EXHIBIT 99.1
MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS
The following narrative analysis should be read in combination with our
consolidated financial statements included herein.
Effective August 31, 2002, Reliant Energy, Incorporated (Reliant Energy)
consummated a restructuring transaction (the Restructuring) in which it, among
other things, (1) conveyed its Texas electric generation assets to Texas Genco
Holdings, Inc. (Texas Genco), (2) became an indirect, wholly owned subsidiary of
a new utility holding company, CenterPoint Energy, Inc. (CenterPoint Energy),
(3) was converted into a Texas limited liability company named CenterPoint
Energy Houston Electric, LLC (CenterPoint Houston or the Company), and (4)
distributed the capital stock of its operating subsidiaries to CenterPoint
Energy. As part of the Restructuring, each share of Reliant Energy common stock
was converted into one share of CenterPoint Energy common stock. Pursuant to the
provisions of certain of its existing debt agreements applicable when the
properties or assets of Reliant Energy were transferred to another entity
substantially as an entirety, CenterPoint Energy assumed certain debt and other
obligations of Reliant Energy, and Reliant Energy was released as the primary
obligor on such debt. Immediately subsequent to the Restructuring, we had
outstanding (a) $614.7 million of first mortgage bonds issued directly to third
parties, (b) $546.5 million of first mortgage bonds that collateralized
medium-term notes and pollution control bonds of CenterPoint Energy (such
amounts are not reflected in our consolidated financial statements because of
the contingent nature of the obligations), (c) $300 million of notes issued by a
subsidiary, (d) $735.8 million of transition bonds issued by a subsidiary, and
(e) a $1.6 billion note issued to CenterPoint Energy. In addition, we had a $400
million credit facility. At December 31, 2002 we had $3.7 billion in outstanding
indebtedness and had issued $1.1 billion of first mortgage bonds and second
mortgage bonds as collateral for long-term debt of CenterPoint Energy.
We operate Reliant Energy's former electric transmission and distribution
business, which continues to be subject to cost-of-service rate regulation and
is responsible for the delivery of electricity sold to retail customers by
retail electric providers in the 5,000 square mile service area of Houston,
Texas and surrounding metropolitan areas as well as the transmission of bulk
power into and out of the Houston area.
Contemporaneous with the Restructuring, CenterPoint Energy registered and
became subject, with its subsidiaries, to regulation as a registered holding
company system under the Public Utility Holding Company Act of 1935 (1935 Act).
The 1935 Act directs the Securities and Exchange Commission (SEC) to regulate,
among other things, transactions among affiliates, sales or acquisitions of
assets, issuances of securities, distributions and permitted lines of business.
CONSOLIDATED RESULTS OF OPERATIONS
The consolidated financial statements present the former subsidiaries of
Reliant Energy that were distributed to CenterPoint Energy in the Restructuring
as discontinued operations, in accordance with Statement of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets" (SFAS No. 144). Accordingly, our consolidated financial statements
reflect these operations as discontinued operations for each of the three years
in the period ended December 31, 2002. Additionally, the conveyance of Reliant
Energy's electric generation assets to Texas Genco has been reflected as
discontinued operations in accordance with SFAS No. 144 for each of the three
years in the period ended December 31, 2002.
The following discussion of consolidated results of operations is based on
earnings from continuing operations before interest expense, distribution on
trust preferred securities, and income taxes (EBIT). EBIT, as defined, is shown
because it is a financial measure used by CenterPoint Energy to evaluate our
performance and we believe it is a measure of financial performance that may be
used as a means to analyze and compare companies on the basis of operating
performance. We expect that some analysts and investors will want to
1
review EBIT when evaluating our company. EBIT is not defined under accounting
principles generally accepted in the United States of America (GAAP), should not
be considered in isolation or as a substitute for a measure of performance
prepared in accordance with GAAP and is not indicative of operating income from
operations as determined under GAAP. Additionally, our computation of EBIT may
not be comparable to other similarly titled measures computed by other
companies, because all companies do not calculate it in the same fashion. We
consider operating income to be a comparable measure under GAAP. We believe the
difference between operating income and EBIT is not material. We have provided a
reconciliation of consolidated operating income to EBIT and EBIT to net income
in the table below.
