennium had funded $12
million of this commitment, $2 million of which was funded during the first nine
months of 2004. Millennium expects the balance to be funded over the next three
years. In March 2004, Haddington sold one of its investments and recognized the
related gain as income. In April 2004, Millennium received a $7 million
distribution from Haddington related to the sale. In June 2004, Haddington wrote
down another of its investments and recognized the related loss. Millennium's
share of the loss was $2 million, before tax. Millennium recorded its share of
Haddington's income and loss during the first nine months of 2004, which
includes Haddington's gains and losses on investments. Millennium accounts for
its investment in Haddington under the equity method.
Valley Ventures III, LP (Valley Ventures) is a venture capital fund that
invests in information technology, microelectronics and biotechnology, primarily
within the southwestern U.S. Another member of the UniSource Energy Board of
Directors is a general partner of the company that manages the fund. Millennium
committed $6 million, including fees, to the fund and owns approximately 15% of
the fund. As of September 30, 2004, Millennium had funded $2 million of this
commitment, $1 million of which was funded during the first nine months of 2004.
Millennium expects the balance to be funded by the end of 2007. Millennium
accounts for this investment under the equity method due to an ability to
exercise significant influence over the fund based on the related party
affiliation disclosed above.
Carboelectrica Sabinas, S. de R.L. de C.V. (Sabinas) is a Mexican limited
liability company created to develop up to 800 megawatts (MW) of coal-fired
generation in the Sabinas region of Coahuila, Mexico. Sabinas also owns 19.5% of
Minerales de Monclova, S.A. de C.V. (Mimosa). Mimosa is an owner of coal and
associated gas reserves. Mimosa supplies metallurgical coal to the Mexican steel
industry and thermal coal to the major electric utility in Mexico. Millennium
owns 50% of Sabinas. Altos Hornos de Mexico, S.A. de C.V. (AHMSA) and affiliates
own the remaining 50%. UniSource Energy's Chairman, President and Chief
Executive Officer is an alternate member of the board of directors of AHMSA.
Since 1999, both AHMSA and Mimosa are parties to a suspension of payments
procedure, under applicable Mexican law, which is the equivalent of a U.S.
Chapter 11 proceeding. Under certain circumstances, Millennium has the right to
sell (a put option) its interest in Sabinas to an AHMSA affiliate for $20
million plus an accrued service fee. These circumstances include failure of
Sabinas to reach financial closing on the generation project within a specified
time. Millennium's put option is secured by collateral initially valued in
excess of $20 million. Millennium accounts for the investment in Sabinas under
the equity method; however, Sabinas accounts for its investment in Mimosa under
the cost method.
Nations Energy Corporation (Nations Energy) is wholly owned by Millennium.
Through subsidiaries, Nations Energy has a 32% interest in a 43 MW power plant
in Panama. Although Nations Energy still intends to sell its interest in this
plant, the $0.8 million book value of the investment was written off in June
2004 because attempts to sell the asset to date have been unsuccessful.
NATIONS ENERGY CONTINGENCY
In September 2001, Nations Energy sold its 26% equity interest in a power
project located in Curacao, Netherlands Antilles to Mirant Curacao Investments,
Ltd. (Mirant Curacao), a subsidiary of Mirant Corporation (Mirant). Nations
Energy received $5 million in cash and an $11 million receivable from Mirant
Curacao. The receivable was recorded at its net present value of $8 million
using an 8% discount rate, the discount being recognized as interest income over
the five-year life of the receivable. As of September 30, 2004, Nations Energy's
receivable from Mirant Curacao was approximately $8 million. The receivable is
primarily included in Investments and Other Property - Other on UniSource
Energy's balance sheet. The first payment of $2 million on the receivable was
received in June 2004. The remaining payments are expected to be received as
follows: $4 million in July 2005 and $5 million in July 2006.
The receivable is guaranteed by Mirant Americas, Inc., a subsidiary of
Mirant. On July 14, 2003, Mirant, Mirant Americas, Inc. and various other Mirant
companies filed for Chapter 11 bankruptcy protection. Mirant Curacao was not
included in the Chapter 11 filings. Projected cash flows for the power project
support the expectation that Mirant Curacao will have sufficient future cash
flows to pay the remaining receivable and any applicable interest. However,
Nations Energy cannot predict the ultimate outcome that Mirant's bankruptcy will
have on the collectibility of the receivable from Mirant Curacao. Nations Energy
will continue to evaluate the collectibility of the receivable, but currently
expects to collect the receivable in its entirety and has not recorded any
reserve for this receivable.
MILLENNIUM COMMITMENTS
22
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
Millennium's funding levels and share ownership in its investments are
subject to change in the future. Millennium has no remaining debt commitments
and its outstanding equity commitments are currently limited to $4 million to
Haddington and $3 million to Valley Ventures. Millennium may commit to provide
additional funding to its investments in the future.
Global Solar had commitments to incur future expenses relating to
government contracts totaling less than $1 million at September 30, 2004 and $1
million at December 31, 2003.
NOTE 9. COMMITMENTS AND CONTINGENCIES
- --------------------------------------
MILLENNIUM COMMITMENTS AND CONTINGENCY
See Note 8 for a description of Millennium's commitments and contingency.
UNISOURCE ENERGY CONTINGENCIES
LITIGATION CONCERNING THE PROPOSED ACQUISITION AGREEMENT
On August 26, 2004, the Pennsylvania Avenue Event Driven Fund filed a class
action complaint in the Superior Court of the State of Arizona on behalf of the
holders of UniSource Energy common stock against UniSource Energy and its
directors (Pennsylvania Ave. Event Driven Fund v. UniSource Energy Corp., et al.
(D. Ariz.)) relating to the proposed acquisition of UniSource Energy by an
affiliate of Saguaro Utility. The plaintiff alleges, among other things, that
members of UniSource Energy's board of directors breached their fiduciary duties
to UniSource Energy's shareholders in connection with the proposed acquisition
by tailoring the acquisition to meet the specific needs of Saguaro Utility and
basing the acquisition on financial results of UniSource Energy that were
subsequently restated to recognize additional net income. The plaintiff is
seeking to enjoin the acquisition, which was approved by shareholders of
UniSource Energy in March 2004. UniSource Energy's motion to dismiss the action
is pending before the court. UniSource Energy believes that the lawsuit is
without merit and will vigorously contest it.
ACQUISITION FEES
UniSource Energy has entered into agreements with New Harbor Incorporated
(New Harbor) and Morgan Stanley & Co. Incorporated (Morgan Stanley) in
connection with the acquisition of UniSource Energy by Saguaro Utility. The
transaction fee payable to New Harbor is $9 million. UniSource Energy paid New
Harbor $2 million upon announcement of the transaction in November 2003, with
the balance of the transaction fee contingent and payable upon the closing of
the transaction. In connection with the acquisition, UniSource Energy has agreed
to pay Morgan Stanley a transaction fee of up to $3 million, which includes
their monthly advisory fee. UniSource Energy paid Morgan Stanley $1 million in
November 2003 and $0.4 million in April 2004 upon shareholders approving the
transaction, and will pay Morgan Stanley $1 million contingent and payable upon
the acquisition closing. These transaction fees, which were expensed as
incurred, are included in Other Operations and Maintenance Expense in UniSource
Energy's Statements of Income and in Payment of Other Operation and Maintenance
Costs in UniSource Energy's Statements of Cash Flows.
In certain circumstances, in the event of termination of the acquisition
agreement, UniSource Energy would be required to pay Saguaro Acquisition Corp.'s
expenses and a termination fee in an aggregate amount of up to $25 million.
TEP CONTINGENCIES
SPRINGERVILLE GENERATING STATION COMPLAINT
Environmental activist groups have expressed concerns regarding the
construction of any new units at the Springerville Generating Station. In
January 2003, environmental activist groups appealed an ACC Order affirming the
ACC's approval of the expansion at the Springerville Generating Station to the
23
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
Superior Court of the State of Arizona. On October 22, 2003, the Superior Court
affirmed the ACC's issuance of the Certificate of Environmental Compatibility
for Springerville Generating Station. The Court granted TEP and the ACC's motion
for summary judgment from the environmental activist groups. The environmental
activist groups appealed the Superior Court decision on December 30, 2003 and
filed an amended notice of appeal on January 2, 2004 with the Arizona Court of
Appeals. Oral argument in the Court of Appeals was conducted on October 13, 2004
and a decision by the Court is currently pending.
In November 2001, the Grand Canyon Trust (GCT), an environmental activist
group, filed a complaint in U.S. District Court against TEP for alleged
violations of the Clean Air Act at the Springerville Generating Station. The
complaint alleged that more stringent emission standards should apply to Units 1
and 2. These standards could require new permits and the installation of
additional facilities, meeting Best Available Control Technology standards, for
the continued operation of Units 1 and 2. In 2002, the U.S. District Court
granted TEP's motion for summary judgment on one of the primary issues in the
case: whether TEP commenced construction within 18 months and/or by March 19,
1979, after the original 1977 air permit covering Units 1 and 2 was issued. The
Court found that TEP had commenced construction of the Springerville Generating
Station in the time periods required by the original permits. There were two
remaining allegations: that (a) TEP discontinued construction for a period of 18
months or longer and did not complete construction in a reasonable period of
time, and (b) TEP did not commence construction, for purposes of New Source
Performance Standard applicability, by September 18, 1978. On March 4, 2003, the
U.S. District Court determined that the GCT had not commenced the case on a
timely basis and dismissed the case. The GCT appealed this decision to the U.S.
Court of Appeals for the 9th Circuit. On September 2, 2004, the 9th U.S. Circuit
Court of Appeals vacated the U.S. District Court's decision on both the summary
judgment and the timeliness grounds, and remanded the proceedings for further
consideration by the U.S. District Court. TEP has filed a petition for rehearing
of the 9th Circuit Court decision. If the petition for rehearing is not granted,
and TEP decides not to appeal the 9th Circuit Court decision to the U.S. Supreme
Court, the case would be remanded to the U.S. District Court.
TEP believes these claims are without merit and intends to continue to
vigorously contest them.
LITIGATION AND CLAIMS RELATED TO SAN JUAN GENERATING STATION
On May 16, 2002, the GCT and the Sierra Club filed a citizen lawsuit under
the Clean Air Act in federal district court in New Mexico against Public Service
Company of New Mexico (PNM) as operator of San Juan. TEP owns 50% of San Juan
Units 1 and 2, which equates to 19.8% of the total San Juan Generating Station.
The lawsuit alleges two violations of the Clean Air Act and related regulations
and permits. One of the two claims, concerning the initial permitting of San
Juan, was dismissed by the court in August 2003. The remaining claim alleged
that PNM violated its present Title V operating permit for Units 1, 3 and 4 by
exceeding the 20% opacity standard on numerous occasions between 1998 and 2002;
opacity is a means to monitor the particulate matter contained in an emission.
PNM has exchanged written settlement offers and entered into a settlement
conference with the plaintiffs.
In September 2003, the New Mexico Environment Department (NMED) notified
PNM, operator of San Juan, of alleged excess emissions and opacity in violation
of the permits at San Juan Units 1, 3, and 4. The NMED issued a draft compliance
order assessing unspecified civil penalties. PNM has entered into discussions
with the NMED concerning the alleged excess emissions and opacity violations. No
compliance order has been issued in this matter.
The EPA has listed San Juan as a potential damage case pursuant to the
Resource Conservation and Recovery Act due to claims by third parties that the
San Juan Generating Station has contaminated water resources in the region as a
result of disposing of fly ash in the surface mine pits adjacent to the
generating station. PNM and the coal supplier to San Juan vigorously deny these
allegations. The EPA is investigating the claims.
TEP may have to pay a portion of any settlement or the cost of new
pollution control equipment installed based on its ownership of San Juan.
Because settlement negotiations are ongoing, and the matter may proceed to
trial, TEP is unable to predict the outcome of this litigation and claims.
24
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
POSTRETIREMENT AND PENSION BENEFIT COSTS AT VARIOUS GENERATING STATIONS
The coal suppliers to Springerville Generating Station and each of TEP's
remote generating stations have submitted demands for payment by TEP of
postretirement and pension benefit costs for these coal suppliers' employees
under the coal supply agreements with TEP.
Navajo Generating Station: Peabody Western Coal Company (Peabody), the coal
supplier to the Navajo Generating Station, has filed a lawsuit against the
participants at Navajo, including TEP, for retiree postretirement benefit costs.
TEP owns 7.5% of the Navajo Generating Station. The Navajo participants and
Peabody have agreed to stay the discovery process in this litigation until
February 28, 2005 to allow the parties additional time to negotiate a potential
settlement.
To the extent that amounts become known and payment probable, TEP will
record a liability for additional postretirement and pension benefit costs at
the Navajo and San Juan Generating Stations. TEP does not expect any settlement
to be material to TEP.
Springerville Generating Station: In June 2004, TEP paid $3 million in
settlement of the claim for postretirement benefit costs related to the coal
supply agreement at Springerville Generating Station. In addition, a clause was
deleted from the coal supply agreement that would have allowed costs related to
increases in welfare and pension benefits resulting from attempts to unionize or
union negotiations to be passed to TEP. TEP expensed $0.5 million in 2003 and
$0.5 million in June 2004 as the cost associated with the settlement for the
period April 2002 through June 2004. The remaining settlement of $2 million
represents a prepayment and will be amortized to coal inventory over the
remaining life of the coal supply agreement through 2010 and expensed as fuel is
burned.
Four Corners Generating Station: The claim for postretirement at Four
Corners was settled as part of the coal contract extension. TEP paid $0.3
million for postretirement benefits in September 2003.
ENVIRONMENTAL RECLAMATION AT REMOTE GENERATING STATIONS
TEP currently pays on-going reclamation costs related to the coal mines
which supply the remote generating stations, and it is probable that TEP will
have to pay a portion of final reclamation costs upon mine closure. When a
reasonable estimate of final reclamation costs is available, the liability is
recognized as a cost of coal over the remaining term of the respective coal
supply agreement. At September 30, 2004, TEP estimates its undiscounted final
reclamation liability to be $42 million, and the present value of TEP's
liability for final reclamation approximates $12 million at the expiration dates
of the coal supply agreements.
Amounts recorded for final reclamation are subject to various assumptions
and determinations, such as estimating the costs of reclamation, estimating when
final reclamation will occur, and the credit-adjusted risk-free interest rate to
be used to discount future liabilities. Changes that may arise over time with
regard to these assumptions and determinations will change amounts recorded in
the future as expense for post-term reclamation. TEP does not believe that
recognition of its final reclamation obligations will be material to TEP in any
single year since recognition occurs over the remaining lives of its coal supply
agreements.
GUARANTEES AND INDEMNITIES
In the normal course of business, UniSource Energy and certain subsidiaries
enter into various agreements providing financial or performance assurance to
third parties on behalf of certain subsidiaries. We enter into these agreements
primarily to support or enhance the creditworthiness of a subsidiary on a
stand-alone basis. The most significant of these guarantees are 1) UES'
guarantee of $160 million of aggregate principal amount of senior unsecured
notes issued by UNS Gas and UNS Electric to purchase the Citizens Arizona gas
and electric utility assets, 2) UniSource Energy's guarantee of approximately $8
million in natural gas transportation and supply payments in addition to
building and equipment lease payments for UNS Gas, UNS Electric, and
subsidiaries of Millennium, and 3) Millennium's guarantee of approximately $4
million in commodity-related payments for MEG and building lease payments for a
subsidiary at September 30, 2004. To the extent liabilities exist under the
contracts subject to these guarantees, such liabilities are included in
UniSource Energy's consolidated balance sheets.
25
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
In addition, UniSource Energy and its subsidiaries have indemnified the
purchasers of interests in certain investments from additional taxes due for
years prior to the sale of such investments. The terms of the indemnifications
provide for no limitation on potential future payments; however, we believe that
we have abided by all tax laws and paid all tax obligations. We have not made
any payments under the terms of these indemnifications to date.
We believe that the likelihood UniSource Energy, UES, or Millennium would
be required to perform or otherwise incur any significant losses associated with
any of these guarantees or indemnities is remote.
NOTE 10. TEP WHOLESALE ACCOUNTS RECEIVABLE AND ALLOWANCES
- ----------------------------------------------------------
TEP's Accounts Receivable from Electric Wholesale Sales, included in Trade
Accounts Receivable on the balance sheet, totaled $19 million at September 30,
2004 and $26 million at December 31, 2003, net of allowances. TEP's Allowance
for Doubtful Accounts on the balance sheet includes $13 million at September 30,
2004 and $10 million at December 31, 2003 related to sales to the California
Power Exchange (CPX) and the California Independent System Operator (CISO) in
2001 and 2000. Excluding the receivables from the CPX and the CISO,
substantially all of the September 30, 2004 wholesale receivable balance has
been collected as of the date of this filing.
TEP's collection shortfall from the CPX and the CISO was approximately $9
million for sales made in 2000 and $7 million for sales made in 2001. Since that
time, the FERC staff has proposed various methodologies for calculating amounts
of refunds/offsets applicable to wholesale sales made into the CISO's spot
markets from October 2000 to June 2001. Based upon a FERC order in March 2003
(as reaffirmed by the FERC on October 16, 2003), TEP estimated that it would
receive approximately $6 million of its $16 million receivable. In May 2004, the
FERC issued two separate orders addressing numerous issues in the refund
calculation and the fuel cost allowance calculation (an offset to the refund
obligation). Based on these new orders, TEP increased its reserve for sales to
the CPX and the CISO by $3 million in the second quarter of 2004 by recording a
reduction of wholesale revenues.
There are several other outstanding legal issues, complaints and lawsuits
concerning the California energy crisis related to the FERC, wholesale power
suppliers, Southern California Edison Company, Pacific Gas and Electric Company,
the CPX and the CISO. TEP cannot predict the outcome of these issues or
lawsuits. We believe, however, that TEP is adequately reserved for its
transactions with the CPX and the CISO.
NOTE 11. UNISOURCE ENERGY EARNINGS PER SHARE (EPS)
- ---------------------------------------------------
Basic EPS is computed by dividing net income by the weighted average number
of common shares outstanding during the period. Diluted EPS assumes that
proceeds from the hypothetical exercise of stock options and other equity-based
awards are used to repurchase outstanding shares of stock at the average fair
market price during the reporting period. The numerator in calculating both
basic and diluted earnings per share for each period is net income. The
following table shows the effects of potential dilutive common stock on the
weighted average number of shares:
26
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------
- In Thousands -
Denominator:
Average Shares of Common Stock Outstanding 34,464 33,838 34,347 33,799
Effect of Dilutive Securities:
Options and Stock Issuable under Employee Benefit Plans 649 532 672 453
- -------------------------------------------------------------------------------------------------------------------------
Total Shares 35,113 34,370 35,019 34,252
=========================================================================================================================
There were no antidilutive options outstanding during the three month and
nine month periods ended September 30, 2004. Options to purchase 20,000 shares
of common stock at $18.84 per share were outstanding during the three months
ended September 30, 2003 but were not included in the computation of diluted EPS
because the options' exercise price was greater than the average market price of
the common stock and, therefore, the effect would be antidilutive. Similarly, an
average of 365,000 antidilutive options was excluded from the year to date
computation of diluted EPS for the nine months ended September 30, 2003.
