UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
Form 10-Q
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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 file number 1-14161
MARKETSPAN CORPORATION
(Exact name of Registrant as specified in its charter)
New York 11-3431358
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
175 East Old Country Road, Hicksville, New York 11801
One MetroTech Center, Brooklyn, New York 11201
(Address of principal executive offices) (Zip Code)
(516) 755-6650 (Hicksville)
(718) 403-1000 (Brooklyn)
(Registrant's telephone number, including area code)
NONE
(Former name, former address and former fiscal year, if changed
since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class of Common Stock Outstanding at November 9, 1998
$.01 par value 146,693,554
MARKETSPAN CORPORATION AND SUBSIDIARIES
INDEX
Part I. FINANCIAL INFORMATION Page No.
Condensed Consolidated Balance Sheet -
September 30, 1998 and March 31, 1998 3
Condensed Consolidated Statement of Income -
Three and Six Months Ended September 30,
1998 and 1997 5
Condensed Consolidated Statement of Cash Flows -
Six Months Ended September 30,1998 and 1997 6
Notes to Condensed Consolidated Financial
Statements 7
Management's Discussion and Analysis of Results
of Operations and Financial Condition 14
Risk Management 30
Part II. OTHER INFORMATION
Item 1 - Legal Proceedings 33
Item 5 - Other Information 34
Item 6 - Exhibits and Reports on Form 8-K 35
Signature 37
2
MARKETSPAN CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
(IN THOUSANDS OF DOLLARS)
SEPTEMBER 30, 1998 MARCH 31, 1998
---------------------- -----------------------
(UNAUDITED) (AUDITED)
ASSETS
PROPERTY
Electric -utility $ 1,096,773 $ 4,049,629
Gas-utility 3,185,575 1,233,281
Common and other 425,670 409,029
Accumulated depreciation (1,456,073) (1,877,858)
Gas exploration and production, at cost 853,762 -
Accumulated depletion (296,850) -
---------------------- -----------------------
3,808,857 3,814,081
---------------------- -----------------------
OTHER PROPERTY & INVESTMENTS 118,848 50,816
---------------------- -----------------------
REGULATORY ASSETS
Base financial component, net - 3,155,334
Rate moderation component - 434,004
Shoreham post-settlement costs - 1,005,316
Shoreham nuclear fuel - 66,455
Unamortized cost of issuing securities 5,830 159,941
Postretirement benefits other than pensions 50,772 340,109
Regulatory tax asset 65,484 1,737,932
Other 175,462 192,763
---------------------- -----------------------
297,548 7,091,854
---------------------- -----------------------
CURRENT ASSETS
Cash and temporary cash investments 1,756,876 180,919
Customer accounts receivable 111,061 321,372
Other accounts receivable 292,755 43,744
Allowance for uncollectible accounts (25,115) (23,483)
Special deposits 131,154 95,790
Accrued revenues 42,839 124,464
Gas and fuel oil in storage, at average cost 149,797 46,776
Materials and supplies, at average cost 62,150 54,883
Other 184,040 13,807
---------------------- -----------------------
2,705,557 858,272
---------------------- -----------------------
DEFERRED CHARGES
Goodwill 175,030 -
Other 418,787 85,702
---------------------- -----------------------
593,817 85,702
---------------------- -----------------------
---------------------- -----------------------
TOTAL ASSETS $ 7,524,627 $ 11,900,725
====================== =======================
See accompanying Notes to the Condensed Consolidated Financial Statements.
3
MARKETSPAN CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
(IN THOUSANDS OF DOLLARS)
SEPTEMBER 30, 1998 MARCH 31, 1998
---------------------- -----------------------
(UNAUDITED) (AUDITED)
CAPITALIZATION AND LIABILITIES
CAPITALIZATION
Common stock , authorized 450,000,000 shares
outstanding 155,227,254 and 121,680,759 shares,
respectively stated at $ 2,973,704 $ 1,707,559
Retained earnings 722,293 956,092
Treasury stock purchased (101,483) (1,204)
Foreign currency translation adjustment (569) -
---------------------- -----------------------
Total common equity 3,593,945 2,662,447
Preferred stock 448,000 562,600
Long-term debt 1,544,065 4,381,949
---------------------- -----------------------
TOTAL CAPITALIZATION 5,586,010 7,606,996
---------------------- -----------------------
REGULATORY LIABILITIES 49,373 389,431
---------------------- -----------------------
CURRENT LIABILITIES
Current maturities of long-term debt 397,000 101,000
Current redemption requirements of preferred stock - 139,374
Accounts payable and accrued expenses 548,734 258,701
Dividends payable 71,866 58,748
Taxes accrued 1,922 34,753
Customer deposits 29,150 28,627
Class Settlement 60,000 60,000
Interest accrued 17,527 146,607
-----------------------
---------------------- -----------------------
1,126,199 827,810
---------------------- -----------------------
DEFERRED CREDITS AND OTHER LIABILITIES
Deferred federal income tax 341,428 2,539,364
Class Settlement 31,037 46,940
Pensions and other postretirement benefits 140,833 401,401
Claims, damages & other reserves 138,085 66,254
Other 12,005 22,529
---------------------- -----------------------
663,388 3,076,488
---------------------- -----------------------
MINORITY INTEREST IN SUBSIDIARY COMPANY 99,657 -
---------------------- -----------------------
TOTAL CAPITALIZATION AND LIABILITIES $ 7,524,627 $ 11,900,725
====================== =======================
See accompanying Notes to the Condensed Consolidated Financial Statements.
4
MARKETSPAN CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENT OF INCOME
(IN THOUSANDS OF DOLLARS EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED SIX MONTHS ENDED
----------------------------- ----------------------------------
SEPTEMBER 30, September 30, SEPTEMBER 30, September 30,
1998 1997 1998 1997
------------- -------------- -------------- --------------
REVENUES
Electric distribution $ - $ 790,331 $ 330,080 $ 1,350,417
Electric generation and services 171,621 - 239,593 -
Gas distribution 200,595 62,078 353,121 166,480
Gas production 30,545 - 42,258 -
Other 23,497 - 30,192 -
----------- ----------- ---------- -------------
Total Revenues 426,258 852,409 995,244 1,516,897
OPERATING EXPENSES
Fuel and purchased power - 180,926 91,796 329,512
Purchased gas 59,994 25,740 124,384 68,931
Operations 215,936 87,502 365,352 181,808
Maintenance 37,152 26,885 70,791 54,667
Depreciation, depletion and amortization 60,090 39,268 107,645 78,162
Regulatory and other amortizations - 40,785 (39,343) 6,134
Operating taxes 77,807 122,337 175,565 231,660
Federal income taxes (credit) (16,191) 86,354 (76,652) 119,332
----------- ----------- ---------- -------------
Total Operating Expenses 434,788 609,797 819,538 1,130,206
----------- ----------- ---------- -------------
OPERATING INCOME (8,530) 242,612 175,706 386,691
OTHER INCOME AND (DEDUCTIONS)
Transaction related expenses - - (63,651) -
Interest and other 30,650 2,261 24,140 6,483
----------- ----------- ---------- ----------
INCOME BEFORE INTEREST CHARGES 22,120 244,873 136,195 393,174
INTEREST CHARGES 39,776 100,489 116,601 203,628
----------- ----------- ---------- -------------
NET INCOME (LOSS) (17,656) 144,384 19,594 189,546
Preferred stock dividend requirements 8,694 12,948 19,910 25,917
----------- ----------- ---------- -------------
EARNINGS (LOSS) FOR COMMON STOCK $ (26,350) $ 131,436 $ (316) $ 163,629
=========== =========== ========== =============
AVERAGE COMMON SHARES OUTSTANDING(000) 157,328 121,341 145,747 121,244
BASIC AND DILUTED EARNINGS (LOSS) PER COMMON SHARE $ (0.17) $ 1.09 $ (0.00) $ 1.35
=========== =========== ========== =============
See accompanying Notes to the Condensed Consolidated Financial Statements.