The following table sets forth selected financial and operating data for
the years ended December 31, 2000, 2001 and 2002, followed by a discussion of
significant variances in period-to-period results:
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
------------------------
2000 2001 2002
------ ------ ------
(IN MILLIONS)
Operating Revenues:
Electric revenues........................................ $2,161 $2,100 $1,525
ECOM true-up............................................. -- -- 697
------ ------ ------
Total Operating Revenues.............................. 2,161 2,100 2,222
------ ------ ------
Operating Expenses:
Purchased power.......................................... -- -- 66
Operation and maintenance................................ 586 650 575
Depreciation and amortization............................ 356 299 271
Taxes other than income taxes............................ 284 288 213
------ ------ ------
Total Operating Expenses.............................. 1,226 1,237 1,125
------ ------ ------
Operating Income........................................... 935 863 1,097
Other Income, net.......................................... 20 44 21
------ ------ ------
EBIT....................................................... 955 907 1,118
Interest Expense and Distribution on Trust Preferred
Securities............................................... (231) (233) (285)
------ ------ ------
Income From Continuing Operations Before Income Taxes and
Preferred Dividends...................................... 724 674 833
Income Tax Expense......................................... (233) (228) (286)
------ ------ ------
Income From Continuing Operations Before Preferred
Dividends................................................ 491 446 547
Income (Loss) from Discontinued Operations................. (44) 535 132
Preferred Dividends........................................ -- (1) --
------ ------ ------
Net Income................................................. $ 447 $ 980 $ 679
====== ====== ======
</Table>
2002 Compared to 2001. Prior to January 1, 2002, CenterPoint Energy's
electric operations reflected the regulated electric utility business, including
generation, transmission and distribution, and retail electric sales. As of
January 1, 2002, with the opening of the Texas market to full retail electric
competition, generation and retail sales are no longer subject to cost of
service regulation. Retail electric sales involve the sale of electricity and
related services to end users of electricity and were included as part of the
bundled regulated service prior to 2002. This business is now conducted by
Reliant Resources. The previously regulated generation operations in Texas are
now a part of Texas Genco. We report results from two sources:
- the regulated electric transmission and distribution operations; and
- the generation-related stranded costs recoverable by us as a regulated
utility.
2
As a result of the implementation of deregulation, we recover the cost of
our service through an energy delivery charge, and not as a component of the
prior bundled rate, which included energy and delivery charges. The design of
the new energy delivery rate differs from the prior bundled rate. The
winter/summer rate differential for residential customers has been eliminated
and the energy component of the rate structure for commercial and industrial
customers has been removed, which will tend to lessen some of the pronounced
seasonal variation of revenues which has been experienced in prior periods.
Although our former retail sales business is no longer conducted by us,
retail customers remained regulated customers of Reliant Energy through the date
of their first meter reading in 2002. Operations during this transition period
are reflected in our business. Operations during this transition period also
included power purchased from Texas Genco of approximately $48 million.
We reported EBIT of $1.1 billion in 2002, consisting of EBIT of $421
million for the regulated electric transmission and distribution business,
including retail sales during the transition period as discussed above, and
non-cash EBIT of $697 million of Excess Costs Over Market (ECOM) regulatory
assets associated with costs recorded pursuant to the Texas electric
restructuring law as explained below. Operating revenues were $1.5 billion,
excluding ECOM, and purchased power costs were $66 million in 2002. The
purchased power costs relate to operation of the regulated utility during the
transition period discussed above.
Under the Texas electric restructuring law, each power generator that is
unbundled from an integrated electric utility in Texas has an obligation to
conduct state mandated capacity auctions of 15% of its capacity. In addition,
under a master separation agreement between CenterPoint Energy and Reliant
Resources, Texas Genco is contractually obligated to auction all capacity in
excess of the state mandated capacity auctions. The auctions conducted
periodically between September 2001 and January 2003 were consummated at prices
below those used in the ECOM model by the Public Utility Commission of Texas
(Texas Utility Commission). Under the Texas electric restructuring law, we, as a
regulated utility, may recover in a regulatory proceeding scheduled for 2004 any
difference between market prices received through the state mandated auctions
and the Texas Utility Commission's earlier estimates of those market prices.
This difference, recorded as a regulatory asset, produced $697 million of EBIT
in 2002.
Our throughput declined 2% during 2002 as compared to 2001. The decrease
was primarily due to reduced energy delivery in the industrial sector resulting
from self-generation by several major customers, partially offset by increased
residential usage primarily due to non-weather related factors. Additionally,
despite a slowing economy, total metered customers continued to grow at an
approximate annual growth rate of 2% during 2002.
Operation and maintenance expenses decreased by $75 million in 2002,
compared to 2001. The decrease was primarily due to:
- a $77 million decrease in factoring expense as a result of the
termination of an agreement under which we sold our customer accounts
receivable;
- a $10 million decrease in transmission cost of service; and
- a $16 million decrease in transmission line losses in 2002 as this is now
a cost of retail electric providers.
These decreases were partially offset by a $25 million increase in benefits
expense, including severance costs of $11 million in connection with a reduction
in work force in 2002.
In June 1998, the Texas Utility Commission issued an order approving a
transition to competition plan (Transition Plan) filed by Reliant Energy in
December 1997. In order to reduce Reliant Energy's exposure to potential
stranded costs related to generation assets, the Transition Plan permitted the
redirection of depreciation expense to generation assets that we otherwise would
apply to transmission, distribution and general plant assets. In addition, the
Transition Plan provided that all earnings above a stated overall annual rate of
return on invested capital be used to recover our investment in generation
assets. Reliant Energy implemented the Transition Plan effective January 1,
1998. For further discussion of the Transition Plan, please read Note 4(a) to
our consolidated financial statements.
3
Depreciation and amortization decreased $28 million in 2002 compared to
2001. The decrease was primarily due to a decrease in amortization of the book
impairment regulatory asset ($281 million) recorded in June 1999, which was
fully amortized in December 2001, offset by depreciation expense recorded in
2002 as a result of the discontinuance of redirection of depreciation expense
related to electric transmission and distribution assets ($217 million) and
increased amortization related to transition property associated with the
transition bonds issued in November 2001 ($35 million). For further discussion
related to the impairment recorded in June 1999, please read Note 4(a) to our
consolidated financial statements.
