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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
-------------------------
FORM 10-Q
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter Ended June 30, 1998
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from _____to_____
Commission Registrant, State of Incorporation, I.R.S. Employer
File Number Address and Telephone Number Identification No.
----------- ---------------------------------- ------------------
333-09033 Southern Investments UK plc None
(Registered in England & Wales)
800 Park Avenue
Aztec West
Almondsbury
Bristol
BS32 4SE, UK
(01144) 1454 201101
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No __
Description of Shares Outstanding
Registrant Common Stock at July 31, 1998
- --------- -------------- -------------------
Southern Investments UK plc Par Value(pound)1 Per Share 500,400,587
1
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
This Quarterly Report Form 10-Q of Southern Investments UK plc (the
"Company") contains forward-looking statements in addition to historical
information. The Company cautions that there are various important factors that
could cause actual results to differ materially from those indicated in the
forward-looking statements; accordingly, there can be no assurance that such
indicated results will be realized. These factors include legislative and
regulatory issues (such as the results of the current review of regulation, and
the results of the supply and distribution price reviews scheduled to take
effect April 1, 2000, see Management's Discussion and Analysis "Future Earnings
Potential"); the extent and timing of the entry of additional competition in the
supply market; potential business strategies, including acquisitions or
dispositions of assets or internal restructuring that may be pursued by the
Company or South Western Electricity plc ("SWEB"); changes in or application of
environmental and other laws and regulations to which the Company and SWEB are
subject; political, legal and economic conditions and developments in which the
Company and SWEB operate; financial market conditions and the results of
financing efforts; changes in commodity prices and interest rates; weather and
other natural phenomena; the performance of projects undertaken by the Company
or SWEB and the success of efforts to invest in and develop new opportunities;
and other factors discussed in the reports, filed from time to time by the
Company with the Securities and Exchange Commission ("SEC").
2
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(In Millions)
For the Three Months Ended June 30,
-----------------------------------
1998 1997
---- ----
(Note G)
OPERATING REVENUES (pound) 181 $ 302 (pound) 172
COST OF SALES 114 190 111
------ ----- ------
GROSS MARGIN 67 112 61
------ ----- ------
OPERATING EXPENSES:
Maintenance 8 13 8
Depreciation and amortization 12 20 11
Selling, general, and administrative 16 27 15
------ ----- ------
Total operating expenses 36 60 34
------ ----- ------
Operating income 31 52 27
------ ----- ------
OTHER INCOME (EXPENSE):
Interest expense (15) (25) (13)
Other, net 8 13 5
------ ----- ------
Total other income (expense) (7) (12) (8)
------ ----- ------
INCOME BEFORE INCOME TAXES 24 40 19
INCOME TAXES (8) (13) (5)
------ ----- ------
NET INCOME (pound) 16 $ 27 (pound) 14
====== ===== ======
The accompanying notes form an integral part of these condensed consolidated statements.
3
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In Millions)
For the Three Months Ended June 30,
----------------------------------
1998 1997
---- ----
(Note G)
NET CASH PROVIDED BY OPERATING
ACTIVITIES (pound) 47 $ 78 (pound) 51
------ ----- ------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures (15) (25) (17)
Other 8 13 (1)
------ ----- ------
Net cash used in investing activities (7) (12) (18)
------ ----- ------
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments of dividends (20) (33) (25)
Change in short-term borrowings (23) (38) (9)
------ ----- ------
Net cash used in financing activities (43) (71) (34)
------ ----- ------
NET DECREASE IN CASH AND CASH
EQUIVALENTS (3) (5) (1)
CASH AND CASH EQUIVALENTS, beginning of
period 5 8 3
------ ----- ------
CASH AND CASH EQUIVALENTS, end of period (pound) 2 $ 3 (pound) 2
====== ===== ======
SUPPLEMENTAL CASH FLOW DISCLOSURES:
Cash paid for interest (pound) (10) $ (17) (pound) (10)
====== ===== ======
Cash paid for income taxes (pound) - $ - (pound) -
====== ===== ======
The accompanying notes form an integral part of these condensed consolidated statements.