5
MARKETSPAN CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS OF DOLLARS)
Six Months Ended
September 30 September 30
1998, 1997,
------------------------------------------------
OPERATING ACTIVITIES
Net Income $ 19,594 $ 189,546
ADJUSTMENTS TO RECONCILE NET INCOME TO NET
CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES
Depreciation and amortization 107,645 78,162
Regulatory and other amortizations (45,726) 66,134
Rate moderation component carrying charges (6,411) (11,914)
Amortization of cost of issuing and redeeming securities 5,584 14,948
Deferred Federal income tax (167,814) 76,052
Pensions and other postretirement benefits 11,269 13,265
Income from equity investments (4,049) -
Dividends from equity investments 2,078 -
CHANGES IN CURRENT ASSETS AND LIABILITIES
Accounts receivable and accrued revenues 29,086 12,934
Pensions and other postretirement benefits (283,774) -
Materials and supplies, fuel oil and gas in storage (56,010) (55,590)
Accounts payable and accrued expenses 234,823 12,695
Taxes accrued (90,671) 5,983
Interest accrued (153,706) (42,273)
Class Settlement (15,904) (22,090)
Special deposits (35,364) (28,683)
Other (27,113) 43,978
----------------------- --------------------
Net Cash Provided by (Used in) Operating Activities (476,463) 353,147
----------------------- --------------------
INVESTING ACTIVITIES
Capital expenditures (214,352) (117,468)
Net cash from KeySpan and LILCO transactions 90,168 -
Proceeds from LIPA transaction 2,497,500 -
Shoreham post-settlement costs (6,650) (20,936)
Miscellaneous investment (5,838) (31,293)
----------------------- --------------------
Net Cash Provided by (Used in) Investing Activities 2,360,828 (169,697)
----------------------- --------------------
FINANCING ACTIVITIES
Proceeds from sale of common stock 13,050 9,034
Treasury stock purchased (101,483) -
Issuance (redemption) of preferred stock 75,000 (1,050)
Issuance of long-term debt 3,000 -
Redemption of long-term debt (100,000) -
Preferred stock dividends paid (21,608) (25,937)
Common stock dividends paid (159,434) (107,754)
Other (16,933) (797)
----------------------- --------------------
Net Cash Used in Financing Activities (308,408) (126,504)
----------------------- --------------------
Net Increase in Cash and Cash Equivalents 1,575,957 56,946
======================= ====================
Cash and cash equivalents at beginning of period $ 180,919 $ 64,539
Net Increase in cash and cash equivalents 1,575,957 56,946
======================= ====================
Cash and cash equivalents at end of period $ 1,756,876 $ 121,485
======================= ====================
See accompanying Notes to the Condensed Consolidated Financial Statements.
6
MARKETSPAN CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION OF THE COMPANY
MarketSpan Corporation, d/b/a KeySpan Energy(the "Company"), a New York
corporation, is the successor to Long Island Lighting Company ("LILCO"),
as a result of the transaction with the Long Island Power Authority
("LIPA") discussed below (the "LIPA Transaction") and following the
acquisition ("KeySpan Acquisition") of KeySpan Energy Corporation
("KeySpan"). The Company is a utility holding company that has been
granted an exemption under the Public Utility Holding Company Act of 1935,
as amended. As a result of the transaction with LIPA, LILCO became a
wholly owned subsidiary of LIPA, a corporate municipality and a political
subdivision of New York State.
On September 10, 1998, the Company's Board of Directors authorized filings
to permit the Company to conduct its business under the name KeySpan
Energy. The Company intends to propose a formal name change for
shareholder approval at its 1999 Annual Meeting of Shareholders. On
October 20, 1998 the Company's symbol for its common stock and preferred
stock Series AA listed on the New York and Pacific Stock Exchanges was
changed to "KSE". KeySpan and LILCO common stock are no longer traded.
With the exception of a small portion of Queens County, the Company's
subsidiaries are the only providers of gas distribution services on Long
Island, N.Y.- Nassau, Suffolk, Queens and Kings Counties. In addition, the
Company's subsidiaries provide gas distribution services to Richmond
County, a part of New York City. The Brooklyn Union Gas Company ("Brooklyn
Union"), a subsidiary of the Company, provides gas distribution services
to Kings and Richmond Counties and parts of Queens County, all in New York
City, and KeySpan Gas East Corporation, also a Company subsidiary,
provides gas distribution services to Nassau and Suffolk Counties and the
Rockaway Peninsula in Queens County.
As a result of the LIPA Transaction and KeySpan Acquisition, the
composition of the Company's assets and liabilities at September 30, 1998
reflects the monetization of substantial regulatory and other assets owned
by its predecessor company
7
and a related reduction of financial risk associated with that
company.
2. SALE OF LILCO ASSETS, ACQUISITION OF KEYSPAN AND TRANSFER OF
ASSETS AND LIABILITIES TO THE COMPANY
On May 28, 1998, pursuant to the Agreement and Plan of Merger, dated as of
June 26, 1997, by and among the Company, LILCO, LIPA, and LIPA Acquisition
Corp. (the "Merger Agreement"), LIPA acquired all of the outstanding
common stock of LILCO for $2.4975 billion in cash and thereafter directly
or indirectly assumed certain liabilities, including approximately $3.5
billion in debt, as well as approximately $222 million of LILCO's
preferred stock. In addition, LIPA reimbursed LILCO $117.5 million related
to certain series of preferred stock which were redeemed by LILCO prior to
May 28, 1998. Immediately prior to such acquisition, all of LILCO's assets
employed in the conduct of its gas distribution business and its
non-nuclear electric generation business, and all common assets used by
LILCO in the operation and management of its electric transmission and
distribution ("T&D") business and its gas distribution business and/or its
non-nuclear electric generation business were sold to the Company and
transferred to wholly owned subsidiaries of the Company.
Immediately subsequent to the LIPA Transaction, KeySpan was merged with
and into a subsidiary of the Company, pursuant to an amended and restated
Agreement and Plan of Exchange and Merger, dated as of June 26, 1997
between LILCO and Brooklyn Union. On September 29, 1997, KeySpan became
the parent company of Brooklyn Union when Brooklyn Union reorganized into
a holding company structure.
As a result of these transactions, holders of KeySpan common stock
received one share of the Company's common stock, par value $.01 per
share, for each share of KeySpan common stock they owned and holders of
LILCO common stock received 0.880 of a share of the Company's common stock
for each share of LILCO common stock they owned. Upon the closing of these
transactions, former holders of KeySpan and LILCO owned 32% and 68%,
respectively, of the Company's common stock.
The purchase price of $1.223 billion for the acquisition of KeySpan has
been allocated to assets acquired and liabilities assumed based upon their
estimated fair values. The fair value of the utility assets acquired is
represented by their book
8
value which approximates the value recognized by the New York Public
Service Commission ("PSC") in establishing rates for regulated utility
services. The estimated fair value of KeySpan's non-utility assets
approximates their carrying values.
The Company has recorded goodwill in the amount of $175 million
representing the excess of the acquisition cost over the fair value of the
net assets acquired; the goodwill is being amortized over 40 years.
The following is the comparative unaudited pro forma combined condensed
financial information for the twelve months ended September 30, 1998 and
1997. The pro forma disclosures are intended to reflect the results of
operations as if the LIPA Transaction and the KeySpan Acquisition as
discussed above, were consummated on the first day of the reporting
period. These pro forma disclosures are not indicative of future results
since they include non-recurring charges and credits arising from the LIPA
Transaction and KeySpan Acquisition and do not reflect attainment of
synergy (i.e. efficiency) savings. See Management's Discussion and
Analysis of Results of Operations and Financial Condition "Utility Rate
and Regulatory Matters." The initial benefit of these savings is expected
to be reflected in operating results beginning January 1, 1999. However,
no assurance can be given as to what savings will be obtained. Certain
prior year amounts have been reclassified in the financial statements to
conform with the current year presentation.
Twelve Months Ended
September 30,
1998 1997
---- ----
Pro Forma Results (in thousands
of dollars, except per share
amounts)
Revenues 2,771.4 2,818.2
Operating Income 335.8 323.4
Net Income 195.5 190.8
Earnings Per Share (basic and diluted) 1.04 .99
The decrease in revenues in the twelve month period ended September 30,
1998 as compared to the same period in 1997 was due to lower gas revenues
caused by warmer than normal weather. This decrease was offset primarily
by the realization of certain federal income tax benefits related to the
sale of the generation and gas assets of LILCO to the
9
Company and the funding of post-employment benefits.