Taxes other than income taxes decreased $75 million compared to 2001. The
decrease was primarily due to lower gross receipts taxes ($64 million), which
became the responsibility of the retail electric providers upon deregulation,
and lower franchise taxes ($27 million) partially offset by increased property
taxes ($10 million).
Other income, net decreased $23 million in 2002 compared to 2001. The
decrease was primarily due to a $37 million decrease in interest income from
under-recovery of fuel in 2002 compared to 2001, partially offset by a $19
million increase in interest income from affiliated parties.
Our effective tax rates for 2002 and 2001 were 34.3% and 33.8%,
respectively.
See Note 2 to our consolidated financial statements for a discussion of
discontinued operations.
2001 Compared to 2000. Our EBIT for 2001 decreased $48 million compared to
2000. The decrease was primarily due to milder weather, decreased customer
demand, increased contract services and benefit expenses and a charge recorded
in the fourth quarter of 2001 resulting from the early termination of an
accounts receivable factoring agreement. The decrease was also due to the
implementation of the pilot program for Texas deregulation in August 2001,
reduced rates for certain governmental agencies and increased administrative
expenses related to the separation of our regulated and unregulated businesses.
These decreases were partially offset by decreased amortization expense and
customer growth.
Operating revenues decreased $61 million in 2001 primarily due to decreased
customer demand as a result of the effect of milder weather compared to 2000 and
decreased customer usage on a weather normalized basis.
Operation and maintenance expenses increased $64 million in 2001 compared
to 2000 primarily due to the following items:
- a $27 million increase in benefits expense primarily driven by medical
and pension costs;
- an $11 million increase in administrative expenses related to the
separation of our regulated and unregulated businesses;
- a $20 million charge recorded in the fourth quarter of 2001 resulting
from the early termination of an accounts receivable factoring agreement;
and
- a $7 million increase due to an overall increase in bad debt expense.
Depreciation and amortization expense decreased $57 million primarily due
to a decrease in amortization of the book impairment regulatory asset recorded
in June 1999 and decreased amortization expense due to regulatory assets related
to cancelled projects being fully amortized in June 2000, partially offset by
accelerated amortization of certain regulatory assets related to energy
conservation management as required by the Texas Utility Commission.
Other income, net increased $24 million in 2001 compared to 2000. The
increase was primarily due to an increase in interest income from under-recovery
of fuel in 2001 compared to 2000.
Our effective tax rates for 2001 and 2000 were 33.8% and 32.2%,
respectively.
4
CERTAIN FACTORS AFFECTING FUTURE EARNINGS
Our past earnings are not necessarily indicative of our future earnings and
results of operations. The magnitude of our future earnings and results of our
operations will depend on numerous factors including:
- state and federal legislative and regulatory actions or developments,
including deregulation, re-regulation and restructuring of the electric
utility industry, constraints placed on our activities or business by the
1935 Act, changes in or application of laws or regulations applicable to
other aspects of our business and actions with respect to:
- approval of stranded costs;
- allowed rates of return;
- rate structures;
- recovery of investments; and
- operation and construction of facilities;
- non-payment for our services due to financial distress of our customers,
including our largest customer, Reliant Resources;
- the successful and timely completion of our capital projects;
- industrial, commercial and residential growth in our service territory
and changes in market demand and demographic patterns;
- changes in business strategy or development plans;
- changes in interest rates or rates of inflation;
- unanticipated changes in operating expenses and capital expenditures;
- weather variations and other natural phenomena, which can affect the
demand for power over our transmission and distribution system;
- commercial bank and financial market conditions, our access to capital,
the cost of such capital, receipt of certain approvals under the 1935
Act, and the results of our financing and refinancing efforts, including
availability of funds in the debt capital markets for transmission and
distribution companies;
- actions by rating agencies;
- legal and administrative proceedings and settlements;
- changes in tax laws;
- inability of various counterparties to meet their obligations with
respect to our financial instruments;
- any lack of effectiveness of our disclosure controls and procedures;
- changes in technology;
- significant changes in our relationship with our employees, including the
availability of qualified personnel and the potential adverse effects if
labor disputes or grievances were to occur;
- significant changes in critical accounting policies;
- acts of terrorism or war, including any direct or indirect effect on our
business resulting from terrorist attacks such as occurred on September
11, 2001 or any similar incidents or responses to those incidents;
- the availability and price of insurance;
- the outcome of the pending securities lawsuits against Reliant Energy and
Reliant Resources;
5
- the outcome of the Securities and Exchange Commission investigation
relating to the treatment in our consolidated financial statements of
certain activities of Reliant Resources;
- the ability of Reliant Resources to satisfy its indemnity obligations to
us;
- the reliability of the systems, procedures and other infrastructure
necessary to operate the retail electric business in our service
territory, including the systems owned and operated by the ERCOT ISO;
- political, legal, regulatory and economic conditions and developments in
the United States; and
- other factors discussed in Item 1 of this report under "Risk Factors."
LIQUIDITY
Long-Term Debt. The following table shows future maturity dates of
long-term debt issued by us to third parties and affiliates and expected future
maturity dates of transition bonds issued by our subsidiary CenterPoint Energy
Transition Bond Company, LLC, as of December 31, 2002. Amounts are expressed in
thousands.