NOTE 12. EMPLOYEE BENEFITS PLANS
- ---------------------------------
PENSION BENEFIT PLANS
TEP and UES maintain noncontributory, defined benefit pension plans for
substantially all regular employees and certain affiliate employees. Benefits
are based on years of service and the employee's average compensation. TEP and
UES fund the plans by contributing at least the minimum amount required under
Internal Revenue Service regulations. Additionally, we provide supplemental
retirement benefits to certain employees whose benefits are limited by IRS
benefit or compensation limitations.
OTHER POSTRETIREMENT BENEFIT PLANS
TEP provides limited health care and life insurance benefits for retirees.
All regular employees may become eligible for these benefits if they reach
retirement age while working for TEP or an affiliate. Concurrent with the
acquisition of the Arizona gas and electric assets from Citizens on August 11,
2003, UES assumed a $2 million liability for postretirement medical benefits for
current retirees and a small group of active employees. The majority of UES
employees do not participate in the postretirement medical plan.
The ACC allows TEP and UES to recover postretirement costs through rates
only as benefit payments are made to or on behalf of retirees. The
postretirement benefits are currently funded entirely on a pay-as-you-go basis.
Under current accounting guidance, TEP and UES cannot record a regulatory asset
for the excess of expense calculated per Statement of Financial Accounting
Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than
Pensions (FAS 106), over actual benefit payments.
FASB Staff Position No. FAS 106-2, Accounting and Disclosure Requirements
Related to the Medicare Prescription Drug, Improvement and Modernization Act of
2003 (FSP 106-2), provides guidance related to accounting for the federal
subsidy available to certain employers providing retirees with prescription drug
benefits. For public companies, FSP 106-2 is effective for the first interim or
annual period beginning after June 15, 2004. Adoption of FSP 106-2 is not
expected to have a significant impact on our postretirement benefit costs or
cash flows because prescription drug coverage is only available to a limited
number of UniSource Energy retirees who are Medicare eligible.
27
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
COMPONENTS OF NET PERIODIC BENEFIT COST
The components of net periodic benefit costs are as follows:
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
----------------------------------------------------
Three Months Ended Three Months Ended
September 30, September 30,
2004 2003 2004 2003
- ---------------------------------------------------------------------------------------------------------
-Millions of Dollars -
COMPONENTS OF NET PERIODIC BENEFIT COST
Service Cost $ 1.5 $ 1.2 $ 0.5 $ 0.4
Interest Cost 2.4 2.1 0.9 1.0
Expected Return on Plan Assets (2.7) (2.3) - -
Prior Service Cost Amortization 0.5 0.4 (0.4) (0.4)
Recognized Actuarial Loss 0.4 0.5 0.5 0.6
- ---------------------------------------------------------------------------------------------------------
NET PERIODIC BENEFIT COST $ 2.1 $ 1.9 $ 1.5 $ 1.6
=========================================================================================================
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
----------------------------------------------------
Nine Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
- ---------------------------------------------------------------------------------------------------------
-Millions of Dollars -
COMPONENTS OF NET PERIODIC BENEFIT COST
Service Cost $ 4.5 $ 3.6 $ 1.5 $ 1.2
Interest Cost 7.2 6.3 2.7 3.0
Expected Return on Plan Assets (8.1) (6.9) - -
Prior Service Cost Amortization 1.5 1.2 (1.2) (1.2)
Recognized Actuarial Loss 1.2 1.5 1.5 1.8
- ---------------------------------------------------------------------------------------------------------
NET PERIODIC BENEFIT COST $ 6.3 $ 5.7 $ 4.5 $ 4.8
=========================================================================================================
EMPLOYER CONTRIBUTIONS
As of September 30, 2004, TEP and UES had funded their anticipated
contributions for 2004 of $5 million and $1 million, respectively.
NOTE 13. EQUITY-BASED COMPENSATION PLANS
- -----------------------------------------
We account for UniSource Energy's two equity-based compensation plans, the
Directors' Plan and the Omnibus Plan, under the recognition and measurement
principles of APB 25 as allowed under FAS 123. See Note 1.
The acquisition agreement discussed in Note 2 limits the amount of capital
stock that UniSource Energy can issue under its stock plans and requires that
both of UniSource Energy's stock plans must be terminated upon closing of the
merger. Additionally, both plans contain "Change in Control" provisions that
provide for accelerated vesting of awards when certain conditions are met. The
March 29, 2004 shareholder vote to approve the proposed merger triggered 100%
vesting of all awards under the Omnibus Plan. The provision in the Directors'
Plan results in 100% vesting of all awards if and when the merger is
consummated. Under the terms of the Omnibus Plan, no awards may be made after
February 3, 2004.
28
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
At September 30, 2004, we had stock options, stock units and restricted
stock grants outstanding as discussed below.
STOCK OPTIONS
No stock options were granted under the Directors' Plan during the nine
months ended September 30, 2004 or during the third quarter of 2003. A total of
22,418 stock options were granted under this plan during the nine-month period
ended September 30, 2003. There were no stock options granted to key employees
under the Omnibus Plan during the nine months ended September 30, 2004 or during
the third quarter of 2003. Key employees were awarded 97,818 stock options under
this plan during the nine months ended September 30, 2003. Director stock option
awards currently vest over three years, become exercisable in one-third
increments on each anniversary date of the grant, and expire on the tenth
anniversary of the grant.
A summary of the stock option activity of the Directors' Plan and Omnibus
Plan is as follows:
Nine Months Ended September 30,
2004 2003
- --------------------------------------------------------------------------------------------------------
WEIGHTED Weighted
AVERAGE Average
EXERCISE Exercise
SHARES PRICE Shares Price
- --------------------------------------------------------------------------------------------------------
Options Outstanding,
Beginning of Period 2,478,551 $16.04 2,576,282 $15.77
Granted - - 120,236 $17.77
Exercised (372,466) $15.17 (24,569) $13.47
Forfeited (2,613) $13.86 (14,529) $14.24
----------------- ----------------
Options Outstanding,
End of Period 2,103,472 $16.20 2,657,420 $15.89
================= ================
Options Exercisable,
End of Period 2,081,201 $16.18 1,851,543 $15.13
Weighted Average Remaining Contractual Life at September 30, 2004: 5.93
- --------------------------------------------------------------------------------------------------------
As discussed in Note 1, we apply APB 25 in accounting for our stock option
plans. We have not recognized any compensation cost for these options because
our stock options are granted with an exercise price equal to the market value
of the stock at the grant date. We have also adopted the disclosure-only
provisions of FAS 123. We present, in Note 1, the effect on net income and
earnings per share as if the company had applied the fair value recognition
provisions of FAS 123, as required by Statement of Financial Accounting
Standards No. 148, Accounting for Stock-Based Compensation-Transition and
Disclosure.
Stock options awarded on January 1, 2002 accrue dividend equivalents that
are paid in cash on the earlier of the date of exercise of the underlying option
or the date the option expires. Compensation expense is recognized on the
dividend payment date. No compensation expense was recognized for dividend
equivalents in the third quarter of 2004 as no dividends were paid during the
quarter. We recognized compensation expense for dividend equivalents on stock
option grants of $0.2 million for the nine month period ended September 30,
2004, $0.1 million for the three month period ended September 30, 2003, and $0.3
million for the nine month period ended September 30, 2003.
RESTRICTED STOCK AND STOCK UNITS
There were no new restricted stock awards granted to directors in the third
quarter of 2004 or 2003. In the first quarter of 2004 and 2003, we granted
restricted stock awards to directors totaling 6,480 shares and 5,157 shares,
respectively. The grant date fair value of the shares was $24.68 per share in
2004 and $17.44 per share in 2003. Directors may elect to receive stock units in
lieu of restricted shares. As discussed above, Directors' awards were not
affected by the shareholder vote to approve the proposed merger. The restricted
shares or stock units become 100% vested on the third anniversary of the grant
date, or upon consummation of the merger. Compensation expense equal to the fair
market value on the date of the award is recognized over the vesting period. We
29
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
recorded compensation expense related to these awards of less than $0.1 million
for each of the three and nine month periods ended September 30, 2004 and 2003.
There were no new stock unit awards granted under the Omnibus Plan in the
nine month periods ended September 30, 2004 or 2003. When awards are granted,
compensation expense equal to the fair market value on the date of the award is
recognized over a three or four year vesting period. All stock unit awards under
the Omnibus Plan were fully vested as of March 6, 2004 and were not impacted by
the shareholder vote to approve the proposed merger. Fully vested but unissued
stock unit awards earn stock dividend equivalents. We recognized compensation
expense for stock dividend equivalents of $0.1 million during the third quarter
of 2004. We recognized compensation expense related to earlier awards of less
than $0.1 million for the three months ended September 30, 2003 and for each of
the nine month periods ended September 30, 2004 and 2003.
PERFORMANCE SHARES
In May 2003, the Board of Directors approved a grant of performance shares
to key employees under the Omnibus Plan. The shares were to be awarded at the
end of a three-year performance period based on goal attainment. The grant date
fair value was $17.84 per share. Compensation expense was initially recorded
over the performance period based on the anticipated number and market value of
shares to be awarded. As a result of the shareholder vote to approve the
proposed merger, 53,566 performance shares vested and were distributed.
Compensation expense of $2 million was recorded in the first quarter of 2004 for
this award. No compensation expense was recognized in the third quarter of 2003
for this award. We recognized compensation expense of $0.4 million related to
performance shares for the nine month period ended September 30, 2003.
NOTE 14. INCOME AND OTHER TAXES
- --------------------------------
INCOME TAXES
The differences between the income tax expense and the amount obtained by
multiplying pre-tax income (loss) before cumulative effect of accounting change
by the U.S. statutory federal income tax rate of 35% are as follows:
UNISOURCE ENERGY
------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
RESTATED RESTATED
(SEE NOTE 1) (SEE NOTE 1)
- ------------------------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars -
FEDERAL INCOME TAX EXPENSE AT STATUTORY RATE $ 14,314 $ 16,389 $ 27,189 $ 12,508
State Income Tax Expense, Net of Federal Deduction 1,882 2,153 3,574 1,645
Depreciation Differences (Flow Through Basis) 789 1,086 2,367 3,259
Tax Credits (346) (380) (604) (1,140)
Valuation Allowance - - 500 -
Other 460 201 1,637 295
- ------------------------------------------------------------------------------------------------------------------------------------
INCOME TAX EXPENSE 17,099 19,449 34,663 16,567
- ------------------------------------------------------------------------------------------------------------------------------------
TAX ON CUMULATIVE EFFECT OF ACCOUNTING CHANGE (SEE NOTE 5) - - - 44,236
- ------------------------------------------------------------------------------------------------------------------------------------
TOTAL FEDERAL AND STATE INCOME TAX EXPENSE $ 17,099 $ 19,449 $ 34,663 $ 60,803
====================================================================================================================================
30
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
TEP
------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
RESTATED RESTATED
(SEE NOTE 1) (SEE NOTE 1)
- ------------------------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars -
FEDERAL INCOME TAX EXPENSE AT STATUTORY RATE $ 15,549 $ 19,106 $ 28,053 $ 23,081
State Income Tax Expense, Net of Federal Deduction 2,043 2,511 3,687 3,034
Depreciation Differences (Flow Through Basis) 789 1,086 2,367 3,259
Tax Credits (346) (380) (604) (1,140)
Valuation Allowance - - 500 -
Other 169 72 1,116 108
- ------------------------------------------------------------------------------------------------------------------------------------
INCOME TAX EXPENSE 18,204 22,395 35,119 28,342
- ------------------------------------------------------------------------------------------------------------------------------------
TAX ON CUMULATIVE EFFECT OF ACCOUNTING CHANGE (SEE NOTE 5) - - - 44,236
- ------------------------------------------------------------------------------------------------------------------------------------
TOTAL FEDERAL AND STATE INCOME TAX EXPENSE $ 18,204 $ 22,395 $ 35,119 $ 72,578
====================================================================================================================================
OTHER TAXES
TEP and UES act as conduits or collection agents for excise tax (sales tax)
as well as franchise fees and regulatory assessments. They record liabilities
payable to governmental agencies when electricity is delivered to customers.
Neither the amounts billed nor payable are reflected in the income statement.
NOTE 15. NEW ACCOUNTING PRONOUNCEMENTS
- ---------------------------------------
The FASB recently issued the following Statements of Financial Accounting
Standards (FAS) and FASB Interpretations (FIN):
o FIN 46, Consolidation of Variable Interest Entities, was issued
in January 2003, and was subsequently revised in December 2003
(FIN 46R). The primary objectives of FIN 46R are to provide
guidance on the identification of entities for which control is
achieved through means other than through voting rights (variable
interest entities) and to determine when and which business
enterprises should consolidate the variable interest entity
(primary beneficiary). FIN 46R requires that both the primary
beneficiary and all other enterprises with a significant variable
interest make additional disclosures. For public companies, the
revised FIN 46R is effective for financial periods ending after
March 15, 2004. The adoption of FIN 46R did not have a
significant impact on our financial statements.
o FAS 132, Employers' Disclosures about Pensions and Other
Postretirement Benefits (revised 2003), was issued by the FASB in
December 2003. FAS 132 requires additional disclosures about the
assets, obligations, cash flows, and net periodic benefit cost of
defined benefit pension plans and other defined benefit
postretirement plans beyond those in the original Statement 132
which it replaces. FAS 132, as revised, is effective for fiscal
years ending after December 15, 2003. The revised disclosure
requirements are included in Note 12 above.
See our discussion of FSP 106-2 in Note 12 above.
In July 2004, the Emerging Issues Task Force (EITF) reached a consensus on
Issue No. 02-14, Whether an Investor Should Apply the Equity Method of
Accounting to Investments Other Than Common Stock (EITF 02-14). EITF 02-14
concludes that an investor that has the ability to exercise significant
influence over the operating and financial policies of an investee should apply
the equity method of accounting only when it has an investment in common stock
or an investment that is in-substance common stock. EITF 02-14 is effective for
reporting periods beginning after September 15, 2004. The adoption of EITF 02-14
is not expected to have a significant impact on our financial statements.
31
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
In June 2004, the EITF published Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF
03-1). EITF 03-1 provides application guidance on impairment of securities
accounted for under FAS 115, Accounting for Certain Investments in Debt and
Equity Securities, and cost method investments and requires certain quantitative
and qualitative disclosures for securities that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The disclosure requirements are effective for reporting periods
ending after December 31, 2003. The FASB issued FSP EITF Issue 03-1-1, Effective
Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments in
September 2004 delaying the effective date of the application guidance on
impairment of securities. The adoption of EITF 03-1 is not expected to have a
significant impact on our financial statements.
In August 2003, the EITF published Issue No. 03-11, Reporting Realized
Gains and Losses on Derivative Instruments That Are Subject to FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities, and Not
"Held for Trading Purposes" as Defined in EITF Issue No. 02-3 (EITF 03-11). EITF
03-11 discusses whether realized gains and losses should be shown gross or net
in the income statement for contracts that are not held for trading purposes, as
defined in EITF 02-3, but are derivatives subject to FAS 133. Determining
whether realized gains and losses on derivative contracts not held for trading
purposes should be reported in the income statement on a gross or net basis is a
matter of judgment that depends on the relevant facts and circumstances with
respect to the various activities of the entity. Retroactive application of EITF
03-11 is not required. Beginning January 1, 2004, the realized gains and losses
on derivative instruments that are not held for trading purposes but are
eventually net settled are shown net in the income statement. The impact of
adopting EITF 03-11 was immaterial as of September 30, 2004. See Note 6.
32
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
NOTE 16. SUPPLEMENTAL CASH FLOW INFORMATION
- --------------------------------------------
A reconciliation of net income to net cash flows from operating activities
follows:
UNISOURCE ENERGY
--------------------------------
Nine Months Ended
September 30,
2004 2003
RESTATED
SEE NOTE 1
- -------------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
NET INCOME $ 43,021 $ 86,642
ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH FLOWS
Cumulative Effect of Accounting Change-Net of Tax - (67,471)
Depreciation and Amortization Expense 108,068 95,472
Depreciation Recorded to Fuel and Other O&M Expense 4,636 4,300
Amortization of Transition Recovery Asset 39,712 25,266
Net Unrealized Gain on TEP Forward Electric Sales (1,272) (176)
Net Unrealized Loss on TEP Forward Electric Purchases 250 137
Net Unrealized Gain on MEG Trading Activities (4,020) (2,644)
Amortization of Deferred Debt-Related Costs included in Interest Expense 4,461 2,223
Provision for Bad Debts 2,096 4,018
Deferred Income Taxes 11,544 16,941
(Gains) Losses from Equity Method Entities (5,744) 2,391
Other 17,012 3,187
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable (18,516) (25,534)
Materials and Fuel Inventory (5,453) (2,332)
Accounts Payable 12,729 (10,231)
Interest Accrued (20,576) (16,976)
Taxes Accrued 37,173 12,658
Other Current Assets (49,599) (9,888)
Other Current Liabilities 73,799 18,119
- -------------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES $ 249,321 $ 136,102
=========================================================================================================================
33
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED)
- ----------------------------------------------------------------
TEP
--------------------------------
Nine Months Ended
September 30,
2004 2003
RESTATED
SEE NOTE 1
- ---------------------------------------------------------------------------------------- ---------------- ---------------
-Thousands of Dollars-
NET INCOME $ 45,033 $ 105,076
ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH FLOWS
Cumulative Effect of Accounting Change-Net of Tax - (67,471)
Depreciation and Amortization Expense 94,035 89,976
Depreciation Recorded to Fuel and Other O&M Expense 4,636 4,300
Amortization of Transition Recovery Asset 39,712 25,266
Net Unrealized Gain on TEP Forward Electric Sales (1,272) (176)
Net Unrealized Loss on TEP Forward Electric Purchases 250 137
Amortization of Deferred Debt-Related Costs included in Interest Expense 4,231 2,199
Provision for Bad Debts 1,171 3,910
Deferred Income Taxes 8,781 25,504
Gains from Equity Method Entities (190) (132)
Interest on Note Receivable from UniSource Energy (6,984) (7,660)
Other 17,779 8,652
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable (26,721) (23,204)
Materials and Fuel Inventory (3,259) (801)
Accounts Payable 7,642 (1,046)
Interest Accrued (17,716) (18,661)
Taxes Accrued 39,489 12,342
Other Current Assets 6,187 7,541
Other Current Liabilities 2,882 (1,127)
- -------------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES $215,686 $ 164,625
=========================================================================================================================
NOTE 17. REVIEW BY INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
- -----------------------------------------------------------------
With respect to the unaudited condensed consolidated financial information
of UniSource Energy and TEP for the three-month and nine month periods ended
September 30, 2004 and 2003, PricewaterhouseCoopers LLP reported that they have
applied limited procedures in accordance with professional standards for a
review of such information. However, their separate report dated November 8,
2004 appearing herein states that they did not audit and they do not express an
opinion on that unaudited condensed consolidated financial information.
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.
PricewaterhouseCoopers LLP is not subject to the liability provisions of Section
11 of the Securities Act of 1933 (the Act) for their report on the unaudited
condensed consolidated financial information because that report is not a
"report" or a "part" of a registration statement prepared or certified by
PricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the Act.
34
ITEM 2. - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
- --------------------------------------------------------------------------------
Management's Discussion and Analysis explains the results of operations,
the general financial condition, and the outlook for UniSource Energy
Corporation (UniSource Energy) and its four primary business segments and
includes the following:
o outlook and strategy,
o operating results during the third quarter and first nine months of
2004 compared with the same periods in 2003,
o factors which affect our results and outlook,
o liquidity, capital needs, capital resources, and contractual
obligations,
o dividends, and
o critical accounting policies.