3. BASIS OF PRESENTATION
The financial statements presented herein reflect the consolidated
statements of the Company. For financial reporting purposes, LILCO, as
acquiring company, is deemed the predecessor company pursuant to a
purchase accounting transaction, in which KeySpan was acquired. Since the
acquisition of KeySpan was accounted for as a purchase, purchase
accounting adjustments, including goodwill, have been reflected in the
financial statements herein. Further, the financial statements presented
reflect the results of operations of LILCO from April 1, 1998 through May
28, 1998 and of the consolidated Company from May 29, 1998 through
September 30, 1998. In September, the Company changed its fiscal year to a
fiscal year ending December 31. As a result, the Company's Form 10-K
report will include the transition period April 1, 1998 through December
31, 1998.
In the opinion of the Company, the accompanying unaudited Condensed
Consolidated Financial Statements contain all adjustments necessary to
present fairly the financial position of the Company as of September 30,
1998, and the results of its operations for the three and six months ended
September 30, 1998 and 1997, and cash flows for the six months ended
September 30, 1998 and 1997. Certain reclassifications were made to
conform prior period financial statements with the current period
financial statement presentation. Other than as noted, adjustments were of
a normal, recurring nature.
The weighted average number of common shares outstanding used in the
calculation of earnings per share for the quarter and six months ended
September 30, 1998, reflect the issuance of common stock to consummate the
LIPA Transaction and the KeySpan Acquisition and the reduction associated
with the ongoing stock repurchasing policy of the Company that began on
August 17, 1998.
As permitted by the rules and regulations of the Securities and Exchange
Commission ("SEC"), the Condensed Consolidated Financial Statements do not
include all of the accounting information normally included with financial
statements prepared in accordance with generally accepted accounting
principles. Accordingly, the Condensed Consolidated Financial Statements
should be read in conjunction with the financial
10
statements and notes thereto included in the Long Island Lighting
Company's Annual Report on Form 10-K for the fiscal year ended March 31,
1998, the KeySpan Energy Corporation Annual Report on Form 10-K for the
fiscal year ended September 30, 1997, KeySpan Energy Corporation Form 10-Q
for the quarters ended December 31, 1997 and March 31, 1998, and the
MarketSpan Corporation Form 10-Q for the quarter ended June 30, 1998.
Further, separate financial statements are prepared for subsidiaries that
issue private purpose tax exempt bonds, related amounts of which are
included in the consolidated financial statements presented herein.
The Houston Exploration Company (THEC), a 64% owned subsidiary of the
Company which is engaged in oil and gas exploration and production, uses
the full cost method of accounting for its investment in natural gas and
oil properties. Under the full cost method of accounting, all costs of
acquisition, exploration and development of natural gas and oil reserves
are capitalized into a "full cost pool". To the extent that such
capitalized costs (net of accumulated depreciation, depletion and
amortization) less deferred taxes, exceed the present value (using a 10%
discount rate) of estimated future net cash flows from proved natural gas
and oil reserves plus the lower of cost or fair value of unproved
properties, such excess costs are charged to operations.
THEC estimates that, as of September 30, 1998, using September prices,
actual capitalized costs of natural gas and oil properties exceeded the
ceiling limitation imposed under full cost accounting rules by
approximately $60 million after tax. However, subsequent to September 30,
1998, natural gas prices have increased significantly. Using October
prices, THEC estimates that a $6 million after tax excess exists between
the ceiling limitation and actual capitalized costs of natural gas and oil
properties; therefore, a write-down of the carrying value of natural gas
and oil properties as of September 30, 1998 is not required. However,
natural gas prices continue to experience volatility; thus, depending upon
the strength of natural gas prices and the results of THEC's current
drilling programs, THEC may be required to write down the carrying value
of its natural gas and oil properties in the next quarter.
The gas distribution business is influenced by seasonal weather
conditions. Annual revenues are substantially realized during the heating
season (November 1 to April 30) as a result of the large proportion of
heating sales, primarily
11
residential, compared with total sales. Accordingly, results of operations
historically are most favorable in the three months ended March 31, with
results of operations being next most favorable in the three months ended
December 31. Results for the quarter ended June 30 are marginally
unprofitable, and losses are usually incurred in the quarter ended
September 30.
The gas utility tariffs of Brooklyn Union and KeySpan Gas East Corporation
each contain a weather normalization adjustment that largely offsets
shortfalls or excesses of firm net revenues (revenues less gas costs)
during a heating season due to variations from normal weather.
Electric generation revenues can be affected by weather, if actual
generation varies from contractual amounts. However, the Company estimates
that any weather-related effect on revenues under generation service
contracts with LIPA will be diminimus.
4. ENVIRONMENTAL MATTERS
The Company is subject to various Federal, State and local laws and
regulatory programs related to the environment. These environmental laws
govern both the normal, ongoing operations of the Company as well as the
cleanup of contaminated properties. Ongoing environmental compliance
activities, which historically have not been material, are integrated with
the Company's regular operation and maintenance activities. As of
September 30, 1998 the Company had an accrued liability (and related
regulatory asset)of approximately $102.6 million representing the
previously estimated minimum costs associated with investigation and
remediation at former manufactured gas plant sites.
5. REGULATORY ASSETS AND LIABILITIES
The Company's regulated subsidiaries are subject to the provisions of
Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for
the Effects of Certain Types of Regulation". Regulatory assets arise from
the allocation of costs and revenues to accounting periods for utility
ratemaking purposes differently from bases generally applied by
nonregulated companies. Regulatory assets and liabilities are recognized
in accordance with SFAS-71.
12
The Company's regulatory assets of $297.5 million are primarily comprised
of net regulatory tax assets, transaction costs associated with the LIPA
Transaction and KeySpan Acquisition, certain environmental remediation and
investigation costs and postretirement benefits other than pensions. In
the opinion of management, regulatory assets are fully recoverable in
rates.
In the event that the provisions of SFAS-71 were no longer applicable, the
Company estimates that the related write-off of the net regulatory assets
(regulatory assets less regulatory liabilities) could result in a charge
to net income of approximately $161.3 million or approximately $1.03 per
share of common stock, which would be classified as an extraordinary item.
13
MARKETSPAN CORPORATION AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
Operating Results
The following is a summary of items affecting comparative earnings and a
discussion of the material changes in revenues and expenses during the following
periods:
(1) Three Months ended September 30, 1998 compared to Three Months
ended September 30, 1997.
(2) Six Months ended September 30, 1998 compared to Six Months ended September
30, 1997.
Additional selected pro forma information is provided for the twelve months
ended September 30, 1998 and September 30, 1997 in Note 2 of the Notes to the
Condensed Consolidated Financial Statements.
Results for the three months ended September 30, 1998 include operations of the
consolidated entity for the entire quarter and reflect the seasonal nature of
gas heating sales on the combined customer base. Results for the six months
ended September 30, 1998 include operations of LILCO's former gas and electric
business for the period April 1, 1998 through May 28, 1998. Results for KeySpan
Gas East Corporation, KeySpan and three subsidiaries providing services to LIPA
under various services agreements with LIPA, are reflected for the period May
29, 1998 through September 30, 1998. (See below under "Electric Operations -
LIPA Agreements" for a description of the various agreements.) As required under
purchase accounting, results for the quarter and six months ended September 30,
1997 reflect results of the former LILCO as previously reported, and do not
include results of KeySpan.
Earnings during the first year following the KeySpan Acquisition and
restructuring of the Company's electric operations as a result of the LIPA
Transaction are transitional and not comparable to prior historical periods.
Further, the historical and pro forma results of operations reported herein may
not be indicative of future results or operating trends. In addition,
comparative earnings reflect the manner in which results of operations are
reported under purchase accounting rules. Also, due to the change in the
Company's fiscal year to December 31, 1998, year-end results will include the
results of operations for the transition period April 1 through December 31.