4
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In Millions)
ASSETS
June 30, 1998 March 31,
------------- ---------
(Unaudited) 1998
---------- ----
(Note G)
PROPERTY, PLANT, AND EQUIPMENT (pound) 1,395 $2,330 (pound) 1,389
Less accumulated depreciation 116 194 109
------ ------ ------
Property, plant, and equipment, net 1,279 2,136 1,280
------ ------ ------
OTHER ASSETS:
Investments 17 28 17
Prepaid pension cost 119 199 116
Goodwill, net of accumulated amortization of (pound)12 ($20) at
June 30 and(pound)11 at March 31 171 286 172
------ ------ ------
Total other assets 307 513 305
------ ------ ------
CURRENT ASSETS:
Cash and cash equivalents 2 3 5
Investments 19 32 17
Receivables:
Customer accounts, less provision for uncollectables of (pound)9 ($15) at
June 30 and(pound)9 at March 31 75 125 85
Other 11 18 14
------ ------ ------
Receivables, net 86 143 99
Materials and supplies 4 7 4
Prepaid expenses 22 37 18
------ ------ ------
Total current assets 133 222 143
------ ------ ------
TOTAL ASSETS (pound) 1,719 $2,871 (pound) 1,728
====== ====== ======
The accompanying notes are an integral part of these condensed consolidated balance sheets.
5
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In Millions)
STOCKHOLDER'S EQUITY AND LIABILITIES
June 30, 1998 March 31,
------------- ---------
(Unaudited) 1998
----------- ----
(Note G)
STOCKHOLDER'S EQUITY:
Common stock, (pound)1 par value, 500,400,587 shares authorized, issued
and outstanding (pound) 500 $ 835 (pound) 500
Retained earnings (deficit) (Note B) (167) (279) (163)
------ ------ ------
Total stockholder's equity 333 556 337
------ ------ ------
COMPANY OBLIGATED MANDATORILY REDEEMABLE
PREFERRED SECURITIES OF SOUTHERN INVESTMENTS
UK CAPITAL TRUST I HOLDING COMPANY JUNIOR
SUBORDINATED DEBENTURES 50 84 50
NON-CURRENT LIABILITIES:
Long-term debt 301 503 301
Deferred income taxes 363 606 361
Provision for loss contracts (Note D) 71 119 72
Other 44 73 46
------ ------ ------
Total non-current liabilities 779 1,301 780
------ ------ ------
CURRENT LIABILITIES:
Commercial paper 80 134 80
Short-term borrowings 260 434 283
Accounts payable 38 63 50
Accrued income taxes 88 147 82
Unearned revenue 4 7 4
Accrued interest 11 18 8
Other 76 127 54
------ ------ ------
Total current liabilities 557 930 561
------ ------ ------
TOTAL STOCKHOLDER'S EQUITY AND LIABILITIES (pound) 1,719 $ 2,871 (pound) 1,728
====== ======= ======
The accompanying notes are an integral part of these condensed consolidated balance sheets.
6
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 1998
(Unaudited)
(A) The condensed consolidated financial statements included herein have been
prepared pursuant to the rules and regulations of the SEC and in conformity
with accounting principles generally accepted in the United States. In the
opinion of the Company's management, the information furnished herein
reflects all adjustments (which included only normal recurring adjustments)
necessary to present fairly the results of the three-month periods ended
June 30, 1998 and 1997. The Company's fiscal year end is March 31. Certain
information and footnote disclosures normally included in consolidated
financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to such rules
and regulations, although the Company believes that the disclosures are
adequate to make the information presented not misleading.
The condensed consolidated balance sheet as at March 31, 1998 included
herein has been extracted from audited consolidated financial statements;
all other figures are unaudited. The condensed consolidated financial
statements included herein have been reviewed by the Company's independent
public accountants and their report is included herein as Exhibit 15.
There were no items for inclusion in a consolidated statement of
comprehensive income other than net income as shown on the condensed
consolidated statements of income. Consequently, a consolidated statement
of comprehensive income has not been included.