Management's Discussion and Analysis should be read in conjunction with
UniSource Energy and Tucson Electric Power Company's (TEP) 2003 Form 10-K and
with the Condensed Consolidated Financial Statements, beginning on page 2, which
present the results of operations for the three months and nine months ended
September 30, 2004 and 2003. Certain information in Management's Discussion and
Analysis of Financial Condition and Results of Operations for UniSource Energy
and TEP has been restated. For further information, see Note 1 of Notes to
Condensed Consolidated Financial Statements - Nature of Operations, Basis of
Accounting and Equity-Based Compensation. Management's Discussion and Analysis
explains the differences between periods for specific line items of the
Condensed Consolidated Financial Statements.
References in this report to "we" and "our" are to UniSource Energy and its
subsidiaries, collectively.
OVERVIEW OF CONSOLIDATED BUSINESS
- ---------------------------------
UniSource Energy is a holding company that has no significant operations of
its own. Operations are conducted by UniSource Energy's subsidiaries, each of
which is a separate legal entity with its own assets and liabilities. UniSource
Energy owns substantially all of the outstanding common stock of TEP, and all of
the outstanding common stock of UniSource Energy Services, Inc. (UES),
Millennium Energy Holdings, Inc. (Millennium), and UniSource Energy Development
Company (UED).
TEP, an electric utility, has provided electric service to the community of
Tucson, Arizona, for over 100 years. UES began operations in August 2003. UES,
through its two operating subsidiaries, provides gas and electric service to 30
communities in northern and southern Arizona. Millennium invests in unregulated
businesses, including a developer and manufacturer of thin-film photovoltaic
cells and modules. UED engages in developing generating resources and other
project development activities, including facilitating the expansion of the
Springerville Generating Station. We conduct our business in these four primary
business segments -- TEP's Electric Utility Segment, UES' Gas and Electric
Utility Segment, the Millennium Businesses Segment, and the UED Segment.
TEP is the principal operating subsidiary of UniSource Energy and, at
September 30, 2004, represented approximately 84% of its assets. The seasonal
nature of TEP's business causes operating results to vary significantly from
quarter to quarter. UniSource Energy's results for the nine months ended
September 30, 2004 include three full quarters of operations of UES. UES was not
in operation during the first seven months and eleven days of 2003. Due to sales
of both winter-peaking gas and summer-peaking electricity, UES' consolidated
operating results are expected to be less seasonal than TEP's. Although
representing approximately 6% of UniSource Energy's total assets, losses from
Millennium's unregulated businesses had a significant impact on earnings
reported by UniSource Energy for the three and nine months ended September 30,
2004 and 2003. UED's unregulated business segment, which was established in
February 2001, had a significant impact on our consolidated net income and cash
flows in the fourth quarter of 2003 since the financial closing of Springerville
Unit 3 occurred on October 21, 2003. UED operations did not have a significant
impact on net income or cash flow in the first nine months of 2003 or 2004, nor
is it expected to in future periods.
35
OUTLOOK AND STRATEGIES
AGREEMENT AND PLAN OF MERGER
On November 21, 2003, UniSource Energy and Saguaro Acquisition Corp., a
Delaware corporation, entered into an acquisition agreement providing for the
acquisition of all of the common stock of UniSource Energy for $25.25 per share
by an affiliate of Saguaro Utility Group L.P., an Arizona limited partnership
(Saguaro Utility), whose general partner is Sage Mountain, L.L.C. and whose
limited partners include investment funds affiliated with Kohlberg Kravis
Roberts & Co., L.P., J.P. Morgan Partners, LLC and Wachovia Capital Partners.
Frederick B. Rentschler is the managing member of Sage Mountain, L.L.C., an
Arizona limited liability company.
Pursuant to the terms of the acquisition agreement, Saguaro Acquisition
Corp., a wholly-owned and indirect subsidiary of Saguaro Utility, will merge
with and into UniSource Energy. UniSource Energy will be the surviving
corporation, but will become an indirect wholly-owned subsidiary of Saguaro
Utility. Trading in our stock on the New York Stock Exchange and the Pacific
Exchange will cease immediately as of the effective time of the acquisition.
After that time, the surviving corporation will delist our shares from the New
York Stock Exchange and the Pacific Exchange and de-register our shares under
the Securities Exchange Act of 1934, as amended. UniSource Energy and TEP's
headquarters will remain in Tucson, and we expect that UniSource Energy and
TEP's senior management team will remain generally the same.
Upon the closing of the acquisition, Saguaro Utility will cause the
surviving corporation to pay approximately $880 million in cash to UniSource
Energy's shareholders and holders of stock options, stock units, restricted
stock and performance shares awarded under our stock-based compensation plans.
In connection with the closing of the acquisition, Saguaro Utility intends to
cause the surviving corporation (i) to repay the $95 million inter-company loan
to UniSource Energy from TEP and (ii) to contribute up to $168 million of equity
to TEP. TEP will use a significant portion of these proceeds to retire
outstanding debt.
On March 25, 2004, an affiliate of Saguaro Utility entered into a $410
million credit agreement in connection with a commitment obtained by Saguaro
Utility from lenders in November 2003. The credit agreement will be funded upon
closing of the acquisition of UniSource Energy. It includes a $50 million
revolving credit facility for general corporate purposes and a $360 million term
loan to be used to fund a portion of the acquisition. The lenders' obligations
to make such loans are subject to various closing conditions customary for
credit facilities to be used in an acquisition of this type. The lenders'
financing commitments under this credit agreement expire on February 21, 2005.
UniSource Energy's shareholders approved the acquisition agreement at a
special meeting on March 29, 2004. The acquisition still requires approval by
the Arizona Corporation Commission (ACC), and the Securities and Exchange
Commission (SEC) under the Public Utility Holding Company Act, and the
satisfaction of other conditions set forth in the acquisition agreement.
UniSource Energy filed an application with the ACC for approval of the
acquisition on December 29, 2003. The requirements under the Hart-Scott-Rodino
Antitrust Improvement Act were satisfied on March 19, 2004. Saguaro Utility
filed an application with the SEC for approval of the acquisition on March 30,
2004. On October 12, 2004, the Federal Energy Regulatory Commission (FERC)
issued an order approving the proposed acquisition.
Public hearings on the ACC application were conducted before an
administrative law judge (ALJ) and concluded on July 1, 2004. In its testimony
before the ALJ, the staff of the ACC stated that UniSource Energy had addressed
many of the concerns raised in its initial testimony filed on April 30, 2004.
The staff indicated its continued concern regarding a few remaining issues
related to financial protection of the utility businesses from UniSource Energy
and service quality and reliability. However, the staff indicated it would adopt
a neutral position on the acquisition if certain conditions were met. The
Residential Utility Consumer Office (RUCO) filed initial testimony on April 30,
2004, participated in the ALJ hearings and continues to oppose the acquisition.
Since the conclusion of the hearings, all parties have filed initial briefs and
reply briefs with the ALJ that supported their respective positions.
On November 8, 2004, the ALJ recommended that the ACC deny the application
of Unisource Energy seeking ACC approval for the acquisition. The ALJ's
recommendation was contained in a form of opinion and order which concludes that
the acquisition is not in the public interest.
UniSource Energy vigorously disputes the ALJ's recommendation, which is not
binding on the ACC. The ACC rules permit the filing of exceptions to the ALJ's
recommendation, and Unisource Energy intends to file exceptions. Following the
filing of exceptions, the ACC and its staff will set the date for an open
meeting of the ACC to deliberate the acquisition. The ACC will then issue its
own opinion and order regarding the acquisition.
Either UniSource Energy or Saguaro Acquisition Corp. may terminate the
acquisition agreement in certain circumstances, including if the acquisition is
not consummated by March 31, 2005 or certain regulatory approvals are not
obtained. In certain circumstances, upon the termination of the acquisition
agreement, UniSource Energy would be required to pay Saguaro Acquisition Corp.'s
36
expenses related to the acquisition agreement and a termination fee in an
aggregate amount of up to $25 million. In the event that the ACC denies the
acquisition, issues an order approving the acquisition which does not satisfy
the conditions of the acquisition agreement or fails to approve the transaction
by March 31, 2005, Saguaro Acquisition Corp. may terminate the acquisition
agreement and UniSource Energy would be obligated to reimburse up to $7 million
of its expenses.
While UniSource Energy is hopeful that the ACC will recognize the benefits
of the acquisition and approve the transaction, in light of the ALJ's
recommendation we are unable to predict whether the required regulatory
approvals will be obtained in order to permit the transaction to close. If the
required regulatory approvals are obtained and the other closing conditions are
satisfied, we would expect to close the transaction by the end of the first
quarter of 2005.
OPERATING PLANS AND STRATEGIES
Our financial prospects and outlook for the next few years will be affected
by many competitive, regulatory and economic factors. Our plans and strategies
include the following:
o Obtain all necessary regulatory approvals and satisfy all of the other
closing conditions contained in the acquisition agreement so that the
acquisition of UniSource Energy by an affiliate of Saguaro Utility can
occur.
o Integrate UES' businesses with UniSource Energy's other businesses to
achieve the strategic and financial objectives of the acquisition.
o Oversee the construction of Springerville Unit 3 and continue to
enhance the value of existing assets by working with Salt River
Project to facilitate the development of Springerville Unit 4.
o Enhance the value of TEP's transmission system while continuing to
provide reliable access to generation for TEP's retail customers and
market access for all generating assets. This will include focusing on
completing the Tucson - Nogales transmission line, which would improve
reliability for customers of UNS Electric and could eventually be
connected to Mexico's utility system.
o Continue to manage our existing Millennium investments to maximize
their value.
o Increase production and sales of Global Solar's thin-film photovoltaic
cells and seek strategic partners.
o Promote economic development in our service territories.
o Reduce TEP's debt, using some of our excess cash flows.
o Efficiently manage our generation, transmission and distribution
resources and look for ways to control our operating expenses while
maintaining and enhancing reliability and profitability.
o Expand TEP's portfolio of generating and purchased power resources to
meet growing retail energy demand.
To accomplish our goals, during 2004 we expect TEP to spend approximately
$113 million on capital expenditures and UES to spend approximately $37 million
on capital expenditures. As of September 30, 2004, year-to-date capital
expenditures were $82 million and $27 million for TEP and UES, respectively.
While we believe that our plans and strategies will continue to have a
positive impact on our financial prospects and position, we recognize that we
continue to be highly leveraged, and as a result, our access to the capital
markets may be limited or more expensive than for less leveraged companies.
UNISOURCE ENERGY CONSOLIDATED
RESULTS OF OPERATIONS
- ---------------------
THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED WITH THE THREE MONTHS ENDED
SEPTEMBER 30, 2003
UniSource Energy recorded net income of $24 million, or $0.69 per average
share of Common Stock, in the third quarter of 2004 compared with net income of
$27 million, or $0.81 per average share of Common Stock last year. The following
factors contributed to the change in net income:
37
o TEP's utility gross margin (the sum of electric retail revenues and
electric wholesale revenues less fuel expense and purchased power
expense) did not change materially, due to the offsetting effects of:
- a $5 million increase in TEP's wholesale revenues resulting from
higher wholesale kWh sales; and
- a $7 million increase in TEP's purchased power expense.
The following factors contributed to the decrease in UniSource Energy's net
income when compared with the same period last year:
o a $5 million increase in TEP's amortization of transition recovery
asset; and
o a $2 million increase in depreciation and amortization due primarily
to depreciation and amortization at UES and higher depreciation at TEP
resulting from increased plant in service net of reduced depreciation
rates; partially offset by:
o a $3 million decrease in TEP's total interest expense resulting from
lower fees and rates associated with TEP's Credit Facility that was
refinanced in March 2004, as well as lower capital lease interest
expense; and
o a $2 million decrease in income tax expense due to lower pre-tax
income.
NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED WITH THE NINE MONTHS ENDED
SEPTEMBER 30, 2003
UniSource Energy recorded net income of $43 million, or $1.25 per average
share of Common Stock, in the first nine months of 2004 compared with net income
of $87 million, or $2.56 per average share of Common Stock last year. Results in
the first nine months of 2003 included an after-tax gain of $67 million, or
$2.00 per average share of Common Stock, for the Cumulative Effect of Accounting
Change from the adoption of Statement of Financial Accounting Standards No. 143,
Accounting for Asset Retirement Obligations (FAS 143). Net income before the
Cumulative Effect of Accounting Change was $19 million, or $0.57 per average
share of Common Stock. The following factors contributed to the change in net
income before the Cumulative Effect of Accounting Change:
o a $38 million increase in TEP's utility gross margin (the sum of
electric retail revenues and electric wholesale revenues, less fuel
expense and purchased power expense) resulting from:
- a $27 million increase in retail revenues resulting from cold
weather during January and February and a 2% increase in the
retail customer base;
- a $13 million increase in wholesale revenues resulting from
higher wholesale kWh sales and higher power prices in the first
half of 2004 compared to last year when generating plant outages
limited wholesale opportunities (net of a $3 million reserve for
refund recorded in the second quarter of 2004 related to
wholesale kWh sales made to California during 2000 and 2001);
and
- a $4 million increase in fuel expense due to the higher
availability and use of TEP's coal-fired generating facilities
and increased use of gas-fired generation; partially offset by:
- a $2 million decline in purchased power expense resulting from
fewer planned and unplanned outages at TEP's generating
facilities, reducing the need to purchase replacement power to
meet retail demand.
Other factors contributing to the change in UniSource Energy's net income
in the first nine months of 2004 compared with the same period last year
include:
38
o a $5 million decrease in TEP's total interest expense resulting from
lower fees and rates associated with TEP's Credit Facility that was
refinanced in March 2004, as well as lower capital lease interest
expense;
o net income of $6 million at UES; and
o $9 million of lower net losses at Millennium resulting from income of
$3 million (net of tax) recorded in the first quarter of 2004 related
to Haddington Energy Partners II, LP, (Haddington), one of
Millennium's equity method investments, and lower operating costs at
Global Solar and IPS; offset by
o a $18 million increase in income tax expense due to higher pre-tax
income;
o a $14 million increase in TEP's amortization of transition recovery
asset;
o a $4 million increase in incentive compensation, in part, as a result
of the shareholder vote to approve the acquisition;
o a $4 million increase in TEP's depreciation and amortization due to
increased plant-in-service, offset by a $2 million decrease in
depreciation due to reduced depreciation rates; and
o expenses of $4 million related to the proposed acquisition of
UniSource Energy.
CONTRIBUTION BY BUSINESS SEGMENT
The table below shows the contributions to our consolidated after-tax
earnings (losses) by our four business segments, as well as parent company
expenses.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2004 2003 2004 2003
Restated (1) Restated (1)
- --------------------------------------------------------------------------------------------
Business Segment - Millions of Dollars - - Millions of Dollars -
TEP (2) $ 26 $ 32 $ 45 $ 105
UES (3) - - 6 -
UED - - (1) -
Millennium (1) (3) (3) (12)
UniSource Energy Standalone (4) (1) (2) (4) (6)
- --------------------------------------------------------------------------------------------
Consolidated Net Income $ 24 $ 27 $43 $ 87
============================================================================================
<FN>
(1) See Note 1 of Notes to Condensed Consolidated Financial Statements.
(2) TEP results in the nine months ended September 30, 2003 include an
after-tax gain of $67 million for the Cumulative Effect of Accounting
Change from the adoption of FAS 143.
(3) UES began operations in August 2003.
(4) Primarily represents interest expense (net of tax) on the note payable from
UniSource Energy to TEP.
</FN>
39
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
UNISOURCE ENERGY CONSOLIDATED CASH FLOWS
NINE MONTHS ENDED
SEPTEMBER 30, 2004 2003
- ---------------------------------------------------------------------------
- Millions of Dollars -
Cash Provided by (Used in):
Operating Activities $249 $ 136
Investing Activities (93) (321)
Financing Activities (89) 157
- ---------------------------------------------------------------------------
Net Increase/(Decrease) in Cash $ 67 $ (28)
===========================================================================
UniSource Energy's consolidated cash flows are provided primarily from
retail and wholesale energy sales at TEP and UES, net of the related payments
for fuel and purchased power. Typically, cash from operations is lowest in the
first quarter and highest in the third quarter due to TEP's summer peaking load.
We use our available cash primarily to:
o finance capital expenditures at TEP and UES;
o make investments in our technology affiliates;
o pay dividends to shareholders; and
o reduce leverage at TEP by repaying high coupon debt and investing in
lease debt.
The primary source of liquidity for UniSource Energy, the parent company,
is dividends it receives from its subsidiaries, primarily TEP, from their cash
flow from operations. See Tucson Electric Power Company, Liquidity and Capital
Resources, Dividends, below.
Accrued annual interest on UniSource Energy's promissory note to TEP of
approximately $20 million is payable every two years; the last payment of $20
million was made to TEP in December 2003. Under our tax allocation procedures,
our subsidiaries make income tax payments to UniSource Energy, which makes
payments on behalf of the consolidated group.
As of November 3, 2004, cash and cash equivalents available to UniSource
Energy was approximately $168 million.
As part of our ACC Holding Company Order, we must invest at least 30% of
any proceeds of UniSource Energy equity issuances in TEP until TEP's equity
reaches 37.5% of total capital (excluding capital leases).
OPERATING ACTIVITIES
In the first nine months of 2004, net cash flows from operating activities
increased by $113 million compared with the same period in 2003. The following
factors contributed to the increase:
o a $130 million increase in cash receipts from retail and wholesale
energy customers, net of fuel and purchased energy costs, due to
energy sales at UES and retail and wholesale electric sales at TEP;
o the return of a $17 million deposit related to TEP's second mortgage
indenture; partially offset by:
o a $24 million increase in other taxes paid due primarily to property,
sales and use, franchise and employment taxes paid at UES;
o a $14 million increase in other operations and maintenance (O&M) due
to $19 million of O&M at UES and acquisition-related costs partially
offset by a $4 million decrease of O&M at Millennium; and
40
o a $10 million increase in wages paid due primarily to an $8 million
increase of wages paid at UES and incentive compensation payments to
management pursuant to their employment arrangements triggered by the
shareholder approval of the proposed acquisition of UniSource Energy,
partially offset by a reduction of wages paid at Millennium.
INVESTING ACTIVITIES
Net cash used for investing activities was $228 million lower in the first
nine months of 2004 compared with the same period in 2003, due primarily to a
payment of $229 million related to the purchase of the Arizona gas and electric
utility assets from Citizens Communications Company (Citizens) in the third
quarter of 2003.
FINANCING ACTIVITIES
Net cash used for financing activities was $89 million in the first nine
months of 2004 compared with net cash from financing activities of $157 million
in the same period in 2003. The following factors primarily contributed to the
change:
o in August 2003, UES issued $160 million of notes and obtained a $35
million short-term bridge loan to help finance the acquisition of the
Citizens Arizona gas and electric utility assets; and
o a $20 million decrease in net proceeds from borrowings under TEP's
revolving credit facility; partially offset by:
o TEP repaid $33 million more long-term debt and capital lease
obligations in 2004 than in 2003 ; and
o TEP paid $9 million in debt issuance costs related to the refinancing
of its Credit Agreement.
Our consolidated cash and cash equivalents increased to $168 million at
September 30, 2004, from $129 million at June 30, 2004. We invest cash balances
in high-grade money market securities with an emphasis on preserving the
principal amounts invested.
In the event that we experience lower cash from operations in 2004, we may
adjust our discretionary uses of cash accordingly. We believe, however, that we
will continue to have sufficient cash flow to cover our capital needs, as well
as required debt payments and dividends to shareholders.