Accordingly, historical consolidated
14
year-end results of the Company's primary gas-distribution businesses will not
include earnings from heating-season operations prior to the KeySpan
Acquisition. Moreover, there will be additional charges for an early retirement
program in the fourth quarter and related programs in the near term, as well as
costs related to the integration of all major customer information and financial
reporting systems. The Company expects that the effect of rate reductions that
have been included in utility revenues will begin to be offset in fiscal 1999 as
the related synergy savings begin to be realized through cost reductions.
Earnings
Consolidated results for the quarter ended September 30, 1998 reflected a loss
of $26.4 million, or $0.17 per share, compared to earnings of $131.4 million, or
$1.09 per share, in the corresponding period last year. Comparative results for
the quarter were affected by merger-related charges and reflect the fact that
gas utility customers began receiving the benefit of rate reductions upon the
effective date of the KeySpan Acquisition, before synergy savings are achieved
through cost reductions. Moreover, the change in the Company's asset base and
electric operations resulting from the LIPA Transaction contributed to the
comparative reduction in earnings, which now reflect service-fee revenues to
recover costs at reduced margins under various service contracts with LIPA. (See
Electric Revenues below for additional details.) Results of KeySpan Gas East
Corporation are comparable with last year's results.
Earnings for the quarter ended September 30, 1998 also reflect the incurrence of
losses related to the seasonal nature of gas-heating sales on the combined and
significantly expanded customer base. Earnings from the Company's energy-related
investment group, which are not material in the periods reported, primarily
reflect income from: gas production operations of THEC; investment in the
Iroquois Gas Transmission System; and investment in the Premier Transco Pipeline
in Northern Ireland. Earnings from this group are on target, but reflect
generally soft gas production prices during the period. The Company has a 24.5%
interest in the Premier Transco Pipeline and a similar interest in Phoenix
Natural Gas, which is expanding and refurbishing the gas distribution system
that serves the City of Belfast in Northern Ireland. In addition, the Company is
expanding its resource base in the Gulf of Mexico and Canada, the two critical
areas of supply to support growth in the Northeast and elsewhere in the United
States. Further, the Company expects to continue to form strategic alliances to
capture significant opportunities in North America and in select international
markets.
15
Results of the Company's energy marketing group, which consists of KeySpan
Energy Services Inc., KeySpan Energy Solutions Inc. and KeySpan Energy
Management Inc., reflect the start-up nature of these operations and are not
material in the periods reported. The Company will align these operations in
order to take full advantage of opportunities to increase sales in more
profitable market segments.
Consolidated results for the six months ended September 30, 1998 reflected a
loss of $.3 million, with no effect on a per share basis, compared to earnings
of $163.6 million, or $1.35 per share, in the corresponding period last year. In
addition to the effects of the change in electric operations (as described
above), the Company absorbed substantial costs related to the LIPA Transaction
during the period ended September 30, 1998. The effect of these one time charges
was offset by realizing certain federal income tax benefits related to the sale
of the generation and gas assets of LILCO to the Company and the funding of
post-employment benefits. In addition, the method of amortization of the Rate
Moderation Component (RMC) applicable to LILCO, which is included for two months
- - April and May, changed significantly. (The RMC, which is discussed more fully
under "Rate Moderation Component", was acquired by LIPA as part of the LIPA
Transaction.)
Revenue Summary
Utility firm gas and transportation sales volumes for the quarter ended
September 30, 1998, were 18,886 MDTH, compared to 5,441 MDTH in the
corresponding period last year. Total gas throughput, which includes sales to
interruptible customers, was 34,744 MDTH for the quarter ended September 30,
1998, compared to 10,809 MDTH in the corresponding period last year. Total gas
throughput for the six months ended September 30, 1998 was 56,301 MDTH, as
compared to 24,221 MDTH in the corresponding period last year. Sales for the
quarter and six months ended September 30, 1997 do not include sales made by
KeySpan's gas distribution subsidiary. The increase for the quarter and six
months ended September 30, 1998 reflects significant expansion of the gas
customer base as a result of the KeySpan Acquisition.
The revenues of the Company were significantly affected as a result of the LIPA
Transaction and KeySpan Acquisition. Set forth below are the Company's revenues
for the three and six months ended September 30, 1998 and 1997. (Note 2 to the
Condensed Consolidated Financial Statements includes pro forma information for
the twelve months ended September 30, 1998 and 1997.)
16
Three Months Ended Six Months Ended
September 30, September 30,
($000) ($000)
1998 1997 1998 1997
---- ---- ---- ----
KeySpan Corporation Revenues:
Electric Revenues:
Electric Distribution $ - $ 790,331 $ 330,080 $1,350,417
Electric Gen. & Serv. 171,621 - 239,593 -
Gas Distribution 200,595 62,078 353,121 166,480
Gas Production - THEC 30,545 - 42,258 -
Other Revenues 23,497 - 30,192 -
------ - ------- -
TOTAL REVENUES $ 426,258 $ 852,409 $ 995,244 $1,516,897
========= ========= ========= ==========
Gas Distribution and Production Revenues
The increase in gas distribution and production revenues of approximately $169.1
million for the three months ended September 30, 1998, and $228.9 million for
the six months ended September 30, 1998, when compared to comparable periods in
1997 was principally the result of the inclusion of Brooklyn Union revenues and
gas production revenues of THEC for the entire quarter and for the period May
29, 1998 through September 30, 1998. Pursuant to purchase accounting
requirements, the comparative September 1997 periods included gas distribution
revenues of LILCO only and do not include revenues of KeySpan.
Electric Revenues
Electric revenues for the quarter ended September 30, 1998 represent revenues
under various LIPA Service Agreements. For the six months ended September 30,
1998 revenues are derived from the LIPA Service Agreements for the period May
29, 1998 through September 30, 1998 and electric service revenues covering the
period April 1, 1998 through May 28, 1998. For the comparable 1997 periods,
revenues include electric service revenues of LILCO only.
The decreases in electric revenues of approximately $618.7 million for the three
months ended September 30, 1998 and approximately $780.7 million for the six
months ended September 30, 1998 when compared to the same periods in 1997, were
the result of the LIPA Transaction which was consummated on May 28, 1998. Prior
to the LIPA Transaction, LILCO provided fully integrated electric services to
its customers. Included within the rates charged to customers was a return
(including interest) on the capital investment in the
17
generation and transmission and distribution ("T&D") assets required to operate
the system as well as recovery of the electric business costs to operate the
system. Upon completion of the LIPA Transaction, the nature of the Company's
electric business has changed from that of an owner of an electric generation
and T&D system, with a significant capital investment, to a new role as an owner
of the generation facilities and as a manager of the T&D system now owned by
LIPA. In its new role, the Company's capital investment is significantly reduced
and accordingly, its revenues under the LIPA contracts reflect that reduction.
Revenues after May 28, 1998 reflect the impact of the LIPA Service Agreements
which contribute marginally to earnings.
Revenues resulting from the LIPA Service Agreements include the following:
Revenues realized under the Management Services Agreement(MSA) were
approximately $93.6 million for the quarter ended September 30, 1998 and
approximately $131.4 million for the six months ended September 30, 1998. These
revenues are derived from the performance of the day-to-day operation and
maintenance of LIPA's T&D system and the management of LIPA's interest in the
Nine Mile Point Nuclear Power Station, Unit 2 (NMP2).
Revenues under the Power Supply Agreement (PSA)were approximately $76.7 million
for the quarter ended September 30, 1998 and approximately $103.8 million for
the six months ended September 30, 1998 and are derived from the sale of
capacity and energy to LIPA from the Company's generating facilities.
Revenues under the Energy Management Agreement (EMA) were approximately $1.3
million for the quarter ended September 30, 1998 and approximately $4.3 million
for the six months ended September 30, 1998 and result from the management of
fuel supplies for LIPA to fuel the Company's generating facilities, energy
purchases on a least-cost basis, off-system sales of output from the Company's
generating facilities and other power supplies either owned or under contract to
LIPA.
See "Electric Operations - LIPA Agreements" for a more detailed description of
each of these agreements.