<Table>
<Caption>
CENTERPOINT HOUSTON
------------------------ TRANSITION
YEAR THIRD-PARTY AFFILIATE SUB-TOTAL BONDS TOTAL
- ---- ----------- ---------- ---------- ---------- ----------
2003...................... $ 166,600 $ 166,600 $ 18,722 $ 185,322
2004...................... 41,189 41,189
2005...................... $1,310,000 1,310,000 46,806 1,356,806
2006...................... 54,295 54,295
2007...................... 59,912 59,912
2008...................... 65,529 65,529
2009...................... 73,018 73,018
2010...................... 80,506 80,506
2011...................... 87,995 87,995
2012...................... 45,570 45,570 99,229 144,799
2013...................... 108,590 108,590
2015...................... 150,850 150,850 150,850
2017...................... 127,385 127,385 127,385
2021...................... 102,442 102,442 102,442
2022...................... 62,275 62,275 62,275
2023...................... 450,000 450,000 450,000
2027...................... 56,095 56,095 56,095
2028...................... 536,500 536,500 536,500
---------- ---------- ---------- -------- ----------
Total..................... $1,924,717 $1,083,000 $3,007,717 $735,791 $3,743,508
========== ========== ========== ======== ==========
</Table>
Third-party debt of $1.3 billion maturing in 2005 is senior and secured by
our general mortgage bonds. First mortgage bonds in an aggregate principal
amount of $615 million have been issued directly to third parties. The affiliate
debt is senior and unsecured.
As of October 10, 2002, we increased the size of our credit facility to
$850 million in connection with the amendment and extension of our bank facility
and CenterPoint Energy's bank facility. Proceeds from the loan were used to (1)
repay maturing loans under a $400 million credit facility and (2) repay $450
million of the notes payable to CenterPoint Energy. The $850 million facility
was secured by $850 million aggregate principal amount of our general mortgage
bonds issued under our General Mortgage Indenture dated as of October 10, 2002.
The lien of the general mortgage indenture is junior to that of our Mortgage and
Deed of Trust dated as of November 1, 1944. The $850 million of general mortgage
bonds was released by the banks
6
upon the November 2002 repayment and termination of the facility using proceeds
from our $1.3 billion collateralized term loan as discussed below.
On November 12, 2002, we entered into a $1.3 billion collateralized term
loan maturing November 2005. The interest rate on the loan is the London
inter-bank offered rate (LIBOR) plus 9.75%, subject to a minimum rate of 12.75%.
The loan is secured by our general mortgage bonds. Proceeds from the loan were
used to (1) repay our $850 million term loan as discussed above, (2) repay $100
million of intercompany notes maturing in 2028, (3) repay $300 million of debt
that matured on November 15, 2002 and (4) pay transaction costs. The loan
agreement contains various business and financial covenants including a covenant
restricting our debt, excluding transition bonds, as a percent of its total
capitalization to 68%. The loan agreement also limits incremental secured debt
that may be issued by us to $300 million. At December 31, 2002 we were in
compliance with this covenant.
We have outstanding approximately $1.1 billion aggregate principal amount
of affiliate notes which represent borrowings from our parent.
On February 28, 2003, CenterPoint Energy amended its existing $3.85 billion
bank facility. The amendment provides that proceeds from capital stock or
indebtedness issued or incurred by us must be applied (subject to a $200 million
basket for CERC and its subsidiaries and another $250 million basket for
borrowings by us and CenterPoint Energy's other subsidiaries and other limited
exceptions) to repay bank loans and reduce the bank facility. Cash proceeds from
issuances of indebtedness to refinance indebtedness existing on October 10, 2002
are not subject to this limitation.
We have issued approximately $1.2 billion aggregate principal amount of
first mortgage bonds and approximately $1.8 billion aggregate principal amount
of general mortgage bonds, of which approximately $1.1 billion combined
aggregate principal amount of first mortgage bonds and general mortgage bonds
collateralizes debt of CenterPoint Energy.
The following table shows the future maturity dates of the $1.1 billion of
first mortgage bonds and general mortgage bonds that we have issued as
collateral for $150 million of CenterPoint Energy's medium term notes and $924
million of pollution control bonds for which CenterPoint Energy is obligated.
These bonds are not reflected in our consolidated financial statements because
of the contingent nature of the obligations. Amounts are expressed in thousands.
<Table>
<Caption>
YEAR FIRST MORTGAGE BONDS GENERAL MORTGAGE BONDS TOTAL
- ---- -------------------- ---------------------- ----------
2003.............................. $166,600 $ 166,600
2011.............................. $ 19,200 19,200
2012.............................. 45,570 45,570
2015.............................. 150,850 150,850
2017.............................. 127,385 127,385
2018.............................. 50,000 50,000
2019.............................. 200,000 200,000
2020.............................. 90,000 90,000
2026.............................. 100,000 100,000
2027.............................. 56,095 56,095
2028.............................. 68,000 68,000
-------- -------- ----------
Total............................. $546,500 $527,200 $1,073,700
======== ======== ==========
</Table>
The aggregate amount of additional general mortgage bonds and first
mortgage bonds that could be issued is approximately $900 million based on
estimates of the value of property encumbered by the General Mortgage, the cost
of such property and the 70% bonding ratio contained in the General Mortgage. As
of December 31, 2002, the outstanding principal amount of first mortgage bonds
and general mortgage bonds
7
aggregated approximately $3.0 billion. The agreement relating to the $1.3
billion collateralized term loan debt maturing in 2005 limits incremental
secured debt to $300 million of general mortgage bonds.