GUARANTEES AND INDEMNITIES
In the normal course of business, UniSource Energy and certain subsidiaries
enter into various agreements providing financial or performance assurance to
third parties on behalf of certain subsidiaries. We enter into these agreements
primarily to support or enhance the creditworthiness of a subsidiary on a
stand-alone basis. The most significant of these guarantees are UES' guarantee
of $160 million of aggregate principal amount of senior unsecured notes issued
by UNS Gas and UNS Electric to purchase the Citizens' Arizona gas and electric
utility assets, UniSource Energy's guarantee of approximately $8 million in
natural gas transportation and supply payments and building and equipment lease
payments for UNS Gas, UNS Electric, and subsidiaries of Millennium, and
Millennium's guarantee of approximately $4 million in commodity-related payments
for MEG and building lease payments for a subsidiary at September 30, 2004. To
the extent liabilities exist under the contracts subject to these guarantees,
such liabilities are included in the consolidated balance sheets.
In addition, UniSource Energy and its subsidiaries have indemnified the
purchasers of interests in certain investments from additional taxes due for
years prior to the sale of such investments. The terms of the indemnifications
provide for no limitation on potential future payments; however, we believe that
we have abided by all tax laws and paid all tax obligations. We have not made
any payments under the terms of these indemnifications to date.
41
We believe that the likelihood that UniSource Energy, UES or Millennium
would be required to perform or otherwise incur any significant losses
associated with any of these guarantees or indemnities is remote.
CONTRACTUAL OBLIGATIONS
There have been no significant changes in our contractual obligations or
other commercial commitments from those reported in our 2003 Annual Report on
Form 10-K.
DIVIDENDS ON COMMON STOCK
The following table shows the declared dividends to UniSource Energy
shareholders for 2004.
DIVIDEND AMOUNT
DECLARATION DATE RECORD DATE PAYABLE DATE PER SHARE OF COMMON STOCK
- -------------------- -------------------- ------------------- ----------------------------
February 6, 2004 February 17, 2004 March 10, 2004 $0.16
May 7, 2004 May 18, 2004 June 10, 2004 $0.16
September 10, 2004 September 21, 2004 October 4, 2004 $0.16
The acquisition agreement allows UniSource Energy to continue to pay
regular quarterly cash dividends until the closing of the acquisition, subject
to limitations upon our ability to increase the amount of such dividends.
UniSource Energy's Board of Directors currently expects to continue to pay
regular quarterly cash dividends on UniSource Energy's Common Stock until the
closing of the acquisition, subject, however, to its evaluation of our financial
condition, earnings, cash flows and dividend policy.
INCOME TAX POSITION
At September 30, 2004, UniSource Energy and TEP had, for federal and state
income tax filing purposes, the following carryforward amounts. These amounts
represent balances resulting from federal returns filed for periods ending on or
before December 31, 2003.
UNISOURCE ENERGY TEP
Amount Expiring Amount Expiring
---------------------- -------------- ---------------------- -------------
-Millions of Dollars- Years -Millions of Dollars- Years
---------------------- -------------- ---------------------- -------------
Net Operating Losses $ 65 2006-2023 $ 42 2006-2009
- ---------------------------- ---------------------- -------------- ---------------------- -------------
Investment Tax Credit 9 2004-2023 9 2004-2023
- ---------------------------- ---------------------- -------------- ---------------------- -------------
AMT Credit 86 - 80 -
- ---------------------------- ---------------------- -------------- ---------------------- -------------
Of the $65 million in Net Operating Losses (NOL) carryforwards at
UniSource Energy, $18 million is subject to limitation due to a reorganization
of certain Millennium entities in December 2002. The future use of these losses
is dependent upon the generation of sufficient future taxable income at the
separate company level. See Critical Accounting Policies, Deferred Tax Valuation
- - TEP and Millennium, below.
TUCSON ELECTRIC POWER COMPANY
RESULTS OF OPERATIONS
- ---------------------
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. The following discussion relates to TEP's utility operations,
unless otherwise noted.
TEP KWH SALES AND REVENUES
Customer growth, weather and other consumption factors affect retail sales
of electricity. Electric wholesale revenues are affected by market prices in the
42
wholesale energy market, availability of TEP generating resources, the price of
fuel, and the level of wholesale forward contract activity.
TEP kWh sales delivered and corresponding revenues for the quarter ended
and nine months ended September 30, 2004 compared with the same periods in 2003
are detailed below.
SALES OPERATING REVENUE
- ------------------------------------------------------------------------------------------------------------------------
2003 Percent 2003 Percent
THREE MONTHS ENDED SEPTEMBER 30, 2004 (RESTATED)(1) Change 2004 (RESTATED)(1) Change
- ------------------------------------------------------------------------------------------------------------------------
- Millions of kWh - - Millions of Dollars -
Electric Retail Sales:
Residential 1,203 1,225 (2%) $113 $116 (3%)
Commercial 548 527 4% 58 54 7%
Industrial 626 651 (4%) 46 48 (4%)
Mining 214 188 14% 10 8 25%
Public Authorities 64 71 (10%) 5 5 -
- ------------------------------------------------------------------------------------------------------------------------
Total Electric Retail Sales 2,655 2,662 - 232 231 1%
- ------------------------------------------------------------------------------------------------------------------------
Electric Wholesale Sales Delivered:
Long-term Contracts 292 295 (1%) 14 14 -
Other Sales 435 344 26% 21 16 31%
Transmission - - - 2 3 (33%)
- ------------------------------------------------------------------------------------------------------------------------
Total Electric Wholesale Sales 727 639 14% 37 33 12%
- ------------------------------------------------------------------------------------------------------------------------
Total 3,382 3,301 2% $269 $264 2%
========================================================================================================================
<FN>
(1) See Note 1 of Notes to Condensed Consolidated Financial Statements.
</FN>
Total revenues from kWh sales to retail customers increased by $1 million
in the third quarter of 2004 due to higher sales to TEP's commercial and mining
customers. TEP's retail customer base increased by 2% to 372,899, while kWh
sales to retail customers in the third quarter of 2004 were flat compared with
the same period last year. Kilowatt-hour sales to residential customers were 3%
lower while kWh sales to commercial customers were 4% higher, primarily
resulting from mild summer weather compared to the third quarter of 2003,
partially offset by customer growth. Cooling degree days declined by 15%
compared with the third quarter of 2003. Copper prices were 61% higher in the
third quarter of 2004 compared with the same period in 2003, leading to
increased mining activity and a 14% increase in kWh sales to TEP's mining
customers. Revenues from TEP's mining customers increased $2 million, benefiting
from increased demand and higher prices for copper. The price of energy provided
to TEP's mining customers is indexed with the market price of copper and was 18%
higher than in the third quarter of 2003.
Wholesale kWh sales were up 14% and wholesale revenues were up 12% compared
with the third quarter of 2003, due to increased sales activity but slightly
lower average market prices for power. The average price for power on the Dow
Jones Palo Verde Index was $45 per MWh in the third quarter of 2004, compared
with $46 per MWh in the same period last year.
43
SALES OPERATING REVENUE
- ------------------------------------------------------------------------------------------------------------------------
NINE MONTHS ENDED 2004 2003 Percent 2004 2003 Percent
SEPTEMBER 30, (RESTATED)(1) Change (RESTATED)(1) Change
- ------------------------------------------------------------------------------------------------------------------------
- Millions of kWh - - Millions of Dollars -
Electric Retail Sales:
Residential 2,748 2,654 4% $253 $245 3%
Commercial 1,384 1,299 7% 145 134 8%
Industrial 1,719 1,719 - 125 124 1%
Mining 611 512 19% 28 20 40%
Public Authorities 180 195 (8%) 13 14 (7%)
- ------------------------------------------------------------------------------------------------------------------------
Total Electric Retail Sales 6,642 6,379 4% 564 537 5%
- ------------------------------------------------------------------------------------------------------------------------
Electric Wholesale Sales Delivered:
Long-term Contracts 919 882 4% 42 40 5%
Other Sales 1,633 1,491 10% 73 62 18%
Transmission - - - 6 6 -
- ------------------------------------------------------------------------------------------------------------------------
Total Electric Wholesale Sales 2,552 2,373 8% 121 108 12%
- ------------------------------------------------------------------------------------------------------------------------
Total 9,194 8,752 5% $685 $645 6%
========================================================================================================================
<FN>
(1) See Note 1 of Notes to Condensed Consolidated Financial Statements.
</FN>
Total revenues from kWh sales to retail customers increased by $27 million
in the first nine months of 2004, resulting from higher energy demand. Total
retail kWh sales increased by 4% in the first nine months of 2004. Kilowatt-hour
sales to residential customers were 4% higher, while kWh sales to commercial
customers were 7% higher, resulting from customer growth and a 28% increase in
first quarter 2004 heating-degree days. The average price of copper was 62%
higher in the first nine months of 2004, leading to increased mining activity
and a 19% increase in kWh sales to TEP's mining customers; revenues from TEP's
mining customers increased $8 million.
Wholesale kWh sales increased 8% and wholesale revenues increased 12% in
the first nine months of 2004. Greater coal plant availability allowed TEP to
sell more excess power into the wholesale market. TEP recorded a $3 million
reserve in the second quarter of 2004 and a $2 million reserve in the first
quarter of 2003 for revenue subject to refund related to wholesale sales made to
the California Independent System Operator (CISO) and the California Power
Exchange (CPX) in 2001 and 2000. These amounts are recorded as a reduction to
wholesale revenue.
44
FUEL AND PURCHASED POWER EXPENSES
TEP's fuel and purchased power expense, and energy resources for the third
quarter and first nine months of 2004 compared with the same periods of 2003 are
detailed in the tables below.
GENERATION EXPENSE
- -------------------------------------------------------------------------------------------------------------
Percent Percent
THREE MONTHS ENDED SEPTEMBER 30, 2004 2003 Change 2004 2003 Change
- -------------------------------------------------------------------------------------------------------------
-Millions of kWh- -Millions of Dollars-
Coal-Fired Generation 2,924 2,965 (1%) $47 $49 (4%)
Gas- Fired Generation 218 211 3% 17 15 13%
- -------------------------------------------------------------------------------------------------------------
Total Generation 3,142 3,176 (1%) 64 64 -
Purchased Power 513 402 28% 29 23 26%
- -------------------------------------------------------------------------------------------------------------
Total Resources 3,655 3,578 2% $93 $87 7%
Less Losses and Company Use 273 277 (1%)
- -------------------------------------------------------------------------------------------------------------
Total Energy Sold 3,382 3,301 2%
=============================================================================================================
Fuel expense at TEP's generating plants was $64 million in both the third
quarter of 2004 and the same period in 2003. During the third quarter of 2004,
generation at TEP's coal-fired generating facilities was 1% lower than the same
period last year, due to minor unplanned outages. The average cost of fuel per
kWh generated for the third quarter of 2004 was 2.02 cents, equal to the same
period last year.
TEP's purchased power expense increased $6 million, or 26%, in the third
quarter of 2004, due primarily to a 28% increase in kWh purchased. See Wholesale
Energy Markets - Energy Prices, below.
GENERATION EXPENSE
- -------------------------------------------------------------------------------------------------------------
Percent Percent
NINE MONTHS ENDED SEPTEMBER 30, 2004 2003 Change 2004 2003 Change
- -------------------------------------------------------------------------------------------------------------
-Millions of kWh- -Millions of Dollars-
Coal-Fired Generation 8,597 7,933 8% $141 $133 6%
Gas- Fired Generation 328 406 (19%) 25 30 (17%)
- -------------------------------------------------------------------------------------------------------------
Total Generation 8,925 8,339 7% 166 163 2%
Purchased Power 936 1,059 (12%) 55 56 (2%)
- -------------------------------------------------------------------------------------------------------------
Total Resources 9,861 9,398 5% $221 $219 1%
Less Losses and Company Use 667 646 3%
- -------------------------------------------------------------------------------------------------------------
Total Energy Sold 9,194 8,752 5%
=============================================================================================================
In the first nine months of 2004, fuel expense increased by $3 million, or
2%, due to the higher availability of and use of TEP's coal-fired generating
facilities. Generation at TEP's coal-fired units increased 8%, or 664 million
kWh, compared with the first nine months of 2003. See Item 3. - Quantitative and
Qualitative Disclosures About Market Risk, below.
Purchased power expense declined by $1 million, or 2%, in the first nine
months of 2004 compared with the same period last year. The higher availability
of TEP's coal-fired resources reduced the need to purchase replacement power.
45
OTHER OPERATING EXPENSES
Other O&M increased by $7 million, or 18%, in the third quarter of 2004,
and $11 million, or 9% in the first nine months of 2004, compared with the same
periods last year. The increases were due primarily to incentive compensation
and TEP's allocated portion of acquisition-related costs. Through September 30,
2004, TEP has expensed $3 million of acquisition-related costs. TEP accrued $4
million in the first nine months of 2004 for annual incentive compensation and
expensed and paid $2 million in incentive compensation resulting from
shareholder approval of the acquisition agreement on March 29, 2004.
Amortization of the Transition Recovery Asset (TRA) increased $5 million in
the third quarter of 2004, and $14 million in the first nine months of 2004,
compared with the same periods in 2003. Amortization of the TRA is the result of
the 1999 Settlement Agreement (TEP Settlement Agreement) with the ACC, which
changed the accounting method for TEP's generation operations. This item
reflects the recovery, through 2008, of transition recovery assets which were
previously regulatory assets of the generation business. The amount of
amortization is a function of the TRA balance and total kWh consumption by TEP's
distribution customers. TEP expects TRA amortization to be $49 million in 2004,
$57 million in 2005, $66 million in 2006, $76 million in 2007 and $29 million in
2008.
OTHER INCOME (DEDUCTIONS)
TEP's income statement includes inter-company interest income of $2 million
for the third quarter of 2004 compared with $3 million for the same period in
2003. This represents Interest Income on the promissory note TEP received from
UniSource Energy in exchange for the transfer to UniSource Energy of its stock
in Millennium in 1998. On UniSource Energy's income statement, this Interest
Income, as well as UniSource Energy's related interest expense, is eliminated as
an inter-company transaction. Inter-company interest income was $7 million in
the first nine months of 2004.
INTEREST EXPENSE
Total interest expense decreased by $3 million, or 7%, in the third quarter
of 2004, resulting from the refinancing of TEP's Credit Agreement in March 2004
and a $1 million decrease in capital lease interest expense. Interest on capital
leases was lower in the third quarter of 2004 due to scheduled repayments of
capital lease obligations.
Total interest expense decreased by $5 million, or 5%, in the first nine
months of 2004. Unamortized fees of $2 million that were expensed in the first
quarter of 2004 as a result of the refinancing of TEP's Credit Agreement were
offset by the lower rates and fees associated with the new Credit Agreement, as
well as a $2 million decrease in capital lease interest expense. See Liquidity
and Capital Resources, TEP Cash Flows, Investing Activities and TEP Credit
Agreement, below.
INCOME TAX EXPENSE
Income tax expense, before Cumulative Effect of Accounting Change,
decreased $4 million in the third quarter of 2004, compared with the same period
in 2003, due to lower pre-tax income. In the first nine months of 2004, Income
Tax Expense before Cumulative Effect of Accounting Change, increased by $7
million compared with the same period in 2003, due to higher pre-tax income.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE
TEP adopted FAS 143 on January 1, 2003 and recorded a one-time $67 million
after-tax gain. Upon adoption of FAS 143, TEP recorded an asset retirement
obligation of $38 million at its net present value of $1 million; increased
depreciable assets by $0.1 million for asset retirement costs, reversed $113
million of costs previously accrued for final removal from accumulated
depreciation, and reversed previously recorded deferred tax assets of $44
million. The adoption of FAS 143 resulted in a reduction to depreciation expense
charged throughout the year because asset retirement costs are no longer
recorded as a component of depreciation expense. See Critical Accounting
Policies - Accounting for Asset Retirement Obligations, below.
46
FACTORS AFFECTING RESULTS OF OPERATIONS
- ---------------------------------------
COMPETITION
The electric utility industry has undergone significant regulatory change
in the last few years designed to encourage competition in the sale of
electricity and related services. However, the experience in California with
deregulation during 2000 and 2001 has caused many states, including Arizona, to
re-examine the viability of retail electric deregulation.
As of January 1, 2001, all of TEP's retail customers became eligible to
choose an alternate energy supplier. Currently, none of TEP's retail customers
is receiving service from an alternate Energy Service Provider (ESP). TEP has
met all conditions required by the ACC to facilitate electric retail
competition, including ACC approval of TEP's direct access tariffs. ESPs must
meet certain conditions before electricity can be sold competitively in TEP's
service territory. Examples of these conditions include ACC certification of
ESPs, and execution of and compliance with direct access service agreements with
TEP.
On January 27, 2004, the Arizona Court of Appeals issued a decision that
addressed challenges to the ACC's Retail Electric Competition Rules. The Court
determined that certain rules established by the ACC relating to the entry of
new competitive electric service providers into the market were invalid. The
ultimate impact on TEP's Settlement Agreement is not known. Motions for
Reconsideration, which is a prerequisite to filing an appeal, were filed by
several Arizona electric cooperatives. On May 4, 2004, Trico Electric
Cooperative filed a Petition for Review at the Arizona Supreme Court.
TEP competes against gas service suppliers and others that provide energy
services. Other forms of energy technologies may provide competition to TEP's
services in the future, but to date, are not financially viable alternatives for
its retail customers. Self-generation by TEP's large industrial customers could
also provide competition for TEP's services in the future, but has not had a
significant impact to date.
In the wholesale market, TEP competes with other utilities, power marketers
and independent power producers in the sale of electric capacity and energy.
RATES
In 1999, the ACC approved the TEP Settlement Agreement between TEP and
certain customer groups related to the implementation of retail electric
competition. The TEP Settlement Agreement provided for certain retail rate
reductions in 1999 and 2000. In addition, TEP was required to file with the ACC
by June 1, 2004 general rate case information, including an updated cost of
service study. Under the terms of the TEP Settlement Agreement, no rate case
filed by TEP through 2008, including the filing on June 1, 2004, may result in a
rate increase. Any rate decrease resulting from the 2004 filing would be
effective no earlier than June 1, 2005.
On June 1, 2004, TEP filed general rate case information with the ACC.
TEP's filing does not propose any change in retail rates. Absent the restriction
on raising rates provided in the TEP Settlement Agreement, the data presented by
TEP would justify a request by TEP for an increase in retail rates of 16%. The
general rate case information uses a historical test year ended December 31,
2003 and establishes, based on TEP's Standard Offer service, that TEP is
experiencing a revenue deficiency of $115 million. The proposed weighted cost of
capital for the test year ended December 31, 2003 is 8.78%, including an 11.5%
return on equity.
On November 5, 2004, a procedural conference with the ACC was held to
discuss how the review of the general rate case information will proceed. The
ACC staff proposed a schedule that calls for staff and intervenor testimony to
be filed in April 2005 and hearings, as appropriate, to begin in July 2005. No
parties opposed staff's recommendation. The administrative law judge took the
matter under advisement and will issue a procedural order.
WESTERN ENERGY MARKETS
As a participant in the western U.S. wholesale power markets, TEP is
directly and indirectly affected by changes in market conditions and market
47
participants. TEP competes with other utilities, power marketers and independent
power producers in the sale of electric capacity and energy at market-based
rates in the wholesale market.