18
Other Revenues
Other revenues for the quarter ended September 30, 1998 include primarily
revenues of the Company's energy management subsidiary for the entire quarter.
This subsidiary provides a variety of services in all facets of energy
management services to customers that operate commercial and industrial
facilities, primarily within the New York City metropolitan area. Other revenues
for the six months ended September 30, 1998 include revenues of KeySpan's energy
management subsidiary for the period May 29, 1998 through September 30, 1998.
Pursuant to purchase accounting requirements, the comparative 1997 periods do
not include KeySpan.
Operating Expenses
Electric fuel expense decreased in both the quarter and six months ended
September 30, 1998 as compared with the comparable 1997 periods, primarily as a
result of the LIPA Transaction. In accordance with the terms of the EMA, LIPA is
responsible for paying directly the cost of purchased power.
For the three and six months ended September 30, 1998, purchased gas costs
reflect the seasonal nature of gas heating consumption. Further, such costs
reflect activity of Brooklyn Union for the period May 29, 1998 through September
30, 1998. Such costs are not included in the comparable 1997 periods due to
purchase accounting requirements.
Operations and maintenance expenses for the three months ended September 30,
1998 have increased as compared to the comparable 1997 period due primarily to
the inclusion of KeySpan operations for the entire quarter and the LIPA
Transaction. Prior to the LIPA Transaction, all T&D related capital projects
were capitalized and charged to depreciation expense over the estimated useful
life of the asset. As a result of the LIPA Transaction, all T&D assets were
acquired by LIPA, and therefore all T&D related costs are now expensed when
incurred and recovered from LIPA through monthly billings.
Operations and maintenance expenses for the six months reflect the one time
charges associated with the LIPA Transaction and the KeySpan Acquisition, the
management of T&D assets acquired by LIPA, and the addition of KeySpan
operations since May 29, 1998. The Company is committed to realizing the
forecasted $1 billion of operating synergy savings (over a ten year
period)already being reflected in both utility tariff rates and contracts with
LIPA;
19
however, no assurance can be given as to what savings will be obtained. As part
of an overall plan to realize the synergy savings, the Company has initiated an
early retirement program and expects to initiate related programs in the near
term.
Due to the LIPA Transaction, operating taxes, including property and gross
receipt taxes, have decreased this quarter and for the current six months as
compared to last year's corresponding periods, despite the addition of KeySpan's
expenses in the current reporting periods. Significant property related assets
were sold to LIPA and, as a result, related property taxes will no longer be
incurred by the Company.
Federal income tax expense reflects changes in pre-tax income and, for the six
months ended September 30, 1998, reflect certain tax benefits related to the
sale of the generation and gas assets of LILCO to the Company and to the funding
of other post-employment benefits.
Other Income and Deductions
Other income for the quarter and six months ended September 30, 1998 includes,
primarily, earnings from the investment of the proceeds from the LIPA
Transaction, incentives earned under the Power Supply Agreement (PSA) and Energy
Management Agreement (EMA) and equity investments of KeySpan. Incentives earned
under the PSA for the quarter and six months ended September 30, 1998 were
approximately $4.0 million. Incentives earned under the EMA were approximately
$2.1 million and approximately $2.5 million for the quarter and six months ended
September 30, 1998, respectively.
For the six months ended September 30, 1998, the transaction related expenses
are primarily non-recurring charges associated with the LIPA Transaction.
Specifically these charges relate to severance payments to certain former
officers of LILCO, amounting to approximately $22.5 million, and LIPA
Transaction costs and certain payments made to LIPA upon the closing of the LIPA
Transaction amounting to approximately $41.2 million. Other deductions primarily
include a charge to earnings to reflect an updated present value of the
remaining payments under a class settlement which became effective in June 1989
and resolved a civil lawsuit against LILCO brought under the Federal Racketeer
Influenced and Corrupt Organization Act.
20
Rate Moderation Component
Prior to the LIPA Transaction, the Rate Moderation Component (RMC) included
within the electric regulatory amortizations and balance sheet, represented the
difference between the Company's revenue requirements under conventional
ratemaking and the revenues provided by its electric rate structure. The RMC was
adjusted for the operation of the Company's Fuel Moderation Component (FMC)
mechanism and the difference between the Company's share of actual operating
costs at NMP2 and amounts provided for in electric rates.
In April 1998, the PSC authorized a revision to the Company's method of
recording its monthly RMC amortization from a straight-line levelized basis over
the Company's rate year, to a monthly amortization based upon each month's
forecasted revenue requirement, which more closely aligned such amortization
with the Company's cost of service. As a result of this change, for the period
April 1, 1998 through May 28, 1998, the Company recorded approximately $51.5
million more of non-cash RMC credits to income (representing accretion of the
RMC balance), or $33.5 million net of tax, than it would have under the previous
method. Coincident with the LIPA Transaction, which included the sale of the
Company's electric related regulatory assets, the RMC was discontinued.
Dividends and Financial Condition (Liquidity)
On September 10, 1998, the Board of Directors declared a quarterly cash dividend
of $0.445 per share on its outstanding common stock payable on November 1, 1998
to shareholders of record on October 15, 1998. Common stock dividend payments
for November 1, 1998 amounted to $66.3 million. Based on recent market prices,
the dividend yield on the Company's common stock approximates 6.0%. The Company
is currently paying the dividend at an annual rate of $1.78 per common share.
The dividend rate will be reviewed annually by the Board of Directors and is
scheduled for review sometime within the quarter ending June 30, 1999. However,
the amount and timing of all dividend payments is subject to the discretion of
the Board of Directors and will depend upon business conditions, results of
operations, financial conditions and other factors. The Company expects that as
it achieves the benefit of synergy savings through expected cost reductions and
gas sales growth from its expanded core gas distribution business, the dividend
payout ratio will be more reflective of the industry norm. In addition, on
October 30, 1998, the Board of Directors declared a quarterly dividend on the
Company's 7.95% Preferred Stock Series AA of $.495 per share payable on December
1, 1998 to shareholders
21
of record on November 11, 1998. The annual dividend rate on the
Series AA is $1.98 per share.
At September 30, 1998, various Company subsidiaries had available lines of
credit. KeySpan's available bank lines of credit, which secure the issuance of
commercial paper, amounted to $150 million. The lines of credit are available to
KeySpan and its subsidiary, Brooklyn Union. In addition, THEC had an available
line of credit of $135 million, from which it borrowed $91 million. In March
1998, THEC issued $100 million of 8.625% Senior Subordinated Notes due 2008.
These notes are subordinate to borrowings under THEC's line of credit.
As a result of the LIPA Transaction, the Company has a significant amount of
cash which it intends to use for, among other things, the repurchase of shares
of its common stock and the expansion of its operations through one or more of
the following types of transactions: mergers with or acquisitions of another
utility; investments in new gas pipelines (and related assets such as storage
fields and processing plants) and gas exploration; or the purchase and/or
construction of additional electric power plants. However, no assurance can be
given that any of the foregoing types of transactions will occur or that such
transactions, if completed, will be integrated with the Company's operations or
prove to be profitable.
On October 30, 1998, the Company announced that the Board of Directors
authorized using up to $500 million for the purchase of common shares in
addition to the Board's previous authorization to purchase up to 15 million
common shares. Purchases from the initial authorization commenced on August 17,
1998. As of September 30, 1998 the Company had repurchased approximately 3.6
million common shares for approximately $101 million and as of October 30, 1998
the Company had repurchased approximately 11 million common shares for
approximately $333 million.
Pursuant to the PSC's orders dated February 5, 1998 and April 14, 1998 approving
the KeySpan Acquisition, Brooklyn Union's and KeySpan Gas East Corporation's
ability to pay dividends is conditioned upon maintenance of a utility capital
structure with debt not exceeding 55% and 58%, respectively, of total utility
capitalization. In addition, the level of dividends paid by both utilities may
not be increased from current levels if a 40 basis point penalty is incurred
under the customer service performance program.