(B) The Company's sole investment and only significant asset is the entire
share capital of SWEB, which is headquartered in Bristol, England. The
Company shows a retained earnings deficit primarily due to dividends in the
amount of (pound)191 million being declared and paid by the Company during
the fiscal year 1996 as proceeds from the sale of SWEB's shares in The
National Grid Group plc provided cash in addition to that provided from
operations. In addition, the first budget of the Labour government included
a "one-off windfall levy on the excess profits of the privatized
utilities". SWEB estimated its liability to be approximately (pound)90
million. The budget also reduced the UK corporation tax rate from 33% to
31%. This decrease resulted in an accounting credit reducing SWEB's
provision for deferred income taxes by approximately (pound)22 million.
Both items impacted earnings in the fiscal year 1998.
(C) Effective March 31, 1998, the Company adopted Financial Accounting
Standards Board ("FASB") Statement No. 131, "Disclosure About Segments of
an Enterprise and Related Information". The Company is primarily engaged
in two electric industry segments: distribution, which involves the
transmission of electricity across its network and its transfer and
delivery to its customers; and supply, which involves bulk purchase of
electricity from the Pool and arranging for its sale and transfer to its
customers. All revenues are in respect of sales to customers in the UK.
Information about the Company's operations in these individual segments,
which also reflect its products and services, is detailed below:
Fiscal Quarter Distribution Supply Other Eliminations Consolidated
-------------- ------------ ------ ----- ------------ ------------
(in millions)
Three months ended June 30, 1998
--------------------------------
Operating revenues (pound) 55 (pound) 167 (pound) 15 (pound) (56) (pound) 181
Operating income 23 1 7 - 31
Total assets at June 30, 1998 1,539 94 86 - 1,719
Three months ended June 30, 1997
--------------------------------
Operating revenues (pound) 52 (pound) 156 (pound) 15 (pound) (51) (pound) 172
Operating income 21 6 - - 27
Total assets at June 30, 1997 1,478 97 111 - 1,686
7
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Included in "Other" above are ancillary business activities of SWEB that
generally support its main electricity distribution and supply businesses
and assets not allocated to specific segments. Interest expense and taxes
are wholly allocated to "Other" and are disclosed in the condensed
consolidated statements of income. The eliminations above primarily
relate to internal sales from the distribution business to the supply
business for the use of the network. Such sales are priced at rates
applicable to SWEB and other suppliers operating in SWEB's Authorized
Area.
(D) SWEB has entered into a contract relating to the purchase of 200 megawatts
of capacity from a 7.69% owned related party, Teesside Power Limited
("Teesside"), for a period of 15 years beginning April 1, 1993. The
contract sets escalating electricity purchase prices at predetermined
levels. The Company has recognized an accrual at the acquisition date for
the excess of these Teesside power purchase costs in each year over an
estimate of the equivalent Pool costs in that respective year. These costs
have been discounted at an appropriate rate to their present value
of (pound)71 million at June 30, 1998 and (pound)72 million at March 31,
1998. Over the past two years, the Pool prices have been less than
anticipated when the accrual was recognized. The Company is continuing to
review the trend of Pool prices and an adjustment to the provision may be
required in the future.
(E) The Company and SWEB have non-trading operations that are exposed to
certain market risks including changes in interest rates, cross currency
exchange rates and the volatility of prices of electricity purchased in
the Pool. To mitigate risk attributable to these exposures the Company
has entered into various derivative financial instruments, the sole
purpose of which is to hedge exposure in these areas. At June 30, 1998,
the status of outstanding derivative contracts was as follows:
(i) The Company and SWEB utilize interest rate swaps to minimize
borrowing costs and mitigate their exposure to fluctuations in interest
rates by allowing them to effectively convert their outstanding variable
rate debt into fixed rate debt. These swaps are designed as hedges of
underlying debt obligations and, as such, the interest rate differential
is reflected as an adjustment to interest expense over the life of the
swaps. At June 30, 1998, sterling interest rate swaps expiring between
2001 and 2012, with notional amounts totalling (pound)600 million,
resulted in an unrealized loss of (pound)33 million.