The generating capacity in Arizona is expected to be approximately 24,000
MW by the end of 2004, which represents an increase of 55% compared with the
capacity available at the end of 2000. A majority of this growth is the result
of 16 new or upgraded gas-fired generating units with a combined capacity of
approximately 8,500 MW. In addition, the presence of fewer creditworthy
counterparties, as well as legal, political and regulatory uncertainties, has
reduced market liquidity and trading volume.
MARKET PRICES
The average market price for around-the-clock energy based on the Dow Jones
Palo Verde Index decreased slightly in the third quarter of 2004 compared with
2003, while the average prices for natural gas based on the Permian Index
increased. Beginning in January 2004, all natural gas used by TEP plants
originated from the Permian Gas Basin.
AVERAGE MARKET PRICE FOR AROUND-THE-CLOCK ENERGY $/MWH
- ------------------------------------------------------------------ -------------
Quarter Ended September 30, 2004 $45
Quarter Ended September 30, 2003 46
Nine Months Ended September 30, 2004 $43
Nine Months Ended September 30, 2003 43
AVERAGE MARKET PRICE FOR NATURAL GAS $/MMBTU
- ------------------------------------------------------------------ -------------
Quarter Ended September 30, 2004 $5.45
Quarter Ended September 30, 2003 4.81
Nine Months Ended September 30, 2004 $5.29
Nine Months Ended September 30, 2003 5.17
Natural gas prices remained at historically high levels throughout 2003 and
into 2004 with continued demand, storage and production concerns. These high gas
and subsequent power prices are currently expected to continue at least for the
next several months. As a result, we expect TEP's fuel and purchased power
expense to be higher in 2004 than in 2003, depending on the actual volumes
purchased. We cannot predict whether these higher prices will continue, or
whether changes in various factors that influence demand and supply will cause
prices to fall again during the remainder of 2004.
We expect the market price and demand for capacity and energy to continue
to be influenced by the following factors during the next few years:
o weather;
o continued population growth in the western U.S.;
o economic conditions in the western U.S.;
o availability of generating capacity throughout the western U.S.;
o the extent of electric utility industry restructuring in Arizona,
California and other western states;
o the effect of FERC regulation of wholesale energy markets;
o the availability and price of natural gas;
o availability of hydropower;
o transmission constraints; and
o environmental restrictions and the cost of compliance.
48
PAYMENT DEFAULTS AND ALLOWANCES FOR DOUBTFUL ACCOUNTS
See Critical Accounting Policies, TEP - Payment Defaults and Allowances for
Doubtful Accounts, below.
GENERATING RESOURCES
WATER SUPPLY
Drought conditions in the Four Corners region, combined with water usage in
upper New Mexico, have resulted in decreasing water levels in the lake that
indirectly supplies water to the San Juan and Four Corners generating stations.
These drought conditions may affect the water supply of the plants if adequate
moisture is not received in the watershed that supplies the area. TEP has a 50%
ownership interest in each of San Juan Units 1 and 2 (322 MW capacity) and a 7%
ownership interest in each of Four Corners Units 4 and 5 (110 MW capacity).
The Operating Agents for the plants have negotiated supplemental water
contracts with the U.S. Bureau of Reclamation and the Jicarilla Apache Nation
for 2004 to assist the plants in meeting their water requirements in the event
of a water shortage. Additionally, negotiations are underway for supplemental
contracts for later years. The Operating Agents indicate that plant operations
will not be materially affected in 2004. However, TEP cannot predict the
ultimate outcome of the drought, or whether it will adversely affect the amount
of power available from the San Juan and Four Corners generating stations.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
TEP CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2004 2003
- --------------------------------------------------- ----------------- ----------
-Millions of Dollars-
Cash from Operations $ 216 $ 165
Capital Expenditures (82) (97)
Debt Maturities (2) (2)
Retirement of Capital Lease Obligations (49) (42)
- --------------------------------------------------- ----------------- ----------
Net Cash Flows Available after Required Payments $ 83 $24
=================================================== ================= ==========
Cash from operations typically is the lowest in the first quarter and
highest in the third quarter due to TEP's summer peaking load. TEP's capital
requirements consist primarily of capital expenditures and optional and
mandatory redemptions of long-term debt and capital lease obligations.
During 2004, TEP expects to generate sufficient internal cash flows to fund
its operating activities, construction expenditures, required debt maturities,
and to pay dividends to UniSource Energy. However, TEP's cash flows may vary due
to changes in energy prices, natural gas prices, availability of coal-fired
generation, changes in short-term interest rates, and other factors. TEP
currently has $60 million available under its Revolving Credit Facility which it
may borrow if cash flows fall short of expectations or if monthly cash
requirements temporarily exceed available cash balances.
OPERATING ACTIVITIES
In the first nine months of 2004, net cash flows from operating activities
increased by $51 million compared with the same period in 2003. The following
factors contributed to the increase:
o a $38 million increase in cash receipts from retail and wholesale
electric customers, net of fuel and purchased energy costs, due
primarily to higher retail energy demand and lower fuel and purchased
power costs;
o the return of a $17 million deposit related to TEP's second mortgage
indenture; and
49
o a $9 million decrease in total interest paid due to lower interest
rates on TEP's Credit Facility, which was refinanced in March 2004,
and lower capital lease obligations outstanding; partially offset by:
o a $6 million increase in income taxes paid due to higher estimated
taxable income for 2004;
o a $4 million increase in O&M costs due to costs related to the
acquisition of UniSource Energy by Saguaro Utility Group L.P.; and
o a $5 million increase in wages paid due to higher incentive
compensation.
INVESTING ACTIVITIES
Net cash used for investing activities was $12 million lower in the first
nine months of 2004 compared with the same period in 2003, due primarily to a
$16 million decline in capital expenditures, partially offset by a $4 million
investment in Springerville Lease Debt. Lower capital expenditures at TEP were
primarily the result of the timing of expected projects. We expect TEP's capital
expenditures to be approximately $113 million in 2004. TEP's capital budget is
established annually; however, it is subject to change as opportunities and
requirements arise related to our service territory.
TEP has sought approvals for construction of a 345-kV transmission line
that would extend from Tucson to Nogales, Arizona and into northern Mexico. The
ACC approved a route for the line in January 2002, but the U.S. Forest Service
has since indicated its preference for an alternate route not approved by the
ACC. As a result, the ACC has ordered TEP to re-open the state line siting
process and to engage in discussions of potential alternatives to the line.
Through September 30, 2004, approximately $10 million in engineering and
environmental expenses have been capitalized related to this project. If the
transmission line does not proceed and the regulators decline to provide for
recovery of such costs through rates, these costs would be immediately expensed.
FINANCING ACTIVITIES
Net cash used for financing activities was $1 million lower in the third
quarter of 2004 compared with the same period in 2003. The following factors
contributed to the decrease:
o a decrease of $40 million in dividends paid by TEP to UniSource
Energy; and
o an increase in other cash inflows of $23 million due primarily to an
$11 million decrease in intercompany tax payments to UniSource Energy
and an increase of $5 million from intercompany transactions with UES;
o TEP repaid $34 million more long-term debt and capital lease
obligations in 2004 than in 2003;
o a $20 million decrease in net proceeds from borrowings under TEP's
Revolving Credit Facility; and
o $9 million paid in debt issuance costs related to the refinancing of
its Credit Agreement.
TEP Credit Agreement
--------------------
On March 25, 2004, TEP entered into a new $401 million credit agreement.
The agreement replaces the credit facilities provided under TEP's $401 million
credit agreement that would have expired in 2006. The new credit agreement
includes a $60 million revolving credit facility for general corporate purposes
and a $341 million letter of credit facility, to support $329 million aggregate
principal amount of tax-exempt variable rate bonds. The credit agreement has a
five-year term, expiring June 30, 2009, and is secured by $401 million in
aggregate principal amount of Second Mortgage Bonds issued under TEP's General
Second Mortgage Indenture.
The credit agreement contains a number of restrictive covenants, including
restrictions on additional indebtedness, liens, sale of assets and
sale-leasebacks. The credit agreement also contains several financial covenants
including: (a) minimum consolidated tangible net worth, (b) a minimum cash
coverage ratio, and (c) a maximum leverage ratio. Under the terms of the credit
agreement, TEP may pay dividends so long as it maintains compliance with the
credit agreement. The previous credit agreement had provided that dividends
could not exceed 65% of TEP's net income. The elimination of such covenant is
50
expected to satisfy, in part, one of the closing conditions contained in the
acquisition agreement that UniSource Energy entered into with Saguaro
Acquisition Corp., by permitting TEP to dividend all of its net income to its
shareholders. The credit agreement also provides that under certain
circumstances, certain regulatory actions could result in a required reduction
of the commitments.
The letter of credit fee of 2.35% on the new facility is significantly
lower than the previous credit agreement's weighted average letter of credit fee
of approximately 5%. The agreement also provides for letter of credit fronting
fees of 0.25%, which will reduce to 0.125% upon the closing of Saguaro Utility's
acquisition of UniSource Energy; the previous agreement's fronting fee was
0.25%. Unreimbursed drawings on a letter of credit bear a variable rate of
interest based on LIBOR plus 2.25% per annum. Interest savings in 2004 will be
partially offset by the March 2004 write-off of $2 million of fees associated
with the prior facility that were capitalized and being amortized through 2006.
Fees of $9 million associated with the entry into the new facility are being
amortized through June 2009.
If TEP borrows under the revolving credit facility, the borrowing costs
would be at a variable interest rate consisting of a spread over LIBOR or an
alternate base rate. The spread is based upon a pricing grid tied to TEP's
leverage. The per annum rate currently in effect on borrowings under TEP's
revolving credit facility, based on its leverage, is LIBOR plus 2.25%. If TEP's
leverage were to change, the spread over LIBOR could range from 1.50% to 2.25%.
Also, TEP pays a commitment fee of 0.50% on the unused portion of the revolving
credit facility.
In January 2004, TEP borrowed $20 million under its revolving credit
facility and repaid it within 30 days. At September 30, 2004, there were no
outstanding borrowings under the revolving credit facility.
CONTRACTUAL OBLIGATIONS
There have been no significant changes in TEP's contractual obligations or
other commercial commitments from those reported in TEP's 2003 Annual Report on
Form 10-K.
DIVIDENDS ON COMMON STOCK
TEP can pay dividends if it maintains compliance with the TEP Credit
Agreement and certain financial covenants, including a covenant that requires
TEP to maintain a minimum level of net worth. As of September 30, 2004, the
required minimum net worth was $352 million. TEP's actual net worth at September
30, 2004, was $437 million. As of September 30, 2004, TEP was in compliance with
the terms of the Credit Agreement.
TEP paid a $7 million dividend in June 2004 and a $12 million dividend in
September 2004. UniSource Energy is the primary holder of TEP's common stock.
The Citizens Settlement Agreement, as approved by the ACC, states that TEP
may not pay dividends to UniSource Energy in excess of 75% of its earnings until
TEP's common equity equals 40% of total capitalization (excluding capital lease
obligations). As of September 30, 2004, TEP's common equity equaled 28% of total
capitalization (excluding capital lease obligations).
In addition to these limitations, the Federal Power Act provides that
electric utilities cannot pay dividends out of funds that are properly included
in the capital account. TEP has an accumulated deficit rather than positive
retained earnings. Although the terms of the Federal Power Act are unclear, we
believe that there is a reasonable basis for TEP to pay dividends from current
year earnings.
51
UNISOURCE ENERGY SERVICES
RESULTS OF OPERATIONS
- ---------------------
UES' net income for the third quarter of 2004 was less than $1 million.
Similar to TEP's operations, UNS Electric's operations are seasonal in nature,
with peak energy demand occurring in the summer months. Operations at UNS Gas
also vary with the seasons, with peak energy usage occurring in the winter
months. In the first nine months of 2004, UES' net income was $6 million.
UNS ELECTRIC
THIRD QUARTER 2004 RESULTS
As of September 30, 2004, UNS Electric had approximately 84,000 retail
customers, a 1% increase from June 30, 2004. The table below shows UNS
Electric's kWh sales and revenues for the three and nine months ended September
30, 2004.
THREE MONTHS ENDED YEAR-TO-DATE
SEPTEMBER 30, 2004 SEPTEMBER 30, 2004
OPERATING OPERATING
SALES REVENUE SALES REVENUE
-MILLIONS -MILLIONS -MILLIONS -MILLIONS
Electric Retail Sales: OF KWH- OF DOLLARS- OF KWH- OF DOLLARS-
----------------------------------------------------------------------------------------
Residential 251 $25 544 $ 55
Commercial 167 16 447 45
Industrial 49 4 151 11
Other 1 - 2 -
----------------------------------------------------------------------------------------
Total Electric Retail Sales 468 $45 1,144 $111
========================================================================================
UNS Electric's utility gross margin (electric revenues less purchased
energy expense) was $14 million in the third quarter of 2004. Purchased energy
expense was $31 million in the third quarter of 2004. UNS Electric purchases all
of its energy requirements under a fixed price contract with Pinnacle West
Capital Corporation (PWCC), thus purchased energy expense is a function of kWh
sales volumes. Other O&M expenses were $6 million for the period. UNS Electric's
contribution to UES' net income was $2 million for the third quarter of 2004.
UNS Electric's utility gross margin (electric revenues less purchased
energy expense) was $37 million for the first nine months of 2004. Purchased
energy expense was $75 million and other O&M expenses were $17 million, for the
period. UNS Electric's contribution to UES' net income was $4 million for the
first nine months of 2004.
52
UNS GAS
THIRD QUARTER 2004 RESULTS
As of September 30, 2004, UNS Gas had approximately 130,000 retail
customers. The table below shows UNS Gas' therm sales and revenues for the three
months ended September 30, 2004.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2004 SEPTEMBER 30, 2004
OPERATING OPERATING
SALES REVENUE SALES REVENUE
----------------------------------------------------------------------------------------------
-MILLIONS -MILLIONS OF -MILLIONS -MILLIONS OF
Retail Therm Sales: OF THERMS- DOLLARS- OF THERMS- DOLLARS-
----------------------------------------------------------------------------------------------
Residential 5 $8 44 $51
Commercial 4 4 19 19
Industrial 1 - 2 1
Public Authority - 1 5 4
----------------------------------------------------------------------------------------------
Total Retail Therm Sales 10 13 70 75
Transport - 1 - 2
Negotiated Sales Program (NSP) 4 2 15 8
----------------------------------------------------------------------------------------------
Total Therm Sales 14 $16 85 $85
==============================================================================================
UNS Gas' utility gross margin (gas revenues less purchased energy expense)
was $7 million in the third quarter of 2004. Purchased energy expense was $9
million in the third quarter of 2004. UNS Gas purchases all of its gas
requirements under a supply and management agreement with BP Energy Company,
thus purchased energy expense is a function of therm sales volumes and the price
of natural gas. Other O&M expenses were $5 million for the period. UNS Gas
reported a net loss of $2 million for the third quarter of 2004. See Factors
Affecting Results of Operations, Rates and Regulation, Purchased Gas Adjustor,
below.
UNS Gas' utility gross margin (gas revenues less purchased energy
expense) was $32 million in the first nine months of 2004. Purchased energy
expense was $55 million and other O&M expenses were $17 million, for the period.
UNS Gas' contribution to UES' net income was $2 million for the first nine
months of 2004.
FACTORS AFFECTING RESULTS OF OPERATIONS
- ---------------------------------------
COMPETITION
As required by the ACC Decision approving UniSource Energy's acquisition of
the Citizens Arizona gas and electric assets, on November 3, 2003, UNS Electric
filed with the ACC an application for approval of a plan to open its service
territories to retail competition by December 31, 2003. The plan addresses all
aspects of implementation. It includes UNS Electric's unbundled distribution
tariffs for both standard offer customers and customers that choose competitive
retail access, as well as Direct Access and Settlement Fee schedules. UNS
Electric direct access rates for both transmission and ancillary services will
be based upon its FERC Open Access Transmission Tariff. The plan is subject to
review and approval by the ACC. As a result of the court decisions concerning
the ACC's Retail Electric Competition Rules, we are unable to predict when and
how the ACC will address this plan. See, TEP - Factors Affecting Results of
Operations, Competition, above.
53
RATES AND REGULATION
PURCHASED GAS ADJUSTOR
UNS Gas' retail rates include a Purchased Gas Adjustor (PGA) mechanism
intended to address the volatility of natural gas prices and allow UNS Gas to
recover its costs through a price adjuster. The difference between the actual
cost of UNS Gas' gas supplies and transportation contracts and the base cost of
gas approved by the ACC are deferred and recovered or repaid through the PGA
mechanism. The PGA charge changes monthly based on an ACC approved mechanism
that compares the twelve-month rolling average gas cost to the base cost of gas,
subject to limitations on how much the price per therm may change in a twelve
month period. When under or over recovery trigger points are met, UNS Gas may
request a PGA surcharge or surcredit to collect or return the amount deferred
from or to customers.
PURCHASED POWER AND FUEL ADJUSTOR CLAUSE
UNS Electric's retail rates include a Purchased Power and Fuel Adjustor
Clause (PPFAC), which allows for a separate surcharge or surcredit to the base
rate for delivered purchased power and fuel to collect or return under or over
recovery of costs.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
UES' capital requirements consist primarily of capital expenditures. UES'
forecast for capital expenditures for the year ending December 31, 2004 is
approximately $37 million. As of September 30, 2004, year-to-date capital
expenditures were $27 million. UES intends to obtain, or have made available to
it through UniSource Energy, a revolving credit facility to use for working
capital purposes. This facility is expected to be in place prior to December 31,
2004.
UNS Gas relies on the PGA mechanism included in its retail rates to recover
its cost of natural gas. Since the price of natural gas continues to remain at
historically high levels, UNS Gas' internal cash flows may not be sufficient in
the short-term to fund all of its operating and capital expenditures. As a
result, UNS Gas may need to borrow on a short-term basis during the winter
heating season of 2004-2005.
UNS Electric expects to generate sufficient internal cash flows to fund its
operating activities and construction expenditures during 2004.
PRIVATE PLACEMENT NOTES
On August 11, 2003, UNS Gas and UNS Electric issued a total of $160 million
of aggregate principal amount of senior unsecured notes in a private placement.
The note purchase agreements for both UNS Gas and UNS Electric contain
certain restrictive covenants, including restrictions on transactions with
affiliates, mergers, liens to secure indebtedness, restricted payments,
incurrence of indebtedness, and minimum net worth. Consolidated Net Worth, as
defined by the note purchase agreements for both UNS Gas and UNS Electric, is
approximately equal to the balance sheet line item, Common Stock Equity. The
table below outlines the actual and required minimum net worth levels of UES,
UNS Gas, and UNS Electric at September 30, 2004.
REQUIRED ACTUAL
COMPANY NET WORTH NET WORTH
- -------------------------------------------------------
-Millions of Dollars-
UES $50 $96
UNS Gas 43 55
UNS Electric 26 41
- -------------------------------------------------------
54
CONTRACTUAL OBLIGATIONS
There have been no significant changes in UES' contractual obligations or
other commercial commitments from those reported in our 2003 Annual Report on
Form 10-K.
DIVIDENDS ON COMMON STOCK
The Citizens Settlement Agreement, as approved by the ACC, limits dividends
payable by UNS Gas and UNS Electric to 75% of earnings until the ratio of common
equity to total capitalization reaches 40%. At September 30, 2004, the ratio of
common equity to total capitalization for UNS Gas was 35% and for UNS Electric
was 40%.