Our subsidiary, CenterPoint Energy Transition Bond Company, LLC, has $736
million aggregate principal amount of outstanding transition bonds that were
issued in 2001 in accordance with the Texas electric restructuring law. Classes
of the transition bonds have final maturity dates of September 15, 2007,
September 15, 2009, September 15, 2011 and September 15, 2015 and bear interest
at rates of 3.84%, 4.76%, 5.16% and 5.63%, respectively. The transition bonds
are secured by "transition property," as defined in the Texas electric
restructuring law, which includes the irrevocable right to recover, through
non-bypassable transition charges payable by retail electric customers,
qualified costs provided in the Texas electric restructuring law. The transition
bonds are reported as our long-term debt, although the holders of the transition
bonds have no recourse to any of our assets or revenues, and our creditors have
no recourse to any assets or revenues (including, without limitation, the
transition charges) of the transition bond company. We have no payment
obligations with respect to the transition bonds except to remit collections of
transition charges as set forth in a servicing agreement between us and the
transition bond company and in an intercreditor agreement among us, our indirect
transition bond subsidiary and other parties.
Bank Facilities. As of December 31, 2002, we had no bank facilities
available to meet our short-term liquidity needs.
In February 2003, we obtained a $75 million revolving credit facility that
terminates on April 30, 2003. A condition precedent to utilizing the facility is
that security in the form of general mortgage bonds must be delivered to the
lender. Rates for borrowings under this facility, including the facility fee,
will be LIBOR plus 250 basis points.
Money Pool. We participate in a "money pool" through which we and certain
of our affiliates can borrow or invest on a short-term basis. Funding needs are
aggregated and external borrowing or investing is based on the net cash
position. The money pool's net funding requirements are generally met by
borrowings of CenterPoint Energy. The terms of the money pool are in accordance
with requirements applicable to registered public utility holding companies
under the 1935 Act. At December 31, 2002, we had borrowings of $48 million from
the money pool. The money pool may not provide sufficient funds to meet our cash
needs.
Temporary Investments. On December 31, 2002, we had approximately $44
million of investments in a money market fund.
Capital Requirements. We anticipate capital expenditures of up to $1.5
billion in the years 2003 through 2007. We anticipate capital expenditures to be
approximately $258 million and $300 million in 2003 and 2004, respectively.
Contractual Obligations. Excluding long-term debt discussed above, our
contractual obligations to make future payments consist of operating leases of
$5 million each in the years 2003 through 2005 and $6 million each in the years
2006 and 2007. For a discussion of operating leases, please read Note 10(a) to
our consolidated financial statements.
Refunds to Our Customers. An order issued by the Texas Utility Commission
on October 3, 2001 established the transmission and distribution rates that
became effective in January 2002. The Texas Utility Commission determined that
we had overmitigated our stranded costs by redirecting transmission and
distribution depreciation and by accelerating depreciation of generation assets
(an amount equal to earnings above a stated overall rate of return on rate base
that was used to recover our investment in generation assets) as provided under
the 1998 transition plan and the Texas electric restructuring law. In this final
order, we are required to reverse the amount of redirected depreciation and
accelerated depreciation taken for regulatory purposes as allowed under the
transition plan and the Texas electric restructuring law. Per the October 3,
2001 order, we recorded a regulatory liability to reflect the prospective refund
of the accelerated depreciation. We began refunding excess mitigation credits
with the January 2002 unbundled bills, to be refunded over a seven-year period.
The annual refund of excess earnings is approximately $237 million. Under the
Texas electric restructuring law, a final settlement of these stranded costs
will occur in 2004.
8
Cash Requirements in 2003. Our liquidity and capital requirements are
affected primarily by our results of operations, capital expenditures, debt
service requirements, and working capital needs. Our principal cash requirements
during 2003 include the following:
- approximately $258 million of capital expenditures;
- an estimated $237 million which we are obligated to return to customers
as a result of the Texas Utility Commission's finding of over-mitigation
of stranded costs; and
- $167 million of maturing long-term debt to affiliate.
We expect to fund cash requirements with cash from operations, liquidations
of short-term investments, short-term borrowings and proceeds from debt
offerings. We believe that our current liquidity, along with anticipated cash
flows from operations and proceeds from possible debt issuances will be
sufficient to meet our cash needs. However, disruptions in our ability to access
the capital markets on a timely basis could adversely affect our liquidity.
Limits on our ability to issue secured debt, as described in this report, may
adversely affect our ability to issue debt securities. In addition, the cost of
our recent secured debt issuances has been very high. A similar cost with regard
to additional issuances could significantly impact our debt service. Please read
"Risk Factors -- Risk Factors Associated with Financial Condition and Other
Risks -- If we are unable to arrange future financings on acceptable terms, our
ability to fund future capital expenditures and refinance existing indebtedness
could be limited" in Item 1 of this report.