22
Utility Rate and Regulatory Matters
Gas Operations
In 1997, Brooklyn Union and LILCO filed a joint petition with the PSC seeking
approval, under section 70 of the New York Public Service Law, of the
combination by which KeySpan and LILCO each would become subsidiaries of the
Company. (See Notes to the Condensed Consolidated Financial Statements, Note 2.,
"Sale of LILCO Assets, Acquisition of KeySpan, and Transfer of Assets and
Liabilities to the Company".) In addition, the petition proposed $1.0 billion of
efficiency savings, excluding gas costs, attributable to operating synergies
that are expected to be realized over the 10 year period following the
combination, to be allocated to ratepayers net of transaction costs. In December
1997, Brooklyn Union, LILCO, the Staff of the Department of Public Service and
six other parties entered into a Settlement Agreement (Stipulation) resolving
all issues among them in the proceeding and, by orders dated February 5, 1998
and April 14, 1998 the PSC approved the Stipulation.
Under the Stipulation, effective May 29, 1998, Brooklyn Union's base rates to
core customers were reduced by $23.866 million annually. In addition, Brooklyn
Union is now subject to an earnings sharing provision pursuant to which it will
be required to credit core customers with 60% of any utility earnings up to 100
basis points above certain threshold return on equity levels over the term of
the rate plan (other than any earnings associated with discrete incentives) and
50% of any utility earnings in excess of 100 basis points above such threshold
levels. The threshold levels are 13.75% in rate year 1998, 13.50% in rate years
1999 through 2001, and 13.25% in rate year 2002. A safety and reliability
incentive mechanism was implemented on the consummation date of the combination,
with a maximum 12 basis point pretax return on equity penalty if Brooklyn Union
fails to achieve certain safety and reliability performance standards. With the
exception of the simplification of the customer service performance standards,
the Brooklyn Union rate plan approved by the PSC in September 1996 remains
unchanged. Any gas cost savings allocable to Brooklyn Union resulting from the
combination will be reflected in rates to utility customers as those savings are
realized.
Also under the Stipulation, a three-year gas rate plan was implemented for
KeySpan Gas East Corporation which provides for, among other things, an
estimated reduction in customers' bills of approximately 3.9%, including fuel
savings, through at least
23
November 30, 2000. This gas rate reduction will occur in three phases as
follows: (i) a reduction in base rates of approximately $12.2 million to reflect
decreases in KeySpan Gas East Corporation's cost of service, which became
effective on February 5, 1998; (ii) a base rate reduction of approximately $6.3
million associated with non-fuel savings related to the KeySpan Acquisition
effective on May 29, 1998 and (iii) an expected reduction in the Gas Adjustment
Clause (GAC) to reflect annual fuel savings associated with the transaction
estimated at approximately $4.0 million. KeySpan Gas East Corporation is subject
to an earnings sharing provision pursuant to which it is required to credit to
core/firm customers 60% of any utility earnings in any rate year up to 100 basis
points above 11.10% and 50% of any utility earnings in excess of 12.10%. Both a
customer service and a safety and reliability incentive performance were
implemented effective December 1, 1997 with maximum pre-tax return on equity
penalties of 40 and 12 basis points, respectively, if KeySpan Gas East
Corporation fails to achieve certain performance standards in these areas.
Industry Restructuring Proceedings
Over the past few years, the PSC has been formulating a policy framework to
guide the transition of New York State's gas distribution industry in the
deregulated gas industry environment. Since May 1, 1996, customers in the
small-volume market have been given the option to purchase their gas supplies
from sources other than the Company's two gas utility subsidiaries. Large-volume
customers had this option for a number of years. In addition to transporting gas
that customers purchase from marketers, the Company's utilities have been
providing billing, meter reading and other services for aggregate rates that
match the distribution charge reflected in otherwise applicable sales rates to
supply these customers.
In November 1998, the PSC issued a policy statement setting forth its vision for
furthering competition in the natural gas industry. Under this vision, regulated
natural gas utilities (LDCs) would plan to exit the business of purchasing gas
for and selling gas to customers (the merchant function) over the next three to
seven years. LDC's would remain the operators of the gas system (the
distribution function) and the provider of last resort of natural gas supplies
during that period and until alternatives are developed. The PSC's goal is to
encourage more competition at the local level by separating the merchant
function from the distribution function.
24
The PSC has acknowledged that each utility has operating circumstances unique to
its service territory and therefore separation of the merchant and distributions
functions should be done on a utility-by-utility basis. With this in mind, the
PSC will institute individual proceedings for each regulated natural gas utility
so that the parties can determine the most effective means of achieving the
Commission's goals. In addition, the PSC will also institute generic proceedings
to examine reliability and other issues.
The Company conceptually supports the vision articulated in the policy
statement. However, in the Company's view, any transition to a new industry
structure must adequately address a number of unresolved issues to ensure that
separating the merchant and distribution functions is in the best interest of
natural gas customers and is equitable to LDC's. Such issues include: system
reliability, recovery of prudently incurred costs, the obligation to provide
service to all firm customers, tax disparity among suppliers, administrative
overheads, customer acceptance and the obligation to be "supplier of last
resort". Further, the Company will also pursue legislative changes where needed.
The Company is not currently able to determine what effect these changes, if
implemented, may have on its operations.
Electric Operations - LIPA Agreements
The Company, through its subsidiaries, provides services to LIPA under the
following agreements:
Management Services Agreement (MSA)
KeySpan Electric Services LLC ("KeySpan Electric") manages the day-to-day
operations, maintenance and capital improvements of the T&D system. LIPA will
exercise control over the performance of the T&D system through specific
standards for performance and incentives to KeySpan Electric. In exchange for
providing the services, KeySpan Electric will earn a $10 million management fee
and will be operating under a contract which provides certain incentives and
imposes certain penalties based upon its performance. Annual service incentives
or penalties under the MSA can reach $7 million if certain targets are achieved
or not achieved. KeySpan Electric can earn certain incentives for cost
reductions associated with its fixed fee to LIPA. These incentives provide for
KeySpan Electric to retain 100% of its cost reductions on the first $5 million
in reductions and retain 50% of additional cost reductions up to 15% of the
total cost budget, thereafter all savings accrue to LIPA.
25
With respect to cost overruns, KeySpan Electric will absorb the first $15
million of overruns, with a sharing of overruns above $15 million. There are
certain limitations on the amount of cost sharing of overruns.
Power Supply Agreement (PSA)
KeySpan Generation LLC ("KeySpan Generation") will sell to LIPA all of the
capacity and, to the extent requested, energy from KeySpan Generation's existing
oil and gas-fired generating plants. Sales of capacity and energy are made with
rates approved by the Federal Energy Regulatory Commission(FERC). Initial rates
that were accepted by FERC (and are currently under review) were implemented on
May 29, 1998. The rates may be modified in the future in accordance with the
terms of the PSA for (i) agreed upon labor and expense indices applied to the
base year,(ii) a return of and on net capital additions required for the
generating facilities, and (iii) reasonably incurred expenses that are outside
the control of KeySpan Generation. The PSA provides incentives and penalties
that can total $4 million annually for the maintenance of the output capability
of the generating facilities.
Energy Management Agreement(EMA)
The EMA provides for KeySpan Energy Trading Services LLC ("KETS") to procure and
manage fuel supplies for LIPA to fuel the generating facilities under contract
to it and perform off-system capacity and energy purchases on a least-cost basis
to meet LIPA's needs. In exchange for these services KETS earns an annual fee of
$1.5 million. In addition, KETS will make off-system sales of excess output from
the generating facilities and other power supplies either owned or under
contract to LIPA. LIPA is entitled to two-thirds of the profit from any
off-system energy sales arranged by KETS. The EMA provides incentives and
penalties that can total $7 million annually for performance related to fuel
purchases and off- system power purchases.
Under the terms of the various LIPA contracts, the combined performance
incentives and penalties for the MSA, PSA and EMA can not exceed $16.5 million
annually.
26
Environmental Matters
The Company is subject to various Federal, State and local laws and regulatory
programs related to the environment. Ongoing environmental compliance
activities, which have not been material, are charged to operation and
maintenance activities. (See Notes to the Condensed Consolidated Financial
Statements, Note 4., "Environmental Matters".)
Year 2000 Readiness
The Company has evaluated the extent to which modifications to its computer
software, hardware and databases will be necessary to accommodate the year 2000.