The note purchase agreements for both UNS Gas and UNS Electric contain
certain restrictive covenants including restrictions on dividends. According to
the note purchase agreements, neither UNS Gas, nor UNS Electric, may declare or
make distributions or dividends (restricted payments) on their common stock
unless, (a) immediately after giving effect to such action no default or event
of default would exist under such company's note purchase agreement and (b)
immediately after giving effect to such action, such company would be permitted
to incur an additional dollar of indebtedness under the debt incurrence test in
such company's note purchase agreement.
MILLENNIUM ENERGY HOLDINGS, INC.
RESULTS OF OPERATIONS
- ---------------------
Through affiliates, Millennium holds investments in unregulated energy and
emerging technology companies. At September 30, 2004, Millennium's assets
represented 6% of UniSource Energy's total assets. Millennium accounts for its
investments under the consolidation method and the equity method. In some cases,
Millennium is an investment's sole provider of funding. When this is the case,
Millennium recognizes 100% of an investment's losses, because as sole provider
of funds it bears all of the financial risk. To the extent an investment becomes
profitable and Millennium has recognized losses in excess of its percentage
ownership, Millennium will recognize 100% of an investment's net income until
Millennium's recognized losses equal its ownership percentage of losses.
The table below provides a breakdown of the net income and losses recorded
by Millennium. These results exclude sales and related costs to TEP.
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Technology Investments
Global Solar and IPS
Research and Development Contract Revenues from Third Parties $ 0.1 $ 0.1 $ 0.4 $ 1.1
Other Revenues from Third Parties 0.7 0.9 2.2 1.3
Research and Development Contract Expenses and Losses (1.1) (1.4) (2.7) (4.0)
Research and Development - Internal Development Expenses (0.1) (0.3) (0.7) (1.4)
Depreciation and Amortization Expense (0.9) (0.9) (2.6) (2.5)
Administrative and Other Costs (1.8) (1.7) (5.3) (7.9)
Income Tax Benefits 1.2 1.4 3.4 5.4
- -----------------------------------------------------------------------------------------------------------------------------
Global Solar and IPS Net Loss (1.9) (1.9) (5.3) (8.0)
MicroSat Net Income (Loss) 0.2 (0.3) 1.6 (1.0)
ITN Net Income (Loss) - 0.1 - (0.2)
- -----------------------------------------------------------------------------------------------------------------------------
Total Technology Investments Net Loss (1.7) (2.1) (3.7) (9.2)
Other Millennium Investments Net Income (Loss) 0.3 (0.6) 1.0 (2.9)
- -----------------------------------------------------------------------------------------------------------------------------
TOTAL MILLENNIUM NET LOSS $ (1.4) $ (2.7) $ (2.7) $ (12.1)
=============================================================================================================================
55
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
Under the acquisition agreement described in Overview of Consolidated
Businesses - Agreement and Plan of Merger above, UniSource Energy is limited as
to the amount it can invest in Millennium in the future. Consequently,
Millennium's ability to provide future funding for the operations of emerging
companies could be affected.
TECHNOLOGY INVESTMENTS
During the first nine months of 2004, Millennium made no contributions to
Global Solar. However, UniSource Energy provided $5 million to Global Solar
under a tax sharing agreement. Millennium has no remaining funding commitments
to Global Solar, other than the tax sharing agreement with UniSource Energy.
Millennium's debt commitment to IPS was $0.5 million at December 31, 2003.
In April 2004, Millennium and Dow Corning Enterprises, Inc. (DCEI) committed to
loan up to an additional $1 million each to IPS. During the first nine months of
2004, Millennium funded all $1.5 million of its commitments to IPS and DCEI
funded its $1 million commitment. Millennium has no further funding commitments
to IPS. Pursuant to the terms of the amended promissory notes with IPS,
Millennium and DCEI have the right to convert at any time the outstanding debt
amounts to equity ownership. DCEI holds warrants to purchase additional
preferred shares of IPS that if exercised, could result in Millennium's
ownership of IPS being reduced to as low as 59%.
Millennium and DCEI are continuing to evaluate the ongoing viability of
IPS. In the event the operations of IPS are discontinued, Millennium would
recognize an after tax loss of less than $1 million.
Millennium made no contributions to MicroSat during the first nine months
of 2004 and has no further funding commitments to MicroSat.
As technology developers, these entities face many challenges, such as
developing technologies that can be manufactured on an economic scale,
technological obsolescence, competition and possible reductions in government
spending to advance technological research and development activities.
OTHER MILLENNIUM INVESTMENTS
Millennium committed $15 million in capital, excluding fees, to Haddington,
a limited partnership which funds energy-related investments. A member of the
UniSource Energy Board of Directors has an investment in Haddington and is a
managing director of the general partner of the limited partnership. At
September 30, 2004, Millennium had funded $12 million of this commitment, $2
million of which was funded during the first nine months of 2004. Millennium
expects the balance to be funded by the end of 2007. In March 2004, Haddington
sold one of its investments and recognized the related gain as income. In April
2004, Millennium received a $7 million distribution from Haddington related to
the sale. In June 2004, Haddington wrote down another of its investments and
recognized the related loss. Millennium's share of the loss was $2 million,
before tax. Millennium recorded its share of Haddington's income and loss during
the first nine months of 2004, which includes Haddington's gains and losses on
investments.
Millennium committed $6 million, including fees, to Valley Ventures III, LP
(Valley Ventures), a venture capital fund that invests in information
technology, microelectronics and biotechnology, primarily within the
southwestern U.S. Another member of the UniSource Energy Board of Directors is a
general partner of the company that manages the fund. As of September 30, 2004,
Millennium had funded $2 million of this commitment, $1 million of which was
funded during the first nine months of 2004. Millennium expects the balance to
be funded by the end of 2007.
Nations Energy is wholly owned by Millennium. Through subsidiaries, Nations
Energy has a 32% interest in a 43 MW power plant in Panama. Although Nations
Energy still intends to sell its interest in this plant, the $0.8 million book
value of the investment was written off in June 2004 because attempts to sell
the asset to date have been unsuccessful.
56
MILLENNIUM COMMITMENTS
Millennium's funding levels and share ownership in its investments are
subject to change in the future. Millennium has no remaining debt commitments
and its outstanding equity commitments are currently limited to $4 million to
Haddington and $3 million to Valley Ventures. Millennium may commit to provide
additional funding to its investments in the future.
Global Solar had commitments to incur future expenses relating to
government contracts totaling less than $1 million at September 30, 2004 and $1
million at December 31, 2003.
MEG LINE OF CREDIT
In September 2004, MEG reduced its bank line of credit from $5 million to
$3 million. As of September 30, 2004, MEG had $3 million in outstanding letters
of credit issued to counterparties. This facility expires in March 2005.
DIVIDENDS ON COMMON STOCK
Millennium did not pay any dividends to UniSource Energy in 2003 or the
first nine months of 2004.
CRITICAL ACCOUNTING POLICIES
- ----------------------------
In preparing financial statements under Generally Accepted Accounting
Principles (GAAP), management exercises judgment in the selection and
application of accounting principles, including making estimates and
assumptions. UniSource Energy and TEP consider Critical Accounting Policies to
be those that could result in materially different financial statement results
if our assumptions regarding application of accounting principles were
different. UniSource Energy and TEP describe their Critical Accounting Policies
below. Other significant accounting policies and recently issued accounting
standards are discussed in the 2003 Annual Report on Form 10-K, Note 1 of Notes
to Consolidated Financial Statements - Nature of Operations and Summary of
Significant Accounting Policies.
ACCOUNTING FOR RATE REGULATION
TEP and UES generally use the same accounting policies and practices used
by unregulated companies for financial reporting under GAAP. However, sometimes
these principles, such as Statement of Financial Accounting Standards No. 71,
Accounting for the Effects of Certain Types of Regulation (FAS 71), require
special accounting treatment for regulated companies to show the effect of
regulation. For example, in setting TEP's and UES' retail rates, the ACC may not
allow TEP or UES to currently charge their customers to recover certain
expenses, but instead requires that these expenses be charged to customers in
the future. In this situation, FAS 71 requires that TEP and UES defer these
items and show them as regulatory assets on the balance sheet until TEP and UES
are allowed to charge their customers. TEP and UES then amortize these items as
expense to the income statement as these charges are recovered from customers.
Similarly, certain revenue items may be deferred as regulatory liabilities,
which are also eventually amortized to the income statement as rates to
customers are reduced.
The conditions a regulated company must satisfy to apply the accounting
policies and practices of FAS 71 include:
o an independent regulator sets rates;
o the regulator sets the rates to recover specific costs of delivering
service; and
o the service territory lacks competitive pressures to reduce rates
below the rates set by the regulator.
57
IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71
TEP
Upon approval by the ACC of the TEP Settlement Agreement in November 1999,
TEP discontinued application of FAS 71 for its generation operations. TEP
continues to apply FAS 71 to its regulated operations, which include the
transmission and distribution portions of its business.
TEP's regulatory assets, net of regulatory liabilities, totaled $238
million at September 30, 2004. Regulatory assets of $23 million are not
presently included in rate base and consequently are not earning a return on
investment.
TEP regularly assesses whether it can continue to apply FAS 71 to its
regulated operations. If TEP stopped applying FAS 71 to these operations, it
would write off the related balances of its regulatory assets as an expense and
its regulatory liabilities as income on its income statement. Based on the
regulatory asset balances, net of regulatory liabilities, at September 30, 2004,
if TEP had stopped applying FAS 71 to its remaining regulated operations, it
would have recorded an extraordinary after-tax loss of $144 million. While
regulatory orders and market conditions may affect cash flows, TEP's cash flows
would not be affected if it stopped applying FAS 71 unless a regulatory order
limited its ability to recover the cost of its regulatory assets.
UES
UES' regulatory liabilities, net of regulatory assets, totaled $7 million
at September 30, 2004. If UES stopped applying FAS 71 to its regulated
operations, it would write off the related balances of its regulatory assets as
an expense and its regulatory liabilities as income on its income statement.
Based on the regulatory liability balances, net of regulatory assets, at
September 30, 2004, if UES had stopped applying FAS 71 to its regulated
operations, it would have recorded an extraordinary after-tax gain of $4
million. UES' cash flows would not be affected if it stopped applying FAS 71
unless a regulatory order limited its ability to recover the cost of its
regulatory assets.
ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. TEP also has certain environmental obligations at the San
Juan Generating Station. TEP has estimated that its share of these obligations
will be approximately $38 million at the date of retirement. As of September 30,
2004 and December 31, 2003, TEP had accrued $1 million for the decommissioning
of its generating facilities. This accrued asset retirement obligation is
included with Other Liabilities on UniSource Energy and TEP's balance sheets.
TEP has various transmission and distribution lines that operate under land
leases and rights of way that contain end dates and restorative clauses. TEP
operates its transmission and distribution lines as if they will be operated in
perpetuity and would continue to be used or sold without land remediation. A
final retirement occurs when an entire transmission or distribution line is
permanently removed from service. Interim retirements occur as components of the
system are replaced. As a result, TEP is not recognizing the costs of final
removal of the transmission and distribution lines in the financial statements.
As of September 30, 2004 and December 31, 2003, TEP had accrued $66 million and
$60 million for the net cost of removal for the interim retirements from its
transmission, distribution and general plant. The amount is shown as a
regulatory liability on UniSource Energy and TEP's balance sheets.
Upon adoption of FAS 143 on January 1, 2003, TEP recorded an asset
retirement obligation of $38 million at its net present value of $1 million,
increased depreciable assets by $0.1 million for asset retirement costs,
reversed $113 million of costs previously accrued for final removal from
accumulated depreciation, reversed previously recorded deferred tax assets by
$44 million and recognized the cumulative effect of accounting change as a gain
of $112 million ($67 million net of tax).
58
UES, MILLENNIUM AND UED
UES has various transmission and distribution lines that operate under land
leases and rights of way that contain end dates and restorative clauses. UES
operates its transmission and distribution lines as if they will be operated in
perpetuity and would continue to be used or sold without land remediation. A
final retirement occurs when an entire transmission or distribution line is
permanently removed from service. Interim retirements occur as components of the
system are replaced. As a result, UES is not recognizing the cost of final
removal of the transmission and distribution lines in the financial statements.
As of September 30, 2004 and December 31, 2003, UES had accrued $2 million and
$1 million for the net cost of removal for interim retirements from its
transmission, distribution and general plant. The amount is shown as a
regulatory liability on UniSource Energy's balance sheet.
Millennium and UED have no asset retirement obligations.
PENSION AND OTHER POSTRETIREMENT BENEFIT PLAN ASSUMPTIONS
We record plan assets, obligations, and expenses related to pension and
other postretirement benefit plans based on actuarial valuations. These
valuations include key assumptions on discount rates, expected returns on plan
assets, compensation increases and health care cost trend rates. These actuarial
assumptions are reviewed annually and modified as appropriate. The effect of
modifications is generally recorded or amortized over future periods. We believe
that the assumptions used in recording obligations under the plans are
reasonable based on prior experience, market conditions and the advice of plan
actuaries.
TEP
TEP discounted its future pension plan obligations using a rate of 6.25% at
December 31, 2003, compared with 6.75% at December 31, 2002. TEP discounted its
other postretirement plan obligations using a rate of 5.5% at December 31, 2003,
compared with 6.75% at December 31, 2002. TEP determines the discount rate
annually based on the rates currently available on high-quality, long-term
bonds. TEP looks to bonds that receive one of the two highest ratings given by a
recognized rating agency and are expected to be available during the period to
maturity of the pension benefits. In selecting the appropriate rate, TEP also
considers the durations of plan obligations.
The pension liability and future pension expense both increase as the
discount rate is reduced. A decrease in the discount rate results in an increase
in the projected benefit obligation (PBO) and the service cost component of
pension expense. Additionally, the recognized actuarial loss is significantly
impacted by a reduction in the discount rate. Since the PBO increases with the
decrease in discount rate, the obligation is much larger than would normally
occur due to normal growth of the plan. This leads to an actuarial loss (or a
greater actuarial loss than would occur in the absence of the discount rate
change), which is amortized over future periods leading to a greater expense.
The resulting change in the interest cost component of pension expense is
dependent on the effect that the change in the discount rate has on the PBO and
will vary based on employee demographics. The effect of the lower rate used to
calculate the interest cost is offset to some degree by a larger obligation. The
relative magnitude of these two changes determines whether interest cost will
increase or decrease. For TEP's pension plans, a 25 basis point decrease in the
discount rate would increase the accumulated benefit obligation (ABO) by
approximately $5 million and the related plan expense for 2004 by approximately
$1 million. A similar increase in the discount rate would decrease the ABO by
approximately $4 million and the related plan expense for 2004 by approximately
$1 million. For TEP's other postretirement benefits plan, a 25 basis point
change in the discount rate would increase or decrease the accumulated
postretirement benefit obligation (APBO) by approximately $2 million. A 25 basis
point change in the discount rate would not have a significant impact on the
related plan expense for 2004.
TEP calculates the market-related value of plan assets using the fair value
of plan assets on the measurement date. At December 31, 2003 and 2002, TEP
assumed its plans' assets would generate a long-term rate of return of 8.75%. In
establishing its assumption as to the expected return on plan assets, TEP
reviews the plans' asset allocation and develops return assumptions for each
asset class based on advice from an investment consultant and the plans' actuary
that includes both historical performance analysis and forward looking views of
the financial markets. Pension expense increases as the expected rate of return
59
on plan assets decreases. A 25 basis point change in the expected return on plan
assets would not have a significant impact on pension expense for 2004.
TEP recorded a minimum pension liability of approximately $4 million at
December 31, 2003, compared with $7 million at December 31, 2002. Improved stock
market conditions offset a further reduction in the assumed discount rate.
Based on the above assumptions, TEP will record pension expense of
approximately $8 million and other postretirement benefit expense of $6 million
ratably throughout 2004. As of September 30, 2004, TEP has made required pension
plan contributions of $5 million in 2004. TEP's other postretirement benefit
plan is not funded. TEP expects to make benefit payments to retirees under the
postretirement benefit plan of approximately $2 million in 2004.
TEP increased the initial health care cost trend rate used in valuing its
postretirement benefit obligation to 12.1% at December 31, 2003. Assumed health
care cost trend rates have a significant effect on the amounts reported for
health care plans. A 1% increase in assumed health care cost trend rates would
increase the postretirement benefit obligation by approximately $5 million and
the related plan expense by approximately $1 million. A similar decrease in
assumed health care cost trend rates would decrease the postretirement benefit
obligation by approximately $5 million and the related plan expense by less than
$1 million.
UES
Concurrent with the acquisition of the Arizona gas and electric utility
assets from Citizens on August 11, 2003, UES established a pension plan for
substantially all of its employees. UES did not assume the pension obligation
for employees' years of service with Citizens. UES performed an actuarial
valuation, as of the date of acquisition, to determine its pension expense for
the balance of 2003. A discount rate of 6.5% was assumed based on rates
available at that date and the duration of plan obligations.
UES discounted its future pension plan obligations using a rate of 6.25% at
December 31, 2003. For UES' pension plan, a 25 basis point change in the
discount rate would have minimal effect on either the ABO or the related pension
expense. UES recorded a minimum pension liability of approximately $1 million at
December 31, 2003. UES will record pension expense of $1 million in 2004. The
pension plan is not yet funded but all required contributions will be made in
accordance with minimum funding standards. UES has made a pension plan
contribution of $1 million in 2004.
On the acquisition date, UES assumed the obligation to provide
postretirement benefits for a small population of former Citizens employees,
both active and retired. The obligation has been recorded at a discounted value
of $2 million using a discount rate of 5.25%. The plan is not funded. UES does
not expect postretirement medical benefit expenses to have a material impact on
its operations.
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND TRADING ACTIVITIES
A derivative financial instrument or other contract derives its value from
another investment or designated benchmark. TEP's, UES' and MEG's derivative
activities are described fully in UniSource Energy and TEP's 2003 Annual Report
on Form 10-K.
TEP has a natural gas supply agreement under which it purchases all of its
gas requirements at spot market prices from Southwest Gas Corporation (SWG). TEP
also has agreements to purchase power that are priced using spot market gas
prices. These contracts meet the definition of normal purchases and are not
required to be marked to market. During the first nine months of 2004, in an
effort to minimize price risk on these purchases, TEP entered into commodity
price swap agreements under which TEP purchases gas at fixed prices and
simultaneously sells gas at spot market prices. The spot market price in the
swap agreements is tied to the same index as the purchases under the SWG and
purchased power contracts. These swap agreements, which expire during the summer
months through 2006, were entered into with the goal of locking in fixed prices
on at least 45% and not more than 80% of TEP's expected summer monthly gas risk
prior to entering into the month. The swap agreements are marked to market on a
monthly basis; however, since the agreements satisfy the requirements for cash
flow hedge accounting, the unrealized gains and losses are recorded in Other
60
Comprehensive Income, a component of Common Stock Equity, rather than being
reflected in the income statement. As the gains and losses on these cash flow
hedges are realized, a reclassification adjustment is recorded in Other
Comprehensive Income for realized gains and losses that are included in net
income.
TEP manages the risk of counterparty default by performing financial
credit reviews, setting limits, monitoring exposures, requiring collateral when
needed, and using a standardized agreement which allows for the netting of
current period exposures to and from a single counterparty.
The market prices used to determine fair values for TEP's and MEG's
derivative instruments are estimated based on various factors including broker
quotes, exchange prices, over the counter prices and time value.