(ii) Foreign currency swap contracts are used by the Company and SWEB to
hedge exposure to currency fluctuations for US dollar denominated debt.
Gains and losses on these hedges are deferred and recognized as an
adjustment to the carrying amount when the hedged transaction occurs. At
June 30, 1998, currency swaps expiring between 2001 and 2007, with
notional amounts totalling (pound)350 million, resulted in an unrealized
profit of (pound)8 million.
(iii) SWEB utilizes contracts for differences ("CFDs") to mitigate its
exposure to volatility in the prices of electricity purchased through the
Pool. Such contracts allow the Company to effectively convert the
majority of its anticipated Pool purchases from market prices to fixed
prices. SWEB's goal is to obtain competitively priced contracts to cover
the majority of its purchase requirements. The gains and losses on such
contracts are deferred and recognized as electricity is purchased.
Management believes that the fair value of these contracts at present is
not materially different than the fair value determined at acquisition.
SWEB also has commitments to purchase capacity under its long term
contracts (see Note D above).
8
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(iv) The Company is exposed to losses in the event of nonperformance by
counterparties to its financial instrument contracts. To mitigate this
credit risk, the Company selects counterparties based on their credit
ratings, limits its exposure to any one counterparty under defined
guidelines, and monitors the market position of the programs and its
relative market position with each counterparty. The Company is unaware
of any counterparty which will fail to meet its obligations.
(F) The Company and SWEB are routinely party to legal proceedings arising in
the ordinary course of business which are not material, either
individually or in aggregate. Neither the Company nor SWEB is a party to
any material legal proceedings nor are they currently aware of any
threatened material legal proceedings. As described below, the Company is
aware of an issue which could subsequently impact SWEB.
The Pensions Ombudsman (a UK statutorily appointed independent
arbitrator) has issued a determination in favor of complaints made by
members of the Electricity Supply Pension Scheme ("ESPS") relating to
another employer's use of ESPS surplus to offset the employer's costs of
providing early pensions on redundancies and certain other items. Under
that determination the Pensions Ombudsman directed the employer to pay
into ESPS the amount of that use of the surplus plus interest. The
determination was challenged in the High Court by the employer, and the
High Court upheld the employer's appeal in a judgment delivered on June
10, 1997. The High Court also granted the complainants leave to appeal to
the Court of Appeal. It is understood that the Court of Appeal hearing
has been scheduled to begin on 26 October 1998. If the complainants'
appeal is successful, either at the Court of Appeal or on a subsequent
appeal to the House of Lords, it will have an adverse effect on SWEB.
Unless the High Court decision is reversed, this case should not impact
SWEB significantly; however it is not practical to make an estimate of
the exposure at the present time.
(G) Solely for the convenience of the reader, certain pounds sterling amounts
included in the condensed consolidated financial statements have been
translated into US dollars at the exchange rate of $1.6695 = (pound)1.00,
the noon buying rate in New York City for cable transfers in pounds
sterling as certified for customs purposes by the Federal Reserve Bank of
New York on June 30, 1998.
(H) The condensed consolidated financial statements included herein have not
been prepared in accordance with the policies of Statement of Financial
Accounting Standards No. 71 "Accounting for the Effects of Certain Types of
Regulation" ("SFAS No. 71"). This pronouncement, under which most US
electric utilities report financial statements, applies to entities which
are subject to cost-based rate regulation. By contrast, SWEB is not subject
to rate regulation, but, rather, is subject to price cap regulation and
therefore the provisions of SFAS No. 71 do not apply. Financial statements
presented in accordance with SFAS No. 71 often contain certain deferred
items which have not been included in rates charged to customers in
compliance with the respective regulatory authority rulings, but which
would have been included in the income statement of enterprises in general
under US GAAP. The accompanying consolidated financial statements of the
Company do not contain such deferrals.
9
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
FIRST FISCAL QUARTER 1999 vs. FIRST FISCAL QUARTER 1998
INTRODUCTION
The Company is a wholly-owned subsidiary of SWEB Holdings Limited
("Holdings"). Holdings is a wholly-owned subsidiary of SWEB Holdings UK
("Holdings UK"), which is owned indirectly by Southern Company ("Southern") and
PP&L Resources, Inc. ("PP&L").