Many computer applications are based on two digits and therefore require some
additional programming to recognize the start of the new millennium.
System Readiness
A corporate-wide program has been established to review Company software,
hardware, embedded systems and associated compliance plans. The program includes
both information technology (IT) and non-IT systems. Non-It systems are
basically vendor supplied embedded systems that are critical to the daily
operations of the Company. These systems are generally in the areas of electric
production, distribution, transmission, gas distribution and communications. The
readiness of suppliers and vendor systems is also under review. The project is
under the direction of the year 2000 Program Office, chaired by the Vice
President, Technology Operations and Corporate Y2K Officer.
The critical areas of operations are being addressed through a business process
review methodology. Each of the Company's critical business processes is being
reviewed to: identify and inventory sub-components; assess for year 2000
compliance; establish repair plans as necessary; and test in a year 2000
environment. The inventory phase for both the IT systems and non- IT systems is
complete. The total assessment phase is 100% complete for the IT systems, and
50% complete for non-IT systems. The assessment phase is expected to be complete
by December 31, 1998.
Hardware, software and embedded systems are being tested and certified to be
year 2000 compliant. Repair and testing is now 65% complete for the IT systems
and 20% complete for the non-IT
27
systems. Components needed to support the critical business processes and
associated business contingency plans are expected to be year 2000 ready by July
1, 1999.
Vendors and business partners needed to support the critical business processes
are also being reviewed for their year 2000 compliance. At this time, none of
these vendors have indicated to the Company that they will be materially
adversely affected by the year 2000 problem.
Risk Scenarios and Contingency Plans
The Company is presently in the process of analyzing each of the critical
business processes to identify possible year 2000 risks. Each critical business
process will be certified by the responsible corporate officer as being year
2000 ready. However, the most reasonably likely worst case scenarios are also
being identified. Business operating procedures will be reviewed to ensure that
risks are minimized when entering the year 2000 and other high risk dates.
Contingency plans are being developed to address possible failure points in each
critical business process, which plans are scheduled to be completed by July,
1999.
While the Company must plan for the following possible worst case scenarios,
management believes that these events are improbable:
Loss of gas pipeline delivery:
The Company's gas utility subsidiaries receive gas delivery from multiple
national and international pipelines and therefore the effects of a loss in any
one pipeline can be mitigated through the use of other pipelines. Complete loss
of all the supply lines is not considered a likely scenario. Nevertheless, the
impact of the loss of any one pipeline is dependent on temperature and
vaporization rate. Should gas supply be decreased due to the loss of a pipeline,
each of the Company's gas utility subsidiaries also has a local liquefied
natural gas facility under its direct control that stores sufficient gas to
offset the temporary loss of any one pipeline. The partial loss of gas supply
will not significantly affect the Company's ability to supply electricity since
most of the plants have the ability to operate on oil.
Loss of electric grid inter-connections/Company operated electric transmission
and distribution facilities:
28
Electric utilities are physically connected on a regional basis to manage
electric load. This is often referred to as the regional grid. Presently the
Company is working, on behalf of LIPA, with other regional utilities to develop
a coordinated operating plan. Should there be an instability in the grid, the
Company has the ability to remove LIPA's facilities and operate independently.
Certain electric system components such as individual generating units,
transmission and distribution control facilities, and the electric energy
management system have the potential to be affected by the year 2000 problem.
The company has inventoried both its and LIPA's electric system components and
developed a plan to certify mission critical processes as year 2000 compliant.
As manager of the transmission and distribution facilities, the Company is
responsible for ensuring that these facilities operate properly and that related
systems are year 2000 compliant. Under the terms of the various LIPA contracts,
LIPA will reimburse the Company for certain year 2000 costs incurred by the
Company for these facilities. Contingency plans are being developed, where
appropriate, for loss of critical system elements. The Company presently
estimates that contingency plans regarding its electric facilities should be
completed by July 1999.
Loss of telecommunications:
The Company has a substantial dependency on many telecommunication systems and
services for both internal and external communication providers. External
communications with the public and the ability of customers to contact the
Company in cases of emergency response is essential. The Company intends to
coordinate its emergency response efforts with the offices of emergency
management of the various local governments within its service territory.
Internally, there are a number of critical processes in both the gas and
electric operating areas that rely on external communication providers.
Contingency plans will address methods for manually monitoring these functions.
These contingency plans should be finalized by July 1999.
In addition to the above, the Company is also planning for the following
scenarios: short term reduction in system power generating capability;
limitation to fuel oil operations; reduction in quality of power output; loss of
automated meter reading; loss of ability to read customer meters, prepare bills
and collect and process customer payments; and loss of the purchasing/materials
management system.
29
The Company believes that, with modifications to existing software and
conversions to new hardware and software, the year 2000 issue will not pose
significant operational problems for its computer systems. However, if such
modifications and conversions are not made, or are not completed on time, and
contingency plans fail, the year 2000 issue could have a material adverse impact
on the operations of the Company, the extent of which cannot currently be
determined.
Cost of Remediation
The Company expects to spend a total of approximately $30.9 million to address
the year 2000 issue. As of October 31, 1998, $11.3 million had been expended on
the project. The largest percentage expended is attributable to the assessment,
repair and testing of corporate IT supported computer software and in-house
written applications, which totals $8.4 million. In 1998, year 2000 IT costs
represent 11.6% of the total IT budget. In 1999, the IT year 2000 costs are
expected to be 8.3% of the IT budget. The year 2000 issue has not directly
resulted in delaying any IT projects. Presently, the Company expects that cash
flow from operations and cash on-hand will be sufficient to fund the year 2000
project expenditures.
Risk Management
In addition to risk inherent in commodity fuel contractual arrangements, the
Company's utility, marketing and gas exploration and production subsidiaries
employ, from time to time, derivative financial instruments, such as natural gas
and oil futures, options and swaps, for the purpose of hedging exposure to
commodity price risk. The value at risk of the related positions as measured by
the maximum adverse price movement in a single day is not material.
Whenever hedge positions are in effect, the Company's subsidiaries are exposed
to credit risk in the event of nonperformance by counter parties to derivative
contracts, as well as nonperformance by the counter parties of the transactions
against which they are hedged. The Company believes that the credit risk related
to the futures, options and swap instruments is no greater than that associated
with the primary commodity contracts which they hedge, as the instrument
contracts are with major investment grade financial institutions, and that
elimination of the price risk lowers the Company's overall business risk. There
were no significant open hedge positions at September 30, 1998 and there
30
was no opportunity to establish acceptable hedging strategies during the
quarter.
New Financial Accounting Standards
The Financial Accounting Standards Board has recently issued the following
accounting standards that will be implemented by the Company: Statement of
Financial Accounting Standards No. 131, "Disclosure about Segments of an
Enterprise and Related Information" (SFAS No. 131); Statement of Financial
Accounting Standards No. 132, "Employer's Disclosures about Pensions and Other
Postretirement Benefits "(SFAS No. 132); and Statement of Financial Accounting
Standards No. 133, "Accounting for Derivative Instruments and Hedging
Activities" (SFAS No. 133).
The Company will adopt SFAS No. 131 and SFAS No. 132 for its current year end
reporting. The Company will adopt SFAS No. 133 in the first quarter of fiscal
year 2000. The Company does not expect any material effect from the adoption of
these statements.
Cautionary Statement Regarding Forward-Looking Statements
Certain statements contained in this Form 10-Q concerning expectations, beliefs,
plans, objectives, goals, strategies, future events or performance and
underlying assumptions and other statements which are other than statements of
historical facts, are forward-looking statements within the meaning of Section
21E of the Securities Exchange Act of 1934, as amended. These forward-looking
statements reflect numerous assumptions and involve a number of risks and
uncertainties and actual results may differ materially from those discussed in
such statements. Among the factors that could cause actual results to differ
materially are: available sources and cost of fuel; State and Federal regulatory
initiatives that increase competition, threaten cost and investment recovery,
and impact rate structures; the ability of the Company to successfully reduce
its cost structure; the successful integration of the Company's subsidiaries;
the degree to which the Company develops non-regulated business ventures; the
ability of the Company to identify and make complimentary acquisitions;
inflationary trends and interest rates; the ability of the Company and its
significant vendors to modify their computer software, hardware and databases to
accommodate the year 2000; and other risks detailed from time to time in other
reports and other documents filed by the Company and its predecessors with the
Securities and Exchange Commission. For any of these statements,
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the Company claims the protection of the safe harbor for forward- looking
information contained in the Private Securities Litigation Reform Act of 1995,
as amended.