TEP and MEG's derivative activities are reported as follows:
INCOME STATEMENT LINE
------------------------------------------------------------------------
NET UNREALIZED GAINS NET REALIZED GAINS
AND LOSSES AND LOSSES
- ---------------------------------------------------------------------------------------------------------------------
TEP Forward Sales Contracts Electric Wholesale Sales Electric Wholesale Sales
TEP Forward Purchase Contracts Purchased Power Purchased Power
TEP Commodity Price Swaps Other Comprehensive Income Fuel Expense
(Balance Sheet)
MEG Trading Activities Other Operating Revenues Other Operating Revenues
- ---------------------------------------------------------------------------------------------------------------------
Although MEG's realized gains and losses on trading activities are reported net
on UniSource Energy's income statement, the related cash receipts and cash
payments are reported separately on UniSource Energy's statement of cash flows.
TEP and MEG's derivative assets and liabilities are reported as follows:
BALANCE SHEET LINE
-------------------------------------------------------
ASSETS LIABILITIES
- -------------------------------------------------------------------------------------------------------------------
TEP (Net) Other Current Assets Other Current Liabilities
MEG (Including Emissions Allowance Inventory) Trading Assets Trading Liabilities
- -------------------------------------------------------------------------------------------------------------------
Because of the complexity of derivatives, the FASB established a
Derivatives Implementation Group (DIG). To date, the DIG has issued more than
100 interpretations to provide guidance in applying Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging
Activities (FAS 133). As the DIG or the FASB continues to issue interpretations,
TEP, UNS Gas and UNS Electric may change the conclusions they have reached and,
as a result, the accounting treatment and financial statement impact could
change in the future.
See Commodity Price Risk in Item 3.
PLANT ASSET DEPRECIABLE LIVES - TEP AND UES
We calculate depreciation expense based on our estimate of the useful lives
of our plant assets. The estimated useful lives, and resulting depreciation
rates used to calculate depreciation expense for the transmission and
distribution businesses of both UES and TEP have been approved by the ACC in
prior rate decisions. Depreciation rates for transmission and distribution
cannot be changed without ACC approval. We are currently reviewing the estimated
useful lives of all our assets due to a variety of factors including the
construction of Springerville Unit 3 and the related environmental upgrades
being made to Springerville Unit 2, new information received from the operators
of the remote generating stations, and information received in connection with
an analysis of FAS 143 retirement obligations.
The estimated remaining useful lives of TEP's generating facilities are
based on management's best estimate of the economic life of the units. These
estimates are based on engineering estimates, economic analysis, and statistical
analysis of TEP's past experience in maintaining the stations. For the first
nine months of 2004, depreciation expense related to generation assets was $27
61
million, and our generation assets are currently depreciated over periods
ranging from 23 to 70 years from the original in-service dates.
During the first quarter of 2004, TEP engaged an independent third party to
review the economic estimated useful lives of its owned generating assets in
Springerville, Arizona. TEP then hired a different independent third party to
perform a depreciation study for its generation assets, taking into
consideration the newly determined economic useful life for the Springerville
assets, and changes in generation plant life information used by the operators
and other participants of the joint power plants in which TEP participates. As a
result of these analyses, TEP lengthened the useful lives of various generation
assets for periods ranging from 11 to 22 years in July 2004. Consequently,
depreciation rates and the corresponding depreciation expense have been revised
prospectively to reflect the life extensions. The expected annual impact of
these changes in depreciation rates is a reduction in depreciation expense of $9
million or $2 million for the quarter ended September 30, 2004. A study is
currently underway by the operating agent of the San Juan Generating Station to
determine whether San Juan's economic useful life has changed from previous
estimates. If the economic life of San Juan is extended by ten years, TEP's
annual depreciation expense would decrease by an additional $4 million.
UNBILLED REVENUE ESTIMATION METHODOLOGY - TEP
TEP's and UES' retail revenues include an estimate of MWhs/therms delivered
but unbilled at the end of each period. Unbilled revenues are dependent upon a
number of factors that require judgment including estimates of retail sales and
customer usage patterns. The unbilled revenue is estimated by comparing the
actual MWhs/therms delivered to the MWhs/therms billed to TEP and UES retail
customers. The excess of MWhs/therms delivered over MWhs/therms billed is then
allocated to the retail customer classes based on estimated usage by each
customer class. TEP and UES then record revenue for each customer class based on
the various bill rates for each customer class. Due to the seasonal fluctuations
of TEP's actual load, the unbilled revenue amount increases during the spring
and summer months and decreases during the fall and winter months. The unbilled
revenue amount for UES gas sales increases during the fall and winter months and
decreases during the spring and summer months, whereas, the unbilled revenue
amount for UES electric sales increases during the spring and summer months and
decreases during the fall and winter months.
In May 2004, we determined that the kWh information used to estimate kWhs
delivered to TEP customers was generally understated. Additionally, we
determined that TEP's then existing method of pricing estimated unbilled kWh
sales quantities among customer classes was weighting usage by lower-priced
customers too heavily and weighting usage by higher-priced customers too
lightly. For TEP, the price paid by customers varies from a low of 3.7 cents per
kWh for interruptible industrial load to a high of 13 cents per kWh for small
commercial customers, so that allocations among customer classes are a
significant element of unbilled revenues. Effective with the second quarter of
2004, we changed the estimation methodology used to quantify unbilled kWh sales
and price the computed unbilled kWh sales quantities to more accurately reflect
actual usage and restated prior periods.
Under the revised estimation methodology, unbilled sales are estimated for
the month by reviewing the meter reading schedule and determining the number of
billed and unbilled kWhs for each cycle. Current month unbilled kWhs are
allocated by customer class. New unbilled revenue amounts are recorded and
unbilled revenue estimates from the prior month are reversed. The primary
difference between the prior estimation methodology and the current methodology
results from the reversal of the prior month's accrued unbilled revenue rather
than a methodology that had the effect of reversing unbilled kWhs, and a more
precise application of the current rates by customer class to kWhs unbilled at
the end of each month.
DEFERRED TAX VALUATION
We record deferred tax liabilities for amounts that will increase income
taxes on future tax returns. We record deferred tax assets for amounts that
could be used to reduce income taxes on future tax returns. We record a
valuation allowance, or reserve, for the deferred tax asset amount that we may
not be able to use on future tax returns. We estimate the valuation allowance
based on our interpretation of the tax rules, prior tax audits, tax planning
strategies, scheduled reversal of deferred tax liabilities, and projected future
taxable income.
At September 30, 2004 and December 31, 2003, UniSource Energy had a
valuation allowance of $11 million, of which $10 million relates to net
operating losses generated by the Millennium entities. In the future, if
62
UniSource Energy and the Millennium entities determine that all or a portion of
the losses may be used on tax returns, then UniSource Energy and the Millennium
entities would reduce the valuation allowance and recognize a tax benefit of up
to $10 million. The primary factor that could cause the Millennium entities to
recognize a tax benefit would be a change in expected future taxable income. The
remaining $1 million valuation allowance relates to investment tax credit
carryforwards at TEP, which may not be able to be used on tax returns prior to
their expiration.
In the future, if UniSource Energy and TEP determine that it is probable
that TEP will not be able to use all or a portion of its net operating loss and
more of its investment tax credit carryforward amounts, then UniSource Energy
and TEP would record additional valuation allowance and recognize tax expense.
Factors that could cause TEP to record a valuation allowance would be a change
in expected future taxable income or a change in tax filing status due to the
proposed acquisition. See Outlook and Strategies - Agreement and Plan of Merger,
above.
NEW ACCOUNTING PRONOUNCEMENTS
- -----------------------------
The FASB recently issued the following Statements of Financial Accounting
Standards (FAS) and FASB Interpretations (FIN):
o FIN 46, Consolidation of Variable Interest Entities, was issued in
January 2003, and was subsequently revised in December 2003 (FIN 46R).
The primary objectives of FIN 46R are to provide guidance on the
identification of entities for which control is achieved through means
other than through voting rights (variable interest entities) and to
determine when and which business enterprises should consolidate the
variable interest entity (primary beneficiary). FIN 46R requires that
both the primary beneficiary and all other enterprises with a
significant variable interest make additional disclosures. For public
companies, the revised FIN 46R is effective for financial periods
ending after March 15, 2004. The adoption of FIN 46R did not have a
significant impact on our financial statements.
o FAS 132, Employers' Disclosures about Pensions and Other
Postretirement Benefits (revised 2003), was issued by the FASB in
December 2003. FAS 132 requires additional disclosures about the
assets, obligations, cash flows, and net periodic benefit cost of
defined benefit pension plans and other defined benefit postretirement
plans beyond those in the original Statement 132 which it replaces.
FAS 132, as revised, is effective for fiscal years ending after
December 15, 2003. The revised disclosure requirements are included in
Note 12 of Notes to Consolidated Financial Statements.
FASB Staff Position No. FAS 106-2, Accounting and Disclosure Requirements
Related to the Medicare Prescription Drug, Improvement and Modernization Act of
2003 (FSP 106-2), provides guidance related to accounting for the federal
subsidy available to employers providing retirees with prescription drug
benefits. For public companies, FSP 106-2 is effective for the first interim or
annual period beginning after June 15, 2004. The adoption of FSP 106-2 is not
expected to have a significant impact on our postretirement benefit costs or
cash flows because prescription drug coverage is available only to a limited
number of UniSource Energy retirees who are Medicare eligible.
In July 2004, the Emerging Issues Task Force (EITF) reached a consensus on
Issue No. 02-14, Whether an Investor Should Apply the Equity Method of
Accounting to Investments Other Than Common Stock (EITF 02-14). EITF 02-14
concludes that an investor that has the ability to exercise significant
influence over the operating and financial policies of an investee should apply
the equity method of accounting only when it has an investment in common stock
or an investment that is in-substance common stock. EITF 02-14 is effective for
reporting periods beginning after September 15, 2004. The adoption of EITF 02-14
is not expected to have a significant impact on our financial statements.
In June 2004, the EITF published Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF
03-1). EITF 03-1 provides application guidance on impairment of securities
accounted for under FAS 115, Accounting for Certain Investments in Debt and
Equity Securities, and cost method investments and requires certain quantitative
and qualitative disclosures for securities that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The disclosure requirements are effective for reporting periods
ending after December 31, 2003. The FASB issued FSP EITF Issue 03-1-1, Effective
Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of
63
Other-Than-Temporary Impairment and Its Application to Certain Investments in
September 2004 delaying the effective date of the application guidance on
impairment of securities. The adoption of EITF 03-1 is not expected to have a
significant impact on our financial statements.
In August 2003, the EITF published Issue No. 03-11, Reporting Realized
Gains and Losses on Derivative Instruments That Are Subject to FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities, and Not
"Held for Trading Purposes" as Defined in EITF Issue No. 02-3 (EITF 03-11). EITF
03-11 discusses whether realized gains and losses should be shown gross or net
in the income statement for contracts that are not held for trading purposes, as
defined in EITF 02-3, but are derivatives subject to FAS 133. Determining
whether realized gains and losses on derivative contracts not held for trading
purposes should be reported in the income statement on a gross or net basis is a
matter of judgment that depends on the relevant facts and circumstances with
respect to the various activities of the entity. Retroactive application of EITF
03-11 is not required. Beginning January 1, 2004, the realized gains and losses
on derivative instruments that are not held for trading purposes but are
eventually net settled are shown net in the income statement. The impact of
adopting EITF 03-11 was immaterial as of September 30, 2004.
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 are including the following cautionary statements to make
applicable and 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 and
other statements that are not statements of historical facts. Forward-looking
statements may be identified by the use of words such as "anticipates,"
"estimates," "expects," "intends," "plans," "predicts," "projects," and similar
expressions. From time to time, we may publish or otherwise make available
forward-looking statements of this nature. All such forward-looking statements,
whether written or oral, and whether made by or on behalf of UniSource Energy or
TEP, are expressly qualified by these cautionary statements and any other
cautionary statements which may accompany the forward-looking statements. In
addition, UniSource Energy and TEP disclaim any obligation to update any
forward-looking statements to reflect events or circumstances after the date of
this report.
Forward-looking statements involve risks and uncertainties, which could
cause actual results or outcomes to differ materially from those expressed in
the forward-looking statements. We express our expectations, beliefs and
projections in good faith and believe them to have a reasonable basis. However,
we make no assurances that management's expectations, beliefs or projections
will be achieved or accomplished. We have identified the following important
factors that could cause actual results to differ materially from those
discussed in our forward-looking statements. These may be in addition to other
factors and matters discussed in other parts of this report:
1. Effects of restructuring initiatives in the electric industry and
other energy-related industries.
2. Effects of competition in retail and wholesale energy markets.
3. Changes in economic conditions, demographic patterns and weather
conditions in our retail service areas.
4. Supply and demand conditions in wholesale energy markets, including
volatility in market prices and illiquidity in markets, which are
affected by a variety of factors. These factors include the
availability of generating capacity in the western U.S., including
hydroelectric resources, weather, natural gas prices, the extent of
utility restructuring in various states, transmission constraints,
environmental regulations and cost of compliance, FERC regulation of
wholesale energy markets, and economic conditions in the western U.S.
5. The creditworthiness of the entities with which we transact business
or have transacted business.
6. Changes affecting our cost of providing electrical service including
changes in fuel costs, generating unit operating performance,
scheduled and unscheduled plant outages, interest rates, tax laws,
environmental laws, and the general rate of inflation.
64
7. Changes in governmental policies and regulatory actions with respect
to financing and rate structures.
8. Changes affecting the cost of competing energy alternatives, including
changes in available generating technologies and changes in the cost
of natural gas.
9. Changes in accounting principles or the application of such principles
to our businesses.
10. Changes in the depreciable lives of our assets.
11. Market conditions and technological changes affecting UniSource
Energy's unregulated businesses.
12. Unanticipated changes in future liabilities relating to employee
benefit plans due to changes in market values of retirement plan
assets and health care costs.
13. The outcome of any ongoing litigation.
14. Ability to obtain financing through debt and/or equity issuances,
which can be affected by various factors, including interest rate
fluctuations and capital market conditions.
15. Ability to develop and operate Springerville Generating Station Unit 3
and achieve expected cost savings.
16. Ability to obtain necessary approvals and satisfy the other closing
conditions contained in the acquisition agreement, so that the
acquisition of UniSource Energy by an affiliate of Saguaro Utility can
occur.
ITEM 3. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- --------------------------------------------------------------------------------
The information contained in this Item updates, and should be read in
conjunction with, information included in Part II, Item 7A in UniSource Energy
and TEP's Annual Report on Form 10-K for the year ended December 31, 2003, in
addition to the interim condensed consolidated financial statements and
accompanying notes presented in Items 1 and 2 of this Form 10-Q.
We are exposed to various forms of market risk. Changes in interest rates,
returns on marketable securities, and changes in commodity prices may affect our
future financial results. The market risks resulting from changes in interest
rates and returns on marketable securities have not changed materially from the
market risks reported in the 2003 Annual Report on Form 10-K . For additional
information concerning risk factors, including market risks, see Safe Harbor for
Forward-Looking Statements, above.
RISK MANAGEMENT COMMITTEE
We have a Risk Management Committee responsible for the oversight of
commodity price risk and credit risk related to the wholesale energy marketing
activities of TEP, the emissions and coal trading activities of MEG, and the
energy procurement activities at TEP and UES. Our Risk Management Committee
consists of officers from the finance, accounting, legal, wholesale marketing,
and the generation operations departments of UniSource Energy. To limit TEP's,
UES' and MEG's exposure to commodity price risk, the Risk Management Committee
sets trading and hedging policies and limits, which are reviewed frequently to
respond to constantly changing market conditions. To limit TEP's, UES' and MEG's
exposure to credit risk, the Risk Management Committee reviews counterparty
credit exposure, as well as credit policies and limits on a quarterly basis and
as needed.
COMMODITY PRICE RISK
We are exposed to commodity price risk primarily relating to changes in the
market price of electricity, natural gas, coal and Emission Allowances.
65
TEP
---
To manage its exposure to energy price risk, TEP enters into forward
contracts to buy or sell energy at a specified price and future delivery period.
Generally, TEP commits to future energy sales based on expected excess
generating capability, forward prices and generation costs, using a diversified
market approach to provide a balance between long-term, mid-term and spot energy
sales. TEP generally enters into forward energy and natural gas purchases during
its summer peaking period to ensure it can meet its load and reserve
requirements and account for other contract and resource contingencies. TEP also
enters into limited forward purchases and sales to optimize its resource
portfolio and take advantage of locational differences in price. These positions
are managed on both a volumetric and dollar basis and are closely monitored
using risk management policies and procedures overseen by the Risk Management
Committee. For example, the risk management policies dictate that TEP cannot
take a short position in the third quarter and must have owned generation
backing up all forward sales positions at the time the sale is made.
The majority of TEP's forward contracts are considered to be "normal
purchases and sales" of energy and are not considered to be derivatives under
FAS 133. TEP records revenues on its "normal sales" and expenses on its "normal
purchases" in the period in which the energy is delivered. From time to time,
however, TEP enters into forward contracts that meet the definition of a
derivative under FAS 133. When TEP has derivative forward contracts, it marks
them to market using actively quoted prices obtained from brokers for the
appropriate energy product. TEP believes that these broker quotations used to
calculate the mark-to-market values represent accurate measures of the fair
values of TEP's positions. The net pre-tax unrealized gains and losses from
TEP's forward electricity contracts were less than $1 million for each of the
three month periods ended September 30, 2004 and 2003 and was approximately $1
million for the nine month period ended September 30, 2004, and less than $1
million for the nine month period ended September 30, 2003. This demonstrates
the limited derivative forward contract activity conducted by TEP and the
limited impact on TEP's operating results and financial condition.
TEP has two purchased power agreements for the period 2003 through 2006.
During the third quarter of 2004, TEP purchased approximately 102,000 MWh under
these contracts; energy purchased under these agreements is adjusted for changes
in the price of natural gas. In the first nine months of 2004, approximately
149,000 MWh were purchased under these contracts.
TEP is also subject to commodity price risk from changes in the price of
natural gas. TEP typically uses generation from its facilities fueled by natural
gas to meet the summer peak demands of its retail customers and to meet local
reliability needs. Due to its increasing seasonal gas usage, TEP hedges a
portion of its natural gas purchases with fixed price contracts for a maximum of
three years, and purchases its remaining gas needs in the spot and short-term
markets through its supplier Southwest Gas Corporation (SWG). The net pre-tax
unrealized gains and losses from TEP's commodity swap agreements recorded as
cash flow hedges and included in Other Comprehensive Income were $3 million as
of September 30, 2004. The net pre-tax realized gains and losses from TEP's
commodity swap agreements that were reclassified out of Other Comprehensive
Income were less than $1 million for the three and nine months periods ended
September 30, 2004.
In the first nine months of 2004, the average price of natural gas was
$5.29 per MMBtu compared with $5.17 per MMBtu in the same period last year.
Natural gas prices remained high throughout 2003 and into 2004 with continued
demand, storage and production concerns. The increase in the regional supply of
gas-generated energy and the completion of a 500-kV transmission connection,
however, allowed TEP to decrease use of its less efficient gas generation units
in favor of more economical purchases of energy in the wholesale market. TEP's
generation output fueled by natural gas was approximately 328,000 MWh, or 4% of
total generation in the first nine months of 2004, compared with approximately
405,000 MWh, or 5% of total generation in same period of 2003.