Prior to the Restructuring, Reliant Energy obtained an order from the SEC
that granted us certain authority with respect to financing, dividends and other
matters. The financing authority granted by that order will expire on June 30,
2003, and CenterPoint Energy must obtain a further order from the SEC under the
1935 Act in order for it and its subsidiaries, including us, to engage in
financing activities subsequent to that date.
The amount of any debt issuance, whether registered or unregistered, or
whether debt is secured or unsecured, is expected to be affected by the market's
perception of our creditworthiness, market conditions and factors affecting our
industry. Proceeds from the issuance of debt are expected to be used to
refinance maturing debt, to finance capital expenditures and to permit the
payment of dividends.
Principal Factors Affecting Cash Requirements in 2004 and 2005. We expect
to issue securitization bonds in 2004 or 2005 to monetize and recover the
balance of stranded costs relating to previously owned electric generation
assets and other qualified costs as determined in the 2004 true-up proceeding.
The issuance will be done pursuant to a financing order to be issued by the
Texas Utility Commission. As with the debt of our existing transition bond
company, payments on these new securitization bonds would also be made out of
funds from non-bypassable charges assessed to retail electric customers required
to take delivery service from us. The holders of the securitization bonds would
not have recourse to any of our assets or revenues, and our creditors would not
have recourse to any assets or revenues of the entity issuing the securitization
bonds. All or a portion of the proceeds from the issuance of securitization
bonds remaining after repayment of our $1.3 billion collateralized term loan are
expected to be utilized to retire affiliate debt and pay a dividend to our
parent.
Impact on Liquidity of a Downgrade in Credit Ratings. As of March 4, 2003,
Moody's Investors Service, Inc. (Moody's), Standard & Poor's Ratings Services, a
division of The McGraw Hill Companies (S&P) and Fitch, Inc. (Fitch) had assigned
the following credit ratings to our senior secured debt:
<Table>
<Caption>
MOODY'S S&P FITCH
------------------- ------------------- -------------------
SECURITY RATING OUTLOOK(1) RATING OUTLOOK(2) RATING OUTLOOK(3)
-------- ------ ---------- ------ ---------- ------ ----------
First Mortgage Bonds........ Baa2 Stable BBB Stable BBB+ Negative
Debt secured by General
Mortgage Bonds............ Baa2 Stable BBB Stable BBB Negative
</Table>
- ---------------
(1) A "stable" outlook from Moody's indicates that Moody's does not expect to
put the rating on review for an upgrade or downgrade within 18 months from
when the outlook was assigned or last affirmed.
9
(2) A "stable" outlook from S&P indicates that the rating is not likely to
change over the intermediate to longer term.
(3) A "negative" outlook from Fitch encompasses a one- to two-year horizon as to
the likely rating direction.
We cannot assure you that these ratings will remain in effect for any given
period of time or that one or more of these ratings will not be lowered or
withdrawn entirely by a rating agency. We note that these credit ratings are not
recommendations to buy, sell or hold our securities and may be revised or
withdrawn at any time by the rating agency. Each rating should be evaluated
independently of any other rating. Any future reduction or withdrawal of one or
more of our credit ratings could have a material adverse impact on our ability
to obtain short- and long-term financing, the cost of such financings and the
execution of our commercial strategies. A decline in credit ratings would also
increase the interest rate on long-term debt to be issued in the capital markets
and would negatively impact our ability to complete capital market transactions.
Our $75 million bank facility executed in February 2003 contains a
"material adverse change" clause that could impact our ability to make new
borrowings under the facility. The "material adverse change" clause relates to
an event, development or circumstance that has had or would reasonably expected
to have a material adverse affect on our business, financial condition or
operations, the legality, validity or enforceability of the loan documents, or
the perfection or priority of the lien of the general mortgage.
Cross Defaults. The terms of our debt instruments generally provide that a
default on obligations by CenterPoint Energy does not cause a default under our
debt instruments. A payment default by us exceeding $50 million will cause a
default under our $1.3 billion loan maturing in 2005. Acceleration of the
maturity of CenterPoint Energy's $150 million of collateralized medium-term
notes due in April 2003 would force us to redeem our related $150 million of
first mortgage bonds.
Other Factors that Could Affect Cash Requirements. In addition to the
above factors, our liquidity and capital resources could be affected by:
- various regulatory actions; and
- the ability of Reliant Resources and its subsidiaries to satisfy their
obligations to us as a principal customer and in respect of its indemnity
obligation to us.
Capitalization. Factors affecting our capitalization include:
- covenants in our borrowing agreements; and
- limitations imposed on us because our parent company is a registered
public utility holding company.
In connection with our parent company's registration as a public utility
holding company under the 1935 Act, the SEC has limited the aggregate amount of
our external borrowings to $3.55 billion. Our ability to pay dividends is
restricted by the SEC's requirement that common equity as a percentage of total
capitalization must be at least 30% after the payment of any dividend. In
addition, the order restricts our ability to pay dividends out of capital
accounts to the extent current or retained earnings are insufficient for those
dividends. Under these restrictions, we are permitted to pay dividends in excess
of the respective current or retained earnings in an amount up to $200 million.