32
Part II. Other Information
Item 1. Legal Proceedings
Subsequent to the closing of the LIPA Transaction and KeySpan Acquisition,
former shareholders of LILCO commenced 13 class action lawsuits in the New York
State Supreme Court, Nassau County, against one or more of LILCO, each of the
former officers and directors of LILCO and the Company. These actions were
consolidated in August 1998. The consolidated action alleges that in connection
with certain payments LILCO had determined were payable in connection with the
LIPA and KeySpan transaction to LILCO's chairman, and to former officers of
LILCO ("Payments") (1) the named defendants breached their fiduciary duty owed
to LILCO and KeySpan former and/or current Company shareholders as a result of
the Payments (2) the named defendants intended to defraud such shareholders by
means of manipulative, deceptive and wrongful conduct, including materially
inaccurate and incomplete news reports and filings with the Securities and
Exchange Commission; and (3) the named defendants recklessly and/or negligently
failed to disclose material facts associated with the Payments. The Company
moved to dismiss the consolidated complaint on September 28, 1998.
In addition, three shareholder derivative actions have been commenced pursuant
to which such shareholders seek the return of the Payments or damages resulting
from among other things, an alleged breach of fiduciary duty on the part of the
former LILCO officers and directors. One action was brought on behalf of LILCO
in federal court, and the other two actions were brought on behalf of the
Company in New York State Supreme Court, Nassau County.
A class action lawsuit has also been filed in the New York State Supreme Court,
Suffolk County, by the County of Suffolk against LILCO's former officers and/or
directors. The County of Suffolk alleges that the Payments were improper, and
seeks to recover the Payments for the benefit of Suffolk County ratepayers.
Finally, two class action securities suits were filed in federal court alleging
that certain officers and directors of LILCO violated the federal securities
laws by failing to properly disclose that the transactions with LIPA and KeySpan
would trigger the Payments. The Company expects that these actions will be
consolidated.
The Company believes the allegations in the suits are entirely without merit,
and is determined to defend the actions vigorously. Under the terms of the LIPA
Agreement, the Company has assumed all indemnification obligations LILCO may
have to its former officers and directors and has agreed to indemnify LILCO for
certain
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liabilities relating to LILCO's activities prior to the closing of the LIPA
Transaction, including the activity relating to the Payments.
In addition, certain related proceedings have been commenced relating to the
Payments and disclosures made by LILCO with respect thereto. These proceedings
include investigations by the New York State Attorney General, the New York
State Public Service Commission and LIPA, joint hearings conducted by two
committees of the New York State assembly, and an informal, non-public inquiry
by the Securities and Exchange Commission. At this time the Company is unable to
determine the outcome of these proceedings, or any of the lawsuits described
above.
In October 1998, the County of Suffolk and the Towns of Huntington and Babylon
commenced an action against LIPA, the Company, the PSC and others in the United
States District Court for the Eastern District of New York (the "Huntington
Lawsuit"). The Huntington Lawsuit alleges, among other things, that LILCO
ratepayers (i) have a property right to receive or share in the alleged capital
gain that resulted from the LIPA Transaction (which gain is alleged to be at
least $1 billion); and (ii) that LILCO was required to refund to ratepayers the
amount of a Shoreham-related deferred tax reserve (alleged to be at least $800
million) carried on the books of LILCO at the consummation of the LIPA
Transaction. The Company has not yet been formally made a party to this
proceeding and is currently unable to determine the effect, if any, this
proceeding will have on its financial condition or results of operations.
Item 5. Other Information
Acquisition of 50% Interest in Gulf Canada Resources Limited
On November 3, 1998, the Company announced that it had reached an agreement
under which it will acquire, through its subsidiary KeySpan Energy Development
Corporation, a 50 percent interest in Gulf Canada Resources Limited's midstream
business in western Canada and will form a partnership with Gulf Canada called
"Gulf Midstream Services Partnership (GMS)". The new business will offer a full
range of midstream services, from wellhead to natural gas marketers and
producers in western Canada. GMS's assets will include interests in 14
processing plants and associated gathering systems. The facilities can process
approximately 1.4 billion cubic feet of natural gas daily, of which the
partnership's share is approximately 750 million cubic feet per day. GMS will
also have a natural gas liquids fractionation, storage and transportation
facilities in Edmonton, a major natural gas liquids
34
hub. GMS will be a major marketer of natural gas and natural gas liquids in
western Canada. Closing of this transaction is subject to a number of conditions
including completion of certain due diligence requirements, receipt of required
third party approvals or the waiver or expiration of certain rights and the
preparation of satisfactory documentation.
The Company will pay Gulf approximately US$ 189 million, subject to adjustment.
In addition, the Company will provide a three-year US$ 65 million loan on
commercial terms that at Gulf's option can be repaid or exchanged by the Company
for an additional interest in GMS (currently anticipated to equal 19.7%). The
Company has agreed to fund Gulf's share of certain discretionary capital
expenditures in GMS for the next three years up to a maximum of approximately
US$ 78 million, in exchange for a proportionate increased share of GMS's cash
flow.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
(10a) Indenture of Trust dated as of December 1, 1997 by and between New
York State Energy Research and Development Authority (NYSERDA) and The
Chase Manhattan Bank, as Trustee, relating to the 1997 Electric
Facilities Revenue Bonds (EFRBs), Series A.
Participation Agreement dated as of December 1, 1997 by and between
NYSERDA and Long Island Lighting Company relating to the 1997 EFRBs,
Series A.
(10b) Employment Agreement dated September 10 1998, between the Company and
Robert B. Catell.
(27) Financial Data Schedule on Schedult UT.
(b) Reports on Form 8-K
On August 5, 1998, the Company filed a Current Report on Form 8-K providing
disclosure under Item 5 applicable to the following:
(1) the resignation of Dr. William J. Catacosinos as Chairman and Chief
Executive Officer and as a director, and the election of Robert B.
Catell to succeed Dr. Catacosinos
35
as Chairman and Chief Executive Officer;
(2) the authorization of the Board of Directors to purchase up to 10% of
the Company's outstanding common stock, or approximately 15 million
shares, through open market purchases;
(3) the announcement that a subsidiary of the Company, KeySpan Energy
Development Corporation, had joined Duke Energy Corporation and the
Williams Companies in developing the Cross BaySM pipeline, which will
transport gas from existing interstate pipelines in New Jersey to New
York City and Long Island.
On September 11, 1998, the Company filed a Current Report on Form 8-K, as
amended on September 22, 1998 and September 29, 1998, providing disclosure under
Items 4, 5 and 8 applicable to the following:
(1) the appointment of Arthur Andersen LLP as independent public
accountants for the Company for its fiscal year ending December 31,
1998;
(2) the appointment of certain officers of the Company;
(3) authorization to amend the Company's Certificate of Incorporation and
By-Laws to provide that the Company would have principal offices in
each of Nassau County and Kings County; and confirmation of existing
By-law provisions relating to the timing of the annual meeting and
certain shareholder related procedural matters for the annual meeting
and proxy statement;
(4) authorization to permit the Company to conduct its business under the
name KeySpan Energy;
(5) creation of certain committees of the Board of Directors and
designation of certain members of such committees; and
(6) the change in the Company's fiscal year end to December 31.
36
MARKETSPAN CORPORATION AND SUBSIDIARIES
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on behalf of the undersigned
there unto duly authorized.
MARKETSPAN CORPORATION
(Registrant)
Date November 16, 1998 s/ Craig G. Matthews
----------------------
Craig G. Matthews
Executive Vice President and
Chief Financial Officer
Date November 16, 1998 s/ Ronald S. Jendras
---------------------
Ronald S. Jendras
Vice President, Controller and
Chief Accounting Officer
37