UES
---
UES is also subject to commodity price risk, primarily from the changes in
the price of natural gas purchased for its UNS Gas customers. This risk is
mitigated through the PGA mechanism in UNS Gas' retail rates which provides an
adjustment to recover the actual costs of gas and transportation. UNS Gas
further reduces this risk by purchasing forward fixed price contracts for a
portion of its projected gas needs under its Price Stabilization Plan. UNS Gas
purchases between 45% and 80% of its estimated gas needs in this manner.
66
UNS Electric is not exposed to commodity price risk for its purchase of
electricity as it has a fixed price full-requirements supply agreement with PWCC
through May 2008. UNS Electric's retail rates include a PPFAC surcharge, which
allows for recovery of costs associated with the current full-requirements power
supply agreement with PWCC.
MEG
---
During the fourth quarter of 2001, MEG began managing and trading Emission
Allowances, coal and related instruments. We manage the market risk of this line
of business by setting notional limits by product, as well as limits to the
potential change in fair market value under a 33% change in price or volatility.
We closely monitor MEG's trading activities, which include swap agreements,
options and forward contracts, using risk management policies and procedures
overseen by the Risk Management Committee. MEG marks its trading positions to
market on a daily basis using actively quoted prices obtained from brokers and
options pricing models for positions that extend through 2007. As of September
30, 2004 and December 31, 2003, the fair value of MEG's trading assets combined
with Emission Allowances it holds in escrow was $88 million and $22 million,
respectively. The fair value of MEG's trading liabilities was $87 million at
September 30, 2004 and $19 million at December 31, 2003. The significant
increase in the fair value of MEG's trading assets and liabilities at September
30, 2004 compared with December 31, 2003 is the result of an increase in the
value of sulphur dioxide (SO2) allowances from $216 per allowance to $535 per
allowance. During the first nine months of 2004, MEG reflected a $4 million
unrealized gain and a $3 million realized loss on its income statement, compared
with an unrealized gain of $3 million and a realized loss of $3 million in the
first nine months of 2003.
Unrealized Gain (Loss) of MEG's Trading Activities
- Millions of Dollars -
------------------------------------------------------------------------------
Source of Fair Value Maturity Maturity Maturity over Total Unrealized
At September 30, 2004 0 - 6 mos. 6 - 12 mos. 1 yr. Gain (Loss)
------------------------------------------------------------------------------
Prices actively quoted $(3) $ - $ - $(3)
Prices based on models and other
valuation methods 4 - 4 8
- ------------------------------------------------------------------------------------------------------------------
Total $ 1 $ - $ 4 $5
==================================================================================================================
CREDIT RISK
UniSource Energy is exposed to credit risk in its energy-related marketing
and trading activities related to potential nonperformance by counterparties. We
manage the risk of counterparty default by performing financial credit reviews,
setting limits monitoring exposures, requiring collateral when needed, and using
a standard agreement which allows for the netting of current period exposures to
and from a single counterparty. Despite such mitigation efforts, there is a
potential for defaults by counterparties. In the fourth quarter of 2000 and the
first quarter of 2001, TEP was affected by payment defaults by SCE and PG&E for
amounts owed to the CPX and CISO. In the fourth quarter of 2001, Enron defaulted
on amounts owed to TEP for energy sales.
We calculate counterparty credit exposure by adding any outstanding
receivable (net of amounts payable if a netting agreement exists) to the
mark-to-market value of any forward contracts. As of September 30, 2004, TEP's
total credit exposure related to its wholesale marketing activities (excluding
defaulted amounts owed by the CPX and the CISO) was approximately $5 million and
MEG's total credit exposure related to its trading activities was $15 million.
TEP and MEG's credit exposure is diversified across approximately 23
counterparties. As of September 30, 2004, approximately $4 million of TEP's
exposure was to non-investment grade companies.
UniSource Energy is also exposed to credit risk related to the sale of
assets owned by Nations Energy Corporation (Nations Energy). In September 2001,
Nations Energy sold its 26% equity interest in a power project located in
Curacao, Netherlands Antilles to Mirant Curacao Investments, Ltd. (Mirant
Curacao) a subsidiary of Mirant Corporation (Mirant). Nations Energy received $5
million in cash and an $11 million receivable from Mirant Curacao. The
receivable was recorded at its net present value of $8 million using an 8%
discount rate, the discount being recognized as interest income over the
five-year life of the receivable. As of September 30, 2004, Nations Energy's
receivable from Mirant Curacao was approximately $8 million. The receivable is
primarily included in Investments and Other Property - Other on UniSource
Energy's balance sheet. The first payment of $2 million on the receivable was
67
received on June 30, 2004. The remaining payments are expected to be received as
follows: $4 million in July 2005 and $5 million in July 2006.
The receivable is guaranteed by Mirant Americas, Inc., a subsidiary of
Mirant. On July 14, 2003, Mirant, Mirant Americas, Inc. and various other Mirant
companies filed for Chapter 11 bankruptcy protection. Mirant Curacao was not
included in the Chapter 11 filings. Projected cash flows for the power project
support the expectation that Mirant Curacao will have sufficient future cash
flows to pay the remaining receivable and any applicable interest. However,
Nations Energy cannot predict the ultimate outcome that Mirant's bankruptcy will
have on the collectibility of the receivable from Mirant Curacao. Nations Energy
will continue to evaluate the collectibility of the receivable, but currently
expects to collect the receivable in its entirety and has not recorded any
reserve for this receivable.
ITEM 4. - CONTROLS AND PROCEDURES
UniSource Energy and TEP have disclosure controls and procedures to ensure
that material information recorded, processed, summarized and reported in their
filings with the SEC is on an accurate and timely basis. Management of UniSource
Energy and TEP, with the participation of the principal executive officer and
principal financial officer of UniSource Energy and TEP, have evaluated these
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended) as of September 30, 2004.
Based on such evaluation, the principal executive officer and principal
financial officer of UniSource Energy and TEP have concluded that such
disclosure controls and procedures were, as of such date, effective at ensuring
that material information is recorded, processed, summarized and reported
accurately and within the time periods specified by the SEC's rules and forms.
Since such evaluation, there have not been any significant changes in UniSource
Energy and TEP's internal controls, over financial reporting that has, or is
reasonably likely to, materially affect these controls.
PART II - OTHER INFORMATION
ITEM 1. - LEGAL PROCEEDINGS
- --------------------------------------------------------------------------------
LITIGATION CONCERNING THE PROPOSED ACQUISITION AGREEMENT
On August 26, 2004, the Pennsylvania Avenue Event Driven Fund filed a class
action complaint in the Superior Court of the State of Arizona on behalf of the
holders of UniSource Energy common stock against UniSource Energy and its
directors (Pennsylvania Ave. Event Driven Fund v. UniSource Energy Corp., et al.
(D. Ariz.)) relating to the proposed acquisition of UniSource Energy by an
affiliate of Saguaro Utility. The plaintiff alleges, among other things, that
members of UniSource Energy's board of directors breached their fiduciary duties
to UniSource Energy's shareholders in connection with the proposed acquisition
by tailoring the acquisition to meet the specific needs of Saguaro Utility and
basing the acquisition on financial results of UniSource Energy that were
subsequently restated to recognize additional net income. The plaintiff is
seeking to enjoin the acquisition, which was approved by shareholders of
UniSource Energy in March 2004. The lawsuit requests an order:
o declaring that the action is properly maintainable as a class action;
o decreeing that the acquisition agreement was entered into in breach of
the directors' fiduciary duties and is therefore unlawful and
unenforceable;
o enjoining the consummation of the acquisition until a new sale process
is adopted;
o ordering directors to exercise their fiduciary duties to obtain a
transaction that is in the best interest of UniSource Energy's
shareholders;
o rescinding, to the extent implemented, the acquisition; and
o awarding the plaintiff the costs of its action, including attorney's
and experts' fees.
68
On October 18, 2004, UniSource Energy filed a motion to dismiss the
complaint, which is pending before the court. UniSource Energy believes that the
lawsuit is without merit and will vigorously contest it.
CITY OF TACOMA
On June 7, 2004, the City of Tacoma, Washington filed a lawsuit (City of
Tacoma v. American Electric Power Service Corporation, et al. (U.S. District Ct.
W. D. Wash.)) against TEP and various other electricity generators and marketers
alleging that the defendants violated antitrust laws by colluding to effect the
price of electricity in the Pacific Northwest from May 2000 through 2001. These
claims are similar to those alleged in the antitrust cases against TEP and other
wholesale electricity market participants described in Item 3. Legal
Proceedings, Cross-Complaints in Wholesale Electricity Antitrust Cases I and II,
of our 2003 Annual Report on Form 10-K (the Wholesale Electricity Antitrust
Cases). Accordingly, on September 14, 2004, the case was transferred to the
United States District Court for the Southern District of California and
consolidated with the Wholesale Electricity Antitrust Cases. TEP along with
other defendants expects to file a motion to dismiss the City of Tacoma
complaint.
TEP believes these claims are without merit and intends to vigorously
contest them.
CALIFORNIA ATTORNEY GENERAL'S UNFAIR COMPETITION LAWSUITS
Beginning in April 2002, the California Attorney General filed complaints
against TEP and other wholesale electricity suppliers or marketers in San
Francisco Superior Court. The complaints seek to impose civil penalties under
California's unfair competition law based upon allegations that defendants
violated the Federal Power Act by failing to properly file their rates with FERC
and by charging "unjust and unreasonable" rates.
Defendants removed the cases to the United States District Court for the
Northern District of California where they were consolidated. The District Court
then dismissed the California Attorney General's complaints finding them barred
by federal preemption and the filed rate doctrine. The California Attorney
General appealed the District Court's dismissal of the complaints. On October
12, 2004, the Ninth Circuit Court of Appeals issued a memorandum decision
affirming the dismissal.
While it appears that the Attorney General may request a rehearing from the
Ninth Circuit, TEP believes these claims are without merit and intends to
vigorously contest them.
We discuss other legal proceedings in Note 9 of Notes to Condensed
Consolidated Financial Statements.
69
ITEM 5. - OTHER INFORMATION
- --------------------------------------------------------------------------------
ADDITIONAL FINANCIAL DATA
The following table reflects the ratio of earnings to fixed charges for
TEP:
9 MONTHS ENDED 12 MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2004 2004
---- ----
(RESTATED) (1)
--------
- ------------------------------------------------------------------------------------------------------
Ratio of Earnings to Fixed Charges 1.46 1.67
- ------------------------------------------------------------------------------------------------------
<FN>
(1) See Note 1 of Notes to Condensed Consolidated Financial Statements.
</FN>
NON-GAAP MEASURES
ADJUSTED EBITDA
- ---------------
Adjusted EBITDA represents EBITDA excluding the cumulative effect of
accounting change which is a non-cash item. EBITDA is earnings before interest,
taxes, depreciation and amortization. Adjusted EBITDA is presented here as a
measure of liquidity because it can be used as an indication of a company's
ability to incur and service debt and is commonly used as an analytical
indicator in our industry. Adjusted EBITDA measures presented may not be
comparable to similarly titled measures used by other companies. Adjusted EBITDA
is not a measurement presented in accordance with United States generally
accepted accounting principles (GAAP), and we do not intend Adjusted EBITDA to
represent cash flows from operations as defined by GAAP. Adjusted EBITDA should
not be considered to be an alternative to cash flows from operations or any
other items calculated in accordance with GAAP or an indicator of our operating
performance.
UniSource Energy and TEP view Adjusted EBITDA, a non-GAAP financial
measure, as a liquidity measure. The most directly comparable GAAP measure to
Adjusted EBITDA is Net Cash Flows from Operating Activities.
ADJUSTED EBITDA AND NET CASH FLOWS FROM OPERATING ACTIVITIES
UNISOURCE ENERGY
----------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
(RESTATED) (1) (RESTATED) (1)
- ----------------------------------------------------------------------------------------------
-Millions of Dollars -
Adjusted EBITDA $ 139 $ 137 $ 354 $ 284
Net Cash Flows from Operations $ 111 $ 92 $ 249 $ 136
- ----------------------------------------------------------------------------------------------
70
TEP
-----------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
(RESTATED) (1) (RESTATED) (1)
- ---------------------------------------------------------------------------------------------------------------
-Millions of Dollars -
Adjusted EBITDA $ 135 $ 140 $ 334 $ 305
Net Cash Flows from Operations $ 100 $ 101 $ 216 $ 165
- ---------------------------------------------------------------------------------------------------------------
<FN>
(1) See Note 1 of Notes to Condensed Consolidated Financial Statements.
</FN>
RECONCILIATION OF ADJUSTED EBITDA TO CASH FLOWS FROM OPERATIONS
UNISOURCE ENERGY
-----------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
(RESTATED) (1) (RESTATED) (1)
- ---------------------------------------------------------------------------------------------------------------
-Millions of Dollars -
ADJUSTED EBITDA (2) $ 139 $ 137 $ 354 $ 284
Net Cash Flows from Operations
Less: Income Taxes 17 19 35 17
Less: Total Interest Expense 41 42 123 123
Changes in Assets and Liabilities and
Other Non-Cash Items 30 16 53 (8)
- ---------------------------------------------------------------------------------------------------------------
NET CASH FLOWS FROM OPERATING ACTIVITIES $ 111 $ 92 $ 249 $ 136
- ---------------------------------------------------------------------------------------------------------------
TEP
-----------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
(RESTATED) (1) (RESTATED) (1)
- ---------------------------------------------------------------------------------------------------------------
-Millions of Dollars -
ADJUSTED EBITDA (2) $ 135 $ 140 $ 334 $ 305
Net Cash Flows from Operations
Less: Income Taxes 18 22 35 28
Less: Total Interest Expense 38 40 115 120
Changes in Assets and Liabilities and
Other Non-Cash Items 21 23 32 8
- ---------------------------------------------------------------------------------------------------------------
NET CASH FLOWS FROM OPERATING ACTIVITIES $ 100 $ 101 $ 216 $ 165
- ---------------------------------------------------------------------------------------------------------------
<FN>
(1) See Note 1 of Notes to Condensed Consolidated Financial Statements.
(2) Adjusted EBITDA was calculated as follows:
</FN>
71
UNISOURCE ENERGY
---------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
(RESTATED) (1) (RESTATED) (1)
- ---------------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars -
Net Income $ 24 $ 27 $ 43 $ 87
Amounts from the Income Statements:
Less: Cumulative Effect of Accounting Change - - - 67
Plus: Income Taxes 17 19 35 17
Plus: Total Interest Expense 41 42 123 123
Plus: Depreciation and Amortization 36 34 108 95
Plus: Amortization of Transition Recovery Asset 19 14 40 25
Plus: Depreciation included in Fuel and Other O&M Expense* 2 1 5 4
- ---------------------------------------------------------------------------------------------------------------------------------
ADJUSTED EBITDA $ 139 $ 137 $ 354 $ 284
- ---------------------------------------------------------------------------------------------------------------------------------
TEP
-------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
(RESTATED) (1) (RESTATED) (1)
- -------------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars -
Net Income $ 26 $ 32 $ 45 $ 105
Amounts from the Income Statements:
Less: Cumulative Effect of Accounting Change - - - 67
Plus: Income Taxes 18 22 35 28
Plus: Total Interest Expense 38 40 115 120
Plus: Depreciation and Amortization 32 31 94 90
Plus: Amortization of Transition Recovery Asset 19 14 40 25
Plus: Depreciation included in Fuel and Other O&M Expense* 2 1 5 4
- -------------------------------------------------------------------------------------------------------------------------------
ADJUSTED EBITDA $ 135 $ 140 $ 334 $ 305
- -------------------------------------------------------------------------------------------------------------------------------
<FN>
(1) See Note 1 of Notes to Condensed Consolidated Financial Statements.
* See Supplemental Cash Flow Information in Note 16 of Notes to Condensed
Consolidated Financial Statements.
</FN>
NET DEBT AND TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS - TEP
- -----------------------------------------------------------
As of As of
September 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
-Millions of Dollars-
Net Debt $ 1,703 $ 1,761
Total Debt and Capital Lease Obligations $ 1,874 $ 1,940
- --------------------------------------------------------------------------------
72
Net Debt represents the current and non-current portions of TEP's long-term
debt and capital lease obligations less investment in lease debt. We have
subtracted investment in lease debt because it represents TEP's ownership of its
own capital lease obligations. Net Debt measures presented may not be comparable
to similarly titled measures used by other companies. Net Debt is not a
measurement presented in accordance with GAAP and we do not intend Net Debt to
represent debt as defined by GAAP. Net Debt should not be considered to be an
alternative to debt or any other items calculated in accordance with GAAP.
RECONCILIATION OF TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS TO NET DEBT
As of As of December
September 30, 31,
2004 2003
- -----------------------------------------------------------------------------------------------
-Millions of Dollars-
Long-Term Debt $ 1,097 $ 1,126
Current Portion - Long-Term Debt 2 2
- -----------------------------------------------------------------------------------------------
TOTAL DEBT 1,099 1,128
Capital Lease Obligations 720 762
Current Portion - Capital Lease Obligations 55 50
- -----------------------------------------------------------------------------------------------
TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS 1,874 1,940
Investment in Lease Debt and Equity (171) (179)
- -----------------------------------------------------------------------------------------------
NET DEBT $ 1,703 $ 1,761
- -----------------------------------------------------------------------------------------------
SEC REPORTS AVAILABLE ON UNISOURCE ENERGY'S WEBSITE
UniSource Energy and TEP make available their Annual Reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments
to those reports as soon as reasonably practicable after they electronically
file them with, or furnish them to, the SEC. These reports are available free of
charge through UniSource Energy's website address:
http://www.unisourceenergy.com. A link from UniSource Energy's website to these
SEC reports is accessible at the UniSource Energy main page.
Information contained at UniSource Energy's website is not part of any
report filed with, or furnished to, the SEC by UniSource Energy or TEP.
The SEC also maintains an Internet site that contains reports, proxy and
information statements, and other information regarding issuers that file
electronically with the SEC. The SEC website address is http://www.sec.gov.
Interested parties may also read and copy any materials UniSource Energy and TEP
file with the SEC at the SEC's Public Reference Room at 450 Fifth Street, NW,
Washington, DC 20549. Information on the operation of the Public Reference Room
is available by calling the SEC at 1-800-SEC-0030.
ITEM 6. - EXHIBITS
- --------------------------------------------------------------------------------
See exhibit index.
73
SIGNATURES
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 subsidiaries.
UNISOURCE ENERGY CORPORATION
----------------------------
(Registrant)
Date: November 9, 2004 /s/ Kevin P. Larson
----------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer
TUCSON ELECTRIC POWER COMPANY
-----------------------------
(Registrant)
Date: November 9, 2004 /s/ Kevin P. Larson
----------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer
74
EXHIBIT INDEX
12 - Computation of Ratio of Earnings to Fixed Charges - TEP.
15 - Letter regarding unaudited interim financial information.
31(a) - Rule 13a-14(a)/15d-14(a) Certification of UniSource Energy, by
James S. Pignatelli.
31(b) - Rule 13a-14(a)/15d-14(a) Certification of
UniSource Energy, by Kevin P. Larson.
31(c) - Rule 13a-14(a)/15d-14(a)
Certification of TEP, by James S. Pignatelli.
31(d) - Rule 13a-14(a)/15d-14(a) Certification of TEP, by Kevin P. Larson.
*32 - Section 1350 Certifications.
* Pursuant to Item 601(b)(32)(ii) of Regulation S-K, this certificate is
not being filed for purposes of Section 18 of the Securities
Exchange Act of 1934).
75