On June 18, 1998, Southern sold an additional 26 percent interest in
Holdings to PP&L. PP&L initially purchased a 25 percent stake in Holdings in
July 1996. This further sale increased PP&L's economic interest in Holdings to
51 percent. Subsequently on June 18, 1998, shares in Holdings held by Southern
and PP&L were exchanged for equivalent shares in Holdings UK. Under the terms of
the agreement, Southern retains operational and management control of SWEB and
the Holdings UK group. Southern continues to hold a majority of the voting
shares in Holdings UK and retains a majority of the Board of Directors. In
addition, all members of SWEB's senior management team remain in place.
The Company was incorporated as a public limited company under the laws of
England and Wales on June 23, 1995, as a vehicle for the acquisition of SWEB,
one of the 12 regional electricity companies ("RECs") in England and Wales
licensed to distribute, supply and, to a limited extent, generate electricity.
In September 1995, the Company gained effective control of SWEB. The Company's
sole investment and only significant asset is the entire share capital of SWEB,
which is headquartered in Bristol, England.
SWEB's two main business lines are the distribution of electricity and the
supply of electricity to approximately 1.3 million customers in its Authorized
Area in southwest England. This area covers approximately 5,560 square miles and
has a resident population of approximately 2.8 million.
RESULTS OF OPERATIONS
Earnings
Operating income for the first quarter fiscal year 1999 was (pound)31
million compared to (pound)27 million for the corresponding quarter fiscal year
1998. The increase in operating income of (pound)4 million is due to an increase
in the distribution business of (pound)2 million and an increase in ancillary
businesses of (pound)7 million offset by a decrease in the supply business of
(pound)5 million.
Significant income statement items appropriate for discussion include the
following:
Increase
---------------------------
(in millions) %
Operating revenues...................... (pound) 9 5
Cost of sales........................... 3 3
Interest expense........................ 2 15
Other income, net....................... 3 60
Income taxes............................ 3 60
10
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
Operating revenues
Revenue increases were primarily within the supply business where revenues
increased by (pound)11 million for the quarter. The number of electricity units
supplied in the first quarter fiscal year 1999 increased by 16%, which mainly
arose from an increase in units supplied to customers within the competitive
supply market. Revenues also increased within the distribution business by
(pound)3 million. Revenues from ancillary businesses, after intra-business
eliminations, decreased by (pound)5 million in the quarter, primarily reflecting
the lower activity in the gas retailing business due to restructuring of that
business, including a teaming arrangement with another organization.
Cost of sales
The increase in the cost of sales primarily relates to energy purchases
due to the increase in units supplied as explained above. This increase in
energy purchases is partly offset by reduced costs in the gas retailing
business.
Interest expense
The increase in interest expense is primarily due to an increase of over
1% in short-term interest rates over the period. The increase in short-term
borrowings, due to the payment of the first instalment of the windfall levy, has
also contributed to the increase in interest expense.
Other income, net
The increase is primarily due to the gain on the disposition of certain
assets in the first quarter fiscal year 1999.
Income taxes
The increase in income taxes is principally due to less permanent
differences between book and taxable income relating to non-taxable investment
income.
Future Earnings Potential
The results of operations discussed above are not necessarily indicative
of future earnings potential. The level of future earnings depends on numerous
factors including the success of the implementation of reorganization plans,
future regulatory price reviews and the level of energy sales and customer
growth/retention in the electricity business. A major impact on future earnings
will be the interest charges from funding requirements to meet the second
instalment of the windfall levy. An item that could also result in additional
funding requirements relates to the outcome of a court ruling related to a
pension matter. See Notes (B) and (F), respectively in the notes to the
condensed consolidated financial statements.