Relationship to CenterPoint Energy. We are a wholly owned subsidiary of
CenterPoint Energy. As a result of this relationship, the financial condition
and liquidity of our parent company could affect our access to capital, our
credit standing and our financial condition.
Asset Sales. Factors affecting our ability to sell assets (including
assets of our subsidiaries) or to satisfy our cash requirements include the
following:
- the 1935 Act may require us to obtain prior approval of certain assets
sales; and
- obligations under existing credit facilities to use certain cash received
from asset sales and securities offerings to pay down debt.
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Pension Plan. As discussed in Note 8(a) to the consolidated financial
statements, we participate in CenterPoint Energy's qualified non-contributory
pension plan covering substantially all employees. Pension expense for 2003 is
estimated to be $26 million based on an expected return on plan assets of 9.0%
and a discount rate of 6.75% as of December 31, 2002. Pension expense for the
year ended December 31, 2002 was $7 million. Future changes in plan asset
returns, assumed discount rates and various other factors related to the pension
will impact our future pension expense and liabilities. We cannot predict with
certainty what these factors will be in the future.
CRITICAL ACCOUNTING POLICIES
A critical accounting policy is one that is both important to the
presentation of our financial condition and results of operations and requires
management to make difficult, subjective or complex accounting estimates. An
accounting estimate is an approximation made by management of a financial
statement element, item or account in the financial statements. Accounting
estimates in our historical consolidated financial statements measure the
effects of past business transactions or events, or the present status of an
asset or liability. The accounting estimates described below require us to make
assumptions about matters that are highly uncertain at the time the estimate is
made. Additionally, different estimates that we could have used or changes in an
accounting estimate that are reasonably likely to occur could have a material
impact on the presentation of our financial condition or results of operations.
The circumstances that make these judgments difficult, subjective and/or complex
have to do with the need to make estimates about the effect of matters that are
inherently uncertain. Estimates and assumptions about future events and their
effects cannot be predicted with certainty. We base our estimates on historical
experience and on various other assumptions that we believe to be reasonable
under the circumstances, the results of which form the basis for making
judgments. These estimates may change as new events occur, as more experience is
acquired, as additional information is obtained and as our operating environment
changes. We believe the following accounting policies involve the application of
critical accounting estimates.
ACCOUNTING FOR RATE REGULATION
SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation"
(SFAS No. 71), provides that rate-regulated entities account for and report
assets and liabilities consistent with the recovery of those incurred costs in
rates if the rates established are designed to recover the costs of providing
the regulated service and if the competitive environment makes it probable that
such rates can be charged and collected. We apply SFAS No. 71, which results in
our accounting for the regulatory effects of recovery of "stranded costs" and
other "regulatory assets" resulting from the unbundling of the transmission and
distribution business from our electric generation operations in our
consolidated financial statements. Certain expenses and revenues subject to
utility regulation or rate determination normally reflected in income are
deferred on the balance sheet and are recognized in income as the related
amounts are included in service rates and recovered from or refunded to
customers. Regulatory assets reflected in our Consolidated Balance Sheets
aggregated $3.2 billion and $4.0 billion as of December 31, 2001 and 2002,
respectively. Significant accounting estimates embedded within the application
of SFAS No. 71 relate to $2.0 billion of recoverable electric generation plant
mitigation assets (stranded costs) and $697 million of ECOM true-up. The
stranded costs are comprised of $1.0 billion of previously recorded accelerated
depreciation and $841 million of previously redirected depreciation. These
stranded costs are recoverable under the provisions of the Texas electric
restructuring law. The ultimate amount of stranded cost recovery is subject to a
final determination, which will occur in 2004 and is contingent upon the market
value of Texas Genco. Any significant changes in our accounting estimate of
stranded costs as a result of current market conditions or changes in the
regulatory recovery mechanism currently in place could result in a material
write-down of all or a portion of these regulatory assets. Regulatory assets
related to ECOM true-up represent the regulatory assets associated with costs
incurred as a result of mandated capacity auctions conducted beginning in 2002
by Texas Genco being consummated at market-based prices that have been
substantially below the estimate of those prices made by the Texas Utility
Commission in the spring of 2001. Any significant changes in our estimate of our
regulatory asset associated with ECOM true-up could have a significant effect on
our financial condition and results of operations. Additionally, any significant
changes in our estimated stranded costs or ECOM true-up recovery could
significantly affect our liquidity
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subsequent to the final true-up proceedings conducted by the Texas Utility
Commission which are expected to conclude in late 2004.
IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived assets recorded in our Consolidated Balance Sheets primarily
consist of property, plant and equipment (PP&E). Net PP&E comprises $3.8 billion
or 42% of our total assets as of December 31, 2002. We make judgments and
estimates in conjunction with the carrying value of these assets, including
amounts to be capitalized, depreciation and amortization methods and useful
lives. We evaluate our PP&E for impairment whenever indicators of impairment
exist. During 2002, no such indicators of impairment existed. Accounting
standards require that if the sum of the undiscounted expected future cash flows
from a company's asset is less than the carrying value of the asset, an asset
impairment must be recognized in the financial statements. The amount of
impairment recognized is calculated by subtracting the fair value of the asset
from the carrying value of the asset.