11
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
There are currently a number of issues which impact the electricity
industry and which are the subject of discussion and consultation papers. The
principal ones are:
(i) In March 1998 the government published a discussion paper ("Green Paper") on
the regulation of the water, electricity, gas and telecommunications utilities
within the UK entitled "A Fair Deal for Consumers: Modernizing the Framework for
Utility Regulation". The government's stated objective for the review is to set
a long term stable framework for utilities which is seen to be fair by all the
interested groups involved. The guiding principles are that regulation must be
transparent, consistent and predictable. The closing date for responses was May
31, 1998. On July 27, 1998 the government announced their conclusions on reform
of utility regulation. Key decisions include merging the electricity and gas
regulators, the retention of RPI - X, social and environmental actions to be
issued by Ministers, and greater transparency. These proposals will be the
subject of new legislation as soon as Parliamentary time permits.
(ii) In May 1998, the Director General of Electricity Supply (the "Regulator")
issued a consultation paper concerning the separation of businesses in the
context of the reviews of the price controls post 2000. It is the Regulator's
view that full separation of supply and distribution would be desirable.
However, they recognize that it is likely that interim arrangements will be
necessary.
(iii) In October 1997, the government's Minister for Science, Energy and
Industry asked the Regulator to consider how a review of electricity trading
arrangements (including the operation of the Pool) might be undertaken, together
with changes in legislation. On March 24, 1998, the Minister agreed to the
Regulator's recommended terms of reference on development of new trading
arrangements. On July 29, 1998 the Regulator published his proposals. The
proposals are for a market-based trading arrangement using forward contracts for
the physical delivery of electricity. A short-time bilateral market is proposed
to enable "fine tuning" of contract positions. The System Operator (National
Grid Company) will be responsible for balancing generation and demand from about
four hours before each half-hour trading period. Suppliers and generators will
be charged an imbalance fee for differences between their contractual and
physical positions by the System Operator. The Regulator also proposes to take a
higher degree of control over the new trading arrangements, than in the present
arrangements.
As these papers are only consultative at this time, it is not possible
for the Company to determine the impact until after such issues have been
finalized by the government, and firm proposals are made by the Regulator. The
additional costs could be significant if full separation was ultimately
required.
The largest portion of SWEB's operating income, approximately 74% in the
first quarter fiscal year 1999, is derived from its distribution business -
essentially the operation and maintenance of the electricity network in its
Authorized Area in the southwest of England. SWEB is the only distributor of
electricity in this area, and management believes that economic, environmental
and regulatory factors are likely to prevent competitors from entering this
business in SWEB's Authorized Area.
Distribution revenues are subject to price cap regulation. The Regulator
applies a price control formula ("DPCF"), P + RPI - X, where P is the price
level at the beginning of each new regulatory period, RPI is the change in the
Retail Price Index and X is an adjustment factor determined by the Regulator. X
is currently 3% for SWEB.
12
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
The DPCF is usually set for a five-year period, subject to more frequent
adjustments as determined necessary by the Regulator. At each review, the
Regulator can require a one-time price adjustment. An initial review by the
Regulator of allowable income in the distribution business led to a reduction of
the price level by 14% for SWEB starting April 1, 1995, followed by efficiency
factors of X = 2% for each year until March 2000. In July 1995, the Regulator
announced the result of a further distribution price review which was
precipitated by certain market events in the UK electric utility industry. For
SWEB, such announcement meant a real reduction of 11% in allowable distribution
income for the twelve months from April 1, 1996, followed by an efficiency
factor of X = 3% for each year, before an allowed increase for inflation. The
Regulator is currently undertaking the next DPCF review expected to become
effective from April 1, 2000.
Within the supply business, customers fall into two categories,
Unregulated and Regulated. Until March 31, 1998, Unregulated Supply Customers
were defined as customers who had an electricity demand of more than 100kW. From
April 1, 1998, Unregulated Supply Customers are defined as customers who are
non-domestic and who have an annual consumption in excess of 12,000kWh.
Unregulated Supply Customers may contract for their electricity from any holder
of a supply license, however, Supply Customers with demand less than 100kW must
continue to take supply from their host REC until competition is allowed (see
below).
Regulated Supply Customers are those customers who are not Unregulated
Supply Customers and largely comprise domestic and small business customers.
Prices charged to Regulated Supply Customers by a REC within its Authorized Area
are controlled by regulation. Until March 31, 1998, the calculation of the
maximum supply charge was based on a supply price control formula ("SPCF"),
similar to the DPCF, plus an ability to pass through certain costs, principally
the costs of energy purchases, transmission and distribution use of system
charges. For the four-year period ending March 31, 1998, an efficiency factor of
X = 2% (before an allowed increase for inflation) was applied to SWEB, offset by
an allowance for both unit and customer growth. From April 1, 1998 supply
business charges to Regulated Supply Customers are subject to a price cap
instead of being based on the SPCF; the concept of pass through costs no longer
applies.
Following the announcement by the Regulator on October 16, 1997, in
respect of its latest supply price review for Regulated Supply Customers
effective from April 1, 1998, SWEB has implemented a tariff reduction of 2.8%
effective from that date. A further 3% reduction (before an allowed increase for
inflation) is planned to be implemented for fiscal year 2000. This average
tariff reduction primarily reflects the expected reduction in power purchase
costs after March 31, 1998 when expensive CFDs, (Note E), agreed by the
government at the time of privatization of the electricity industry, will end,
and the fossil fuel levy will be further reduced.
The exclusive right to supply Regulated Supply Customers (as defined prior
to April 1, 1998) was scheduled to be phased out over a six-month period
commencing April 1, 1998, after which all supply customers would have the
ability to choose their electricity supplier. An announcement by the Regulator
on October 16, 1997 stated that the exclusive right to supply Regulated Supply
Customers should be phased out from September 1998. Each REC has an authorized
start date for competition to commence in its Authorized Area, and SWEB's is
towards the end of calendar year 1998. Once a REC's Authorized Area is open to
competition, then it can compete in the Authorized Area of other RECs where
competition has commenced, and vice versa.
The Regulator has also proposed a penalty on all RECs, including SWEB,
related to the delay in opening competition to Regulated Supply Customers beyond
the April 1, 1998 deadline; any penalty imposed on SWEB is not expected to have
a material impact on earnings. The supply tariffs in fiscal years 1999 and 2000
represent maximum price restraints intended to protect each REC's Regulated
Supply Customers, which it supplies within its Authorized Area.
13
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
SWEB's distribution business does not involve the purchase and sale of
electricity, and therefore SWEB's risk management efforts are focused on the
supply business which is exposed to Pool price volatility. SWEB uses CFDs to
hedge against Pool price volatility. CFDs are contracts predominantly between
generators and suppliers which fix the price of electricity for a contracted
quantity of electricity over a specific time period. Differences between the
actual price set by the Pool and the agreed prices give rise to difference
payments between the parties to the particular CFD. At the present time, SWEB's
forecast total demand for fiscal year 1999 is substantially hedged through
various types of agreements including CFDs.
The most common contracts for supply to Unregulated Supply Customers are
for a twelve-month term and contain fixed rates. SWEB is exposed to two
principal risks associated with such contracts: load shape risk (the risk
associated with a shift in the customer's usage pattern, including absolute
amounts demanded and timing of amounts demanded); and, purchasing price risk
(the cost of purchased electricity relative to the price received from the
supply customer). SWEB employs risk management methods to maximize its return
consistent with an acceptable level of risk. SWEB manages load shape risk by
setting individual customer sales prices based on their expected load shape and
including an additional premium to cover the risk of load shape variation.
Variable volume CFDs are also used when available at a competitive price. SWEB
hedges purchasing price risk by employing a variety of risk management tools,
including management of its supply contract portfolio, hedging contracts and
other means which mitigate risk of future Pool price volatility.
SWEB's ability to manage its purchasing price risk depends, in part, on
the future availability of properly priced risk management mechanisms such as
CFDs. SWEB intends to purchase cover at competitive prices and constantly
evaluates market conditions. No assurance can be given that an adequate,
transparent market for such products will in fact be available and thus that
contracts will be available at competitive prices.
SWEB constantly evaluates whether owning its own source of generation or
contracting for such source or sources is the most appropriate method for
managing purchase price risk, but no assurance can be given that such methods
would be available to, or economically appropriate for, SWEB.