UNBILLED REVENUES
Revenues related to the sale and/or delivery of electricity are generally
recorded when electricity is delivered to customers. However, the determination
of deliveries to individual customers is based on the reading of their meters,
which is performed on a systematic basis throughout the month. At the end of
each month, amounts of electricity delivered to customers since the date of the
last meter reading are estimated and the corresponding unbilled revenue is
estimated. Unbilled electric delivery revenue is estimated each month based on
daily supply volumes, applicable rates and analyses reflecting significant
historical trends and experience. Accrued unbilled revenues recorded in the
Consolidated Balance Sheets as of December 31, 2001 and 2002 were $33 million
and $70 million, respectively.
NEW ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 143, "Accounting for Asset Retirement Obligations" (SFAS No. 143). SFAS No.
143 requires the fair value of an asset retirement obligation to be recognized
as a liability is incurred and capitalized as part of the cost of the related
tangible long-lived assets. Over time, the liability is accreted to its present
value each period, and the capitalized cost is depreciated over the useful life
of the related asset. Retirement obligations associated with long-lived assets
included within the scope of SFAS No. 143 are those for which a legal obligation
exists under enacted laws, statutes and written or oral contracts, including
obligations arising under the doctrine of promissory estoppel. SFAS No. 143 is
effective for fiscal years beginning after June 15, 2002, with earlier
application encouraged. SFAS No. 143 requires entities to record a cumulative
effect of change in accounting principle in the income statement in the period
of adoption. We adopted SFAS No. 143 on January 1, 2003. We have not identified
any asset retirement obligations in connection with the adoption of SFAS No.
143.
We have previously recognized removal costs as a component of depreciation
expense in accordance with regulatory treatment. As of December 31, 2002, these
previously recognized removal costs of $240 million do not represent SFAS No.
143 asset retirement obligations, but rather embedded regulatory liabilities.
In August 2001, the FASB issued SFAS No. 144. SFAS No. 144 provides new
guidance on the recognition of impairment losses on long-lived assets to be held
and used or to be disposed of and also broadens the definition of what
constitutes a discontinued operation and how the results of a discontinued
operation are to be measured and presented. SFAS No. 144 supercedes SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" and Accounting Principles Board Opinion No. 30,
"Reporting the Results of Operations -- Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions," while retaining many of the requirements of these two
statements. Under SFAS No. 144, assets held for sale that are a component of an
entity will be included in discontinued operations if the operations and cash
flows will be or have been eliminated from the ongoing operations of the entity
and the entity will not have any significant continuing involvement in the
operations prospectively. SFAS No. 144 was effective for fiscal years beginning
after December 15, 2001, with early adoption encouraged. SFAS No. 144 did not
materially change the methods we use to measure impairment losses on long-lived
assets, but may result in more future
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dispositions being reported as discontinued operations than would previously
have been permitted. We adopted SFAS No. 144 on January 1, 2002.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections" (SFAS No. 145). SFAS No. 145 eliminates the current requirement
that gains and losses on debt extinguishment must be classified as extraordinary
items in the income statement. Instead, such gains and losses will be classified
as extraordinary items only if they are deemed to be unusual and infrequent.
SFAS No. 145 also requires that capital leases that are modified so that the
resulting lease agreement is classified as an operating lease be accounted for
as a sale-leaseback transaction. The changes related to debt extinguishment are
effective for fiscal years beginning after May 15, 2002, and the changes related
to lease accounting are effective for transactions occurring after May 15, 2002.
We have applied this guidance prospectively as it relates to lease accounting
and will apply the accounting provisions to debt extinguishments to 2003. During
2002, we recorded a $25 million loss on the early extinguishment of debt related
to our $850 million term loan.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" (SFAS No. 146). SFAS No. 146
nullifies Emerging Issues Task Force (EITF) No. 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)" (EITF No. 94-3). The
principal difference between SFAS No. 146 and EITF No. 94-3 relates to the
requirements for recognition of a liability for costs associated with an exit or
disposal activity. SFAS No. 146 requires that a liability be recognized for a
cost associated with an exit or disposal activity when it is incurred. A
liability is incurred when a transaction or event occurs that leaves an entity
little or no discretion to avoid the future transfer or use of assets to settle
the liability. Under EITF No. 94-3, a liability for an exit cost was recognized
at the date of an entity's commitment to an exit plan. In addition, SFAS No. 146
also requires that a liability for a cost associated with an exit or disposal
activity be recognized at its fair value when it is incurred. SFAS No. 146 is
effective for exit or disposal activities that are initiated after December 31,
2002 with early application encouraged. We will apply the provisions of SFAS No.
146 to all exit or disposal activities initiated after December 31, 2002.
In November 2002, the FASB issued FASB Interpretation No. (FIN) 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others" (FIN 45). FIN 45 requires that a
liability be recorded in the guarantor's balance sheet upon issuance of a
guarantee. In addition, FIN 45 requires disclosures about the guarantees that an
entity has issued. The provision for initial recognition and measurement of the
liability will be applied on a prospective basis to guarantees issued or
modified after December 31, 2002. The disclosure provisions of FIN 45 are
effective for financial statements of interim or annual periods ending after
December 15, 2002. The adoption of FIN 45 is not expected to materially affect
our consolidated financial statements. We have adopted the additional disclosure
provisions of FIN 45 in our consolidated financial statements as of December 31,
2002.
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