The UK government's Finance Bill 1998, which received Royal Assent on July
31, 1998, included a reduction in the rate of UK corporation tax from 31% to 30%
effective April 1, 1999. This decrease will result in an accounting credit
reducing SWEB's provision for deferred income taxes by approximately (pound)11
million. This credit will be accounted for in the second quarter fiscal year
1999.
In June 1998, the FASB issued Statement No. 133, "Accounting for
Derivative Instruments and Hedging Activities", which establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. This
statement is effective for fiscal years beginning after June 15, 1999. While the
Company has not yet quantified the impact of adopting this statement on its
financial statements, it could increase volatility in earnings and other
comprehensive income.
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SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
FINANCIAL CONDITION
Overview
The major change in the Company's financial condition during the
three-months to June 30, 1998 was the expenditure by SWEB of approximately
(pound)15 million in property, plant, and equipment, largely in respect of the
distribution network. The funds required for such additions were derived
primarily from operations. It is expected that SWEB's capital requirements in
the foreseeable future for its investment in property, plant, and equipment will
be generated from operating activities.
The significant requirement of the second instalment of the windfall levy
and possible requirements of a pension matter, both discussed above, will
require external financing, and result in increased interest expense. The first
instalment of the windfall levy was funded by short-term borrowings.
Demand for electricity in Great Britain, in general, and in SWEB's
Authorized Area, in particular, is seasonal, with demand being higher in the
winter months and lower in the summer months. SWEB balances the effect of this
and other cyclical influences on its working capital needs with drawings under
its available credit facilities.
The Company's sole investment and only significant asset is the entire
share capital of SWEB. The Company is therefore dependent upon dividends from
SWEB for its cash flow. SWEB can make distribution of dividends to the Company
under English law to the extent that it has distributable reserves, subject to
the retention of sufficient financial resources to conduct its supply and
distribution businesses as required by its regulatory license. The Company
believes that currently sufficient distributable reserves will continue to exist
at SWEB to allow for reasonable and necessary dividends from SWEB, through
operations, to be distributed to the Company. In the UK, the Accounting
Standards Board is currently reviewing the treatment of deferred income tax
accounting. If full provision for deferred income tax were required, SWEB's
distributable reserves could be eliminated.
Financing Activities
The Company has a US commercial paper program under which the maximum
available is $520 million. This program is supported by a swingline and
revolving credit facility provided by a syndicate of banks. The amount available
under the program, which is supported by the swingline and revolving credit
facility, at June 30, 1998 was $167 million. SWEB enters into foreign currency
contracts to hedge the currency risk associated with the interest and principal
of each utilization under this program.
SWEB actively manages its short-term debt, which includes a number of bank
lines of credit in addition to the commercial paper program. At June 30, 1998
the Company and SWEB together had short-term debt of (pound)340 million ($568
million) outstanding ($134 million from commercial paper, $219 million from
swingline and revolving credit facility, and $215 million in other short-term
loans).
15
SOUTHERN INVESTMENTS UK plc and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
To meet short-term cash needs and contingencies, the Company and SWEB
together had at June 30, 1998 approximately (pound)2 million of cash and
(pound)110 million of unutilized committed lines of credit with banks. Also
available was $167 million of the swingline and revolving credit facility
mentioned above. The Company and SWEB have sufficient liquidity to meet the
second instalment of the windfall levy, as previously mentioned.
At June 30, 1998, the Company and SWEB have sterling interest rate swaps
expiring between 2001 and 2012, with notional amounts totalling (pound)600
million, and have cross currency swaps expiring between 2001 and 2007, with
notional amounts totalling (pound)350 million.
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PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits.
15 - Report of Independent Public Accountants
27 - Financial Data Schedule
(b) Reports on Form 8-K.
No report on Form 8-K was filed by the Company during the quarter for which
this report is being filed.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SOUTHERN INVESTMENTS UK plc
/s/ Gale E. Klappa
By Gale E. Klappa
Director
/s/ C.B. (Mike) Harreld
By C. B. (Mike) Harreld
Director, Chief Financial and Accounting Officer
Date: August 12, 1